Most of us are relatively conservative when it comes to determining how much we can afford to spend in retirement. All things being equal, we would rather die with too much money than too little. Apparently, however, some researchers are worried that we may not be spending anywhere near enough and should buy life annuities to rectify that situation. In their recent article, researchers Drs. David Blanchett and Michael Finke reach several conclusions, including:
- “Individuals tend to view money held in savings accounts differently than wealth held in the form of income.”
- “Retirees spend a much higher percentage of their annuitized income and spend about half the amount that they could safely spend from non-annuitized wealth.”
- “Our results provide evidence that retirees bracket wealth held in investments differently than wealth held as income and consequently spend less than would be optimal in a life-cycle model.”
- “Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income”, and
- “Less knowledgeable and risk-averse retirees may be particularly prone to underspending [since?] out of fear of depleting wealth.”
As a result of their research, they argue for implementation of policies that incentivize (or default to) the annuitization of retirement wealth.
We are solid fans of using lifetime income (Social Security, pensions and life annuities) to fund essential expenses in retirement, and we encourage users of the Actuarial Approach to fund the present value of their essential expenses with the present value of their non-risky assets in a “Floor Portfolio” bucket. We are not big fans, however, of using these non-risky assets to fund the present value of expected discretionary expenses, as the expected return on such non-risky assets is generally lower than the expected return on risky assets. Therefore, even though we are not financial advisors, we have no problem encouraging retirees to aggressively fund their expected discretionary expenses with risky asset investments in their “Upside Portfolio” bucket.
Our position on using risky assets to fund discretionary expenses appears to be at odds with the recommendations of Drs. Blanchett and Finke. Not a problem. While we have great respect for these gentlemen, this is not the first time that we will have to agree to disagree with them.
The purpose of this post is to provide assistance to readers who aren’t necessarily interested in buying more life annuities than they need to cover their essential expenses, but would like to maximize their spending to the extent possible without leaving an unintended large estate when they pass (assuming their demise does not occur earlier than expected). We will also include an example.
Using Funded Status and a Surplus Bucket to Increase Spending During Retirement
This is what we suggest to increase spending in retirement: If your beginning-of-year Funded Status exceeds 150% (or 140% if you are more aggressive), you can transfer from your Upside Portfolio Bucket to a “Surplus Bucket” an amount equal to the amount that would reduce your beginning-of-year Funded Status to 150%. The Surplus Bucket would be a low-interest rate account that could be readily accessed (like a checking account), and would not be considered part of the household’s assets once transferred (for Funded Status calculation purposes). The purpose of the Surplus Bucket would be to hold funds designed to be spent over a relatively short period, including possibly taxes on the amount transferred from the Upside Portfolio Bucket. This Surplus Bucket transfer calculation is easy to do (iteratively) in the Actuarial Financial Planner by simply entering an amount in one of the non-recurring expense rows, 0 for the period of delay 1 for the payment period and noting the impact on the calculated Funded Status.
By transferring amounts from the Upside Portfolio bucket to the Surplus Bucket, the household would acknowledge that these funds are “surplus” funds that should be spent over some reasonable period of time in order to maximize spending and avoid leaving an unintended large bequest.
Example
Steve and Edie retired on January 1, 1995. They were both age 65. Steve’s Social Security benefit was $12,000 per annum and Edie’s was $6,000 (one-half of Steve’s). Steve defined benefit pension was $15,000 per annum payable for his life. They also had assets of $300,000 invested 100% in equities. Steve and Edie estimated their annual recurring essential expenses (including taxes) to be $25,000 per annum and their annual recuring discretionary expenses to be $10,000 per annum. They planned to spend $10,000 per annum on vacations until they both reached age 80 (considered to be 100% discretionary).
To calculate Steve and Edie’s January 1, 1995 Funded Status, their Social Security benefits were assumed to increase each year with inflation. Steve’s pension was a fixed dollar amount payable for his life. Their expenses were also assumed to increase with inflation each year. They assumed that the equity in their fully-paid home would cover their long-term care needs if necessary.
Based on a 6% non-risky investment return assumption, an 8% risky investment return assumption 3% inflation and the current AFP lifetime planning period default assumptions, they calculated their January 1, 1995 Funded Status using the Actuarial Financial Planner to be 110.40%.
Projection assumptions: We projected Steve and Edie’s Funded Status calculations each year from January 1, 1995 to January 1, 2025 using the following projection assumptions: The household Social Security benefits and expenses were increased each year by the actual Social Security COLA increase for the year. Their equity investments were assumed to earn the actual return for the S&P 500 for each year. They were assumed to live each year and spend exactly the amounts inputted at the beginning of the year for their expenses. Whenever their beginning of year Funded Status exceeded 150%, they were assumed to transfer funds to their Surplus Bucket to approximately bring their Funded Status down to around 150%. In 2002, the assumed non-risky investment return valuation assumption was lowered from 6% to 5%. In 2008, the assumed non-risky investment return assumption/inflation assumption was lowered from 5%/3% to 4%/2.5%, and in 2023, it was increased to 5%/3%.
Projection Results: As of January 1, 2025 when both Steve and Edie were 95 years old, Steve’s Social Security benefit was $25,303, Edie’s was $12,652 and Steve’s pension was still $15,000. Their annual recurring essential expenses were $52,711 and their annual discretionary expenses were $21,080. They no longer budgeted for vacation expenses (as initially planned). Their January 1, 2025 assets were $475,491 and over the years, they had transferred over $1,000,000 to their Surplus Bucket to spend as they desired. They transferred money to their Surplus Bucket in all but 8 years of their retirement (the first 4 years when their Funded Status was less than 150%, 2003, 2004, 2009 and 2010 when their Funded Status dipped below 150%. As of the beginning of 2025, they transferred $90,000 to their Surplus Bucket and their Funded Status was 156.58%. They still had their home equity and any unspent Surplus Bucket assets to use to fund any long-term care and funeral expense needs.
The largest drop in their Funded Status (which treats any transfers to the Surplus Bucket as spending) was years 2000 to 2003 when it decreased by a total of 26%. So, if their Funded Status was 150% as of January 1, 2000 (which it wasn’t because they transferred less than the full amount they could for 2002), it would have dropped to about 111% as of January 1, 2003. Therefore, at no time during the projection period were Steve and Edie required to decrease their budgeted discretionary spending, and if they had been required to do so, they probably could have simply dipped into their Surplus Bucket at the time, assuming they hadn’t spent all of it (which might have been tough for them to do).
From about 2008 on, the present value of Steve and Edie’s non-risky assets ceased to cover the present value of their essential expenses (because of Steve’s fixed dollar amount life annuity). They could have purchased additional annuity amounts to cover the difference, but again, their likely unspent Surplus Bucket would have more than covered the relatively small emerging shortfall.
If they spent most of the money in their Surplus Bucket on items that were meaningful to them, Steve and Edie were successful in managing their spending and retirement experiences and for the most part, avoided leaving an unintended large legacy.
Summary
We have no reason to question Drs. Blanchett and Finke’s research concluding that less knowledgeable and risk-averse retirees may be particularly prone to underspending out of fear of depleting wealth. It is our hope, however, that by using a better metric (Funded Status) than typically used by financial advisors or other 4% Rule advocates, and perhaps using the Surplus Bucket approach, our more knowledgeable readers can overcome this fear and better manage their spending to achieve their goals. Further, the example in this post clearly shows that if future equity returns duplicate returns over the past 30 years (which we are told we shouldn’t assume), the potential for greater returns and spending maximization is much more likely to occur with a significant portion of household retirement funds in equities rather than a preponderance in annuities.