This post is a follow-up to our post of September 2, 2023, Manage Your Financial Risks in Retirement Like an Actuary, and is in response to the following recent quote from a well-known retirement researcher, “The No. 1 risk in retirement, hands down, is longevity risk.”
Risk/Assumptions in the Aggregate/Potential Impact on the Household Funded Status
If we define retirement risk as the need to either increase household assets or decrease household spending liability in the future as a result of actual future experience being less favorable than assumed experience in the aggregate, then risk will depend on the household’s
- Plan
- Ages
- Funded Status, and
- Assumptions for the future
If assumptions about the future (explicit and implicit) are realized in the aggregate and are unchanged, the household’s Funded Status is expected to remain approximately unchanged from year to year.
The assumptions used to measure household assets and spending liabilities for planning purposes include explicit expectations with respect to:
- lifetime planning periods,
- timing of future planned expenses (separated into recurring and non-recurring as well as essential and discretionary),
- increases in future planned expenses,
- timing and amounts of future lump sum or streams of income payments, and
- returns on invested assets.
In addition to these explicit assumptions, more implicit assumptions may include:
- No future changes in Social Security law or in other sources of income,
- No future marital dissolution or early death of a spouse, and
- No spending in excess of budgeted spending
If planning assumptions or expectations about the future are wrong in the aggregate (and they will be), we must be prepared to make adjustments in our spending or somehow increase our assets to keep our finances in balance. And, unfortunately, a lot can potentially go wrong with personal financial assumptions. For example,
- We may live longer than our expected lifetime planning periods
- The value of assets/investments we own may decrease or not increase as expected
- Our long-term care or other medical expenses may be more costly than we assumed
- The household member with greater lifetime income assets may die early or we may divorce,
- Our taxes or our premiums for various types of insurance may increase faster than expected
- Our future Social Security benefits may be reduced (or not fully indexed with inflation)
- Higher than assumed Inflation may make some or all our planned expenses higher than assumed,
- Our investments may experience periods of lower-than-expected returns
- We may suffer uninsured losses or be a victim of fraud,
- We, or other members of our family, may experience emergencies requiring unexpected expenses, or
- We may, for whatever reason, simply spend more than we thought we would
The events described above (and potentially others) will generally either increase household spending liabilities relative to household assets or decrease assets relative to spending liabilities. In response, if negative experience is not balanced by positive experience, the household may have to reduce planned spending, increase household assets or will have to temporarily dip into rainy-day funds to keep spending liabilities in approximate balance with assets.
Risk/Individual Assumptions/Impact on Funded Status
Since favorable experience with respect to one assumption can balance the negative experience with respect to a different assumption, we don’t normally focus on individual assumption risks but that is certainly possible to do using the Actuarial Financial Planner models available in our website. All that is required is to simply change one default assumption at a time and measure the impact on the plan’s baseline Funded Status.
For this post, we determined the baseline Funded Status for a 62-year-old male retiree with $1,000,000 of accumulated savings (60% of which was assumed to be invested in non-risky assets and 40% in risky assets), a Social Security benefit of $20,000 per annum and the following expected expenses:
- Annual essential expenses, increasing with inflation: $45,000
- Annual discretionary expenses, increasing with inflation: $15,000
- Annual fixed dollar discretionary expenses: $5,000
We used the current default assumptions to determine his baseline Funded Status for this person to be 105.87%
If we increased the default lifetime planning period (LPP) assumption from 32 years to 40 (a 25% increase) and made no other assumption changes, his calculated Funded Status would decrease from 105.87% to 97.26%
By comparison, if we increased each of the above expected expenses by 25% and used the default assumptions, his Funded Status would decrease from 105.87% to 84.69%
Clearly, if expenses are increased by 25% because of inflation or just because of overspending, this would have a larger impact on our hypothetical retiree’s Funded Status than a 25% increase in his assumed lifetime planning period.
Note that the effects of either increasing the LPP by 25% or expenses by 25% would be larger if the change in assumptions were delayed to a later year, but the increase associated with the 25% increase in expenses would still be expected to be larger than the increase in lifetime planning period. The reason for this is that the increase in lifetime planning period also increases our hypothetical retiree’s present value of assets by extending Social Security benefit payments, thus mitigating this increase somewhat.
Summary
Assumptions about the future will not be exactly realized. Differences between actual future experience and assumed future experience create potential risks. That is why it is important to monitor your Funded Status from year to year to observe the trend and make assumption changes (or spending changes) when necessary. The Lifetime Planning Period is an important assumption in this process, but it is not the number 1 risk in retirement, hands up or hands down.
