In their recent post of May 18, 2022, Michael Kitces and Kitces.com are once again trying to convince us all that their “Risk-Based Guardrails (RBG) Model” is a better tool for retirement planning than the typical monte carlo models used by most financial advisors. In their post, they argue that while the “gamification power” of monte Carlo modeling can change household behavior, “the rules of the game can become more clear and easier for clients to follow when we make this shift” [to a RBG model.]
We last discussed the Kitces RBG Model in our post of November 28, 2021. In that post, we indicated that while we agreed that moving to the RBG model was a step in the right direction, we believed that their model is both more complicated and less robust than our Actuarial Financial Planner (AFP) model, and we provided a functionality comparison of the two models. We will not repeat that functionality comparison here, but if you are interested, you can reread our post of November 28, 2021.
Rather than toot our own horn again in this post, we are going to let one of today’s preeminent retirement thought-leaders indirectly do it for us.
In his excellent Advisor Perspectives article, Eight Core Ideas to Guide Retirement Income Planning, retirement researcher Dr. Wade Pfau discusses “Eight key messages and themes [that] have underscored [his] writing and research. Those guidelines serve as a manifesto for [his] approach to retirement income planning.”
While we believe that our Actuarial Financial Planner is consistent with all eight of Dr. Pfau’s core ideas, in this post we are going to focus on just one--Core Idea #7, which we consider the foundational retirement planning principle.
Dr. Pfau describes Core Idea #7 as follows:
- Start with the household balance sheet. A retirement plan involves more than just financial assets. The household balance sheet is the starting point for building a retirement income strategy. This has been a fundamental lesson from various retirement frameworks, such as Jason Branning and M. Ray Grubbs’ Modern Retirement Theory, Russell Investments’ Funded Ratio approach and the Household Balance Sheet view of the Retirement Income Industry Association. At the core of these different methodologies is a desire to treat the household retirement problem in the same way that pension funds treat their obligations. Assets should be matched to liabilities with comparable levels of risk. This matching can either be done on a balance sheet level, using the present values of asset and liability streams, or it can be accomplished on a period-by-period basis to match assets to ongoing spending needs. Structuring the retirement income problem in this way makes it easier to keep track of the different aspects of the plan and to make sure that each liability has a funding source. This also allows a retiree to more easily determine whether they have sufficient assets to meet their retirement needs, or if they may be underfunded with respect to their goals. This organizational framework also serves as a foundation for deciding on an appropriate asset allocation and for seeing clearly how different retirement income tools fit into an overall plan.
The following table provides a basic overview of potential assets and liabilities on the household balance sheet.
In this post we will break down the major thoughts in Dr. Pfau’s Core Idea #7 above and discuss how the AFP satisfies each one.
Start with the Household Balance Sheet. With this sub-heading, Dr. Pfau is telling us that the household balance sheet (which we call the Actuarial Balance Sheet) is the starting point or foundation for financial planning. He reinforces this thought in the second sentence, “The household balance sheet is the starting point for building a retirement income strategy.” One of the primary outputs of the AFP model is an actuarial balance sheet that compares household assets and spending liabilities.
A retirement plan involves more than just financial assets. For budgeting and investment allocation purposes, the AFP considers all household assets that may be used for retirement. These include financial assets and non-financial assets like Social Security, pensions and life annuities.
At the core of these different methodologies is a desire to treat the household retirement problem in the same way that pension funds treat their obligations. Not surprisingly, the AFP is based on the same basic actuarial principles we used as pension plan actuaries to help pension plan sponsors determine plan funding requirements. Note that these basic principles generally involved the use of deterministic assumptions, not stochastic assumptions or monte carlo modeling.
Assets should be matched to liabilities with comparable levels of risk. This is a key concept in the AFP where floor portfolio assets invested in non-risky investments are used to fund essential spending liabilities and upside portfolio assets invested in riskier investments are used to fund discretionary spending liabilities. The AFP uses present values of assets and spending liabilities to perform this matching.
Structuring the retirement income problem in this way makes it easier to keep track of the different aspects of the plan and to make sure that each liability has a funding source. The AFP quantifies the present values of non-recurring and recurring planned spending and compares these present values with the present values of household assets committed to fund such spending.
This also allows a retiree to more easily determine whether they have sufficient assets to meet their retirement needs, or if they may be underfunded with respect to their goals. The AFP provides two comparisons for this purpose: 1) Are total floor portfolio assets sufficient to fund the present value of essential spending and 2) Are total assets sufficient to fund the present value of total planned spending. The magnitude of the Rainy -Day Fund provides an indication of how much surplus or deficit may exist in the current household spending plan.
This organizational framework also serves as a foundation for deciding on an appropriate asset allocation and for seeing clearly how different retirement income tools fit into an overall plan. The AFP helps users determine how much of their assets should be invested in non-risky assets and how much in riskier assets. It does this by quantifying the value of non-risky investments like Social Security and pensions. It can also show the possible effect on the current plan of purchasing an annuity, delaying Social Security commencement, increasing investment in riskier assets, etc.
Conclusion
A good retirement plan should serve as a plan of action for achieving your spending goals in retirement. It should help you decide what actions you will take in the future if (for example):
- your assets do not grow as much as you assume,
- inflation is more than you expect,
- you live longer than you expect,
- your spouse dies
- your Social Security benefits are reduced,
- your desire to spend on discretionary items decreases as you age,
- your children need financial help,
The Actuarial Financial Planner is a relatively uncomplicated tool that can help you plan in retirement. And for those who actually read the Kitces article and want more “gamification power,” the AFP has it in spades. Simply change the input data or assumptions in the input section and the AFP will instantaneously provide a revised actuarial balance sheet and new current year spending budget. And, as recently added, it will also provide you an estimate of your end of year accumulated savings so that you can monitor your progress between actuarial valuations and take appropriate actions if desired.
We encourage you to play with the AFP to see how results change when input items are changed.
Happy planning!
