Thanks to Kitces.com and Justin Fitzpatrick for once again informing financial advisors and retired DIYers that there are better metrics and processes for managing spending in retirement than the probability of success/failure metric typically used in Monte Carlo modeling. Mr. Fitzpatrick’s thoughts are summarized in the section of the August 23-24 Weekend Reading For Financial Advisors titled, Reframing “Risk In Retirement As ‘Over- And Under-Spending’ To Better Communicate Decisions To Clients, And Finding A "Best Guess" Spending Level.”
Monte Carlo models touted by financial advisors are good one-and-done projection models that can show ranges and probabilities of future results based on assumptions about the future. However, these stochastic models don’t predict the future any better than deterministic models and, more importantly, they generally don’t provide a process for changing your plan when the future turns out to be different than assumed.
The Actuarial Approach recommended in this website uses a simple, easy-to-understand Funded Status metric that measures when you may be over-spending or under-spending. It also provides a robust process for managing your assets and spending liabilities in retirement to help you adjust your plan over time to better accomplish your goals. We have previously recommended the following easy-to-follow guardrails be used to manage your assets and spending liabilities in retirement.
Asset Management Guardrails
Asset/Liability Comparison | Recommended Action |
PV Non-Risky Assets less than PV Essential Expenses | Consider Increasing Non-Risky Assets and/or decreasing expenses classified as Essential |
PV Non-Risky Assets greater than PV Essential Expenses | Consider increasing risky assets and/or increasing expenses classified as Essential |
Funded Status less than 95% | Consider increasing assets and/or decreasing spending liabilities |
Spending Management Guardrails
Asset/Liability Comparison | Recommended Action |
Funded Status less than 95% | Consider decreasing spending liabilities and/ or increasing assets |
Funded Status greater than 120% | Consider spending increases |
Funded Status greater than “Surplus” threshold percentage (e.g., 150%); | A “Nudge” For households who may be “behaviorally resistant” to increasing spending even when warranted: Consider transfer from Upside Portfolio to Surplus Bucket to reduce Funded Status to surplus threshold percentage |
Self-Correcting Process
The Actuarial Approach is a self-correcting process in that if actual future experience (including actual future spending vs. budgeted future spending) is less favorable than assumed future experience in the aggregate, the retired household’s Funded Status will decrease over time. If actual experience is more favorable than assumed, the household’s Funded Status will increase over time. If you want to be more conservative (i.e., have a higher probability of not having to decrease spending in retirement, you can simply use more conservative assumptions to determine your Funded Status and/or you can choose a higher “spend-more” guardrail.
Don’t like the Default Assumptions in the Actuarial Financial Planner?
Some advisors or DIYers believe that the default assumptions in the Actuarial Financial Planner are too conservative. They believe they can increase client spending by using more aggressive assumptions from their Monte Carlo models. This line of thinking is irrational. Assumptions don’t determine how much a household can afford to spend in retirement. They only determine the timing of such spending.
It is a relatively easy process to change one or more of the assumptions used to determine a household’s Funded Status to make the asset/liability comparison less conservative (or more in line with assumptions the advisor may be using for Monte Carlo modeling). Of course, using more aggressive assumptions simply increases the probability than downward spending adjustments may be required in the future.
Summary
The Actuarial Approach is a simpler, easier to understand, more flexible and more robust approach than typical Monte Carlo approaches used today by financial advisors. Isn’t it time to ditch Monte Carlo modeling with its probabilities of success/failure and embrace the more robust Actuarial Approach? At a minimum, you should give it a serious try.
