In prior posts, we’ve discussed the three M’s that constitute the actuarial process for keeping your spending in retirement on track and consistent with your spending goals:
- Measuring your Funded Status each year
- Monitoring your Funded Status from year to year, and
- Making changes in your assets or spending liabilities when your Funded Status falls outside a reasonable corridor (guardrails).
In this post, we will discuss two more M’s: Periodically Measuring and Managing your financial risks. If you have completed Steps 1 and 2 above and are contemplating increases in your spending plan this year, we suggest that now may be a good time to measure and possibly manage your financial risks before implementing your plan.
2023 and 2024 were good years for equity returns, with returns on the S&P 500 index exceeding 20% in each year. Despite higher-than-expected essential expense costs, many retirees may be looking at beginning-of-year 2025 Funded Statuses in excess of 140% and may be contemplating increasing their spending for 2025 as a result. We don’t necessarily want to pour cold water on reasonable spending increases, but we do suggest that you take the time to kick the tires on your plan to see how it will hold up under possible less-favorable-than assumed future experience.
Let’s take a look a some “stress-tests” you may wish to consider to measure your risks. All of these tests can be relatively easily performed using the Actuarial Financial Planner (AFP) workbook.
Less favorable than assumed investment return
The Shiller Price to Earnings Ratio as of January 10 was almost 37. This compares with the historical mean for this measure of 17.2. Thus, it is reasonable to assume that future equity returns may be lower than historical averages. To stress-test less favorable than assumed investment returns on equities, you can override and reduce the current default 8% per annum assumption on risky assets and/or you can reduce the value of your current equity holdings (by 50%?) to see what the possible impact would be on your Funded Status.
Possible risk management tip: If the present value of your current non-risky assets/investments don’t cover the present value of your essential expenses, you might consider increasing your asset allocation to non-risky assets/investments. You may also wish to consider maintaining a higher Rainy-Day Fund for this risk.
Higher than assumed future inflation
We have no crystal ball with respect to future inflation. Government deficits continue to increase, but the incoming president has promised to reduce the cost of groceries and gas, reduce taxes, deport illegal immigrants, increase tariffs, etc. Climate change is likely to negatively affect the price of home insurance and/or home prices. To stress-test for higher inflation, you can override the current default inflation assumption of 3% per annum, increase expected rates of increases on various expense items and/or increase your current input estimates for selected expenses. If you rely on your home equity to fund a significant portion of your retirement, you may wish to stress-test the impact of losing some or all of your home equity.
Possible risk management tip: If you are looking to manage inflation risk in expenses and are also looking to increase investments in non-risky assets, you may wish to consider building a TIPs ladder or, if possible, you can also defer commencement of your Social Security benefits. Investment in equities has historically been a good inflation management investment. You may also wish to maintain a higher Rainy-Day Fund for this risk.
Lower than assumed future Social Security benefits
At some point in the relatively near future, Social Security is going to need an infusion of more income to keep paying promised benefits. In lieu of saddling current workers with the entire burden of making the system solvent, Congress may decide to reduce benefits for some current and future beneficiaries. If no action is taken, current best-estimate actuarial projections show an initial 17% decrease across the board for beneficiaries in 2035, but this was before passage of the Social Security Fairness Act of 2025, so it is likely that the 2025 Trustees Report will show an earlier trust fund exhaustion date. Of course, it is likely that Congress will take action prior to the trust fund exhaustion date, but it is not clear whether earlier action will result in potentially higher or lower benefit reductions for certain beneficiaries.
To stress test for lower than assumed future Social Security benefits, you can input a negative amount in an “other asset” cell with a deferred starting date or you can simply reduce your current Social Security benefits to see what the impact is on your Funded Status.
Possible risk management tip: You may wish to consider buying an annuity with a deferred commencement date to cover the expected decrease in your benefits or you may simply maintain a higher Rainy-Day Fund to address this risk.
Conclusion
Despite experiencing significant levels of inflation, many retirees are better off financially than they were several years ago and may be considering increases in their spending plan as a result. We don’t want to be “Debby Downers”, here, and we certainly don’t know what the future will be, but you may wish to stress test some of your assumptions before committing to those spending increases.
