Actuaries use models, dynamic processes and periodic risk assessments to measure and manage risks for financial systems. The same basic actuarial principles and processes used by actuaries for other financial systems can be applied to the problem of how much a retired household can afford to spend in retirement.
In his January 3, 2023 Advisor Perspectives article, fellow Fellow of the Society of Actuaries and friend, Pete Neuwirth, describes risks faced by retired households during “decumulation.” He concludes his article by saying:
“The fundamental nature of decumulation is different from accumulating sufficient assets to provide for a sustainable retirement. While the extensive body of investment and asset-allocation theory developed over the last 50 years is applicable, decumulation is more of a risk management problem where actuarial science should be brought to bear.
At its core, decumulation is an asset-liability and cashflow matching problem governed by random variables from unruly and difficult to determine probability distributions. It will take researchers in both the investment and actuarial professions to make progress.”
I agree.
Risk
Actuarial Standard of Practice (ASOP) No. 51 defines “risk” as follows:
“The potential of actual future measurements deviating from expected future measurements resulting from actual experience deviating from actuarially assumed experience.”
As a pension actuary, I told my clients that together we would select our best assumptions about the future, but they also needed to be prepared when those assumptions turned out to be wrong. The same advice applies to retirees and near-retires in their financial planning.
In Step 7 of our Recommended Financial Planning Process, we recommended that users (or financial advisors)
“…periodically model deviations from assumed experience by stress-testing significant assumptions for the purpose of modifying your plan to mitigate risks.”
As noted by Mr. Neuwirth, assumptions made in an AFP valuation involve more than just the explicit inputted assumptions with respect to future investment returns, longevity and inflation. Other more implicit assumptions may also include:
- No reductions in future Social Security benefits,
- No marital dissolution,
- No spending in excess of inputted expenses and/or inputted increases in those expenses,
- No earlier-than-expected cessation of employment, if applicable
It will also make sense to periodically stress-test these more implicit assumptions from time to time to consider risk mitigation strategies.
For more discussion of assessing and mitigating financial risks in retirement using the AFP, feel free to read (or re-read) my post of May 3, 2022.
Conclusion
Yes, retirement is a risky business. Mr. Neuwirth states in his article that:
“Decumulation remains a very hard problem – one with no “closed form” solution and where research has been very limited. It seems unlikely that a comprehensive general strategy can be developed to address all four risks [unique to decumulation] for everyone or even most people who are developing financial plans for their retirement years.”
I’m going to gently push back on Pete’s statement. I believe that using the annual AFP valuation process (with corridors as suggested in our post of January 7, 2023) and periodic stress-testing of explicit and implicit assumptions used in the AFP is a relatively easy solution to this “very hard problem” that can facilitate development of robust risk mitigation strategies for most retirees.
