Efficient Retirement Design--Combining Private Assets and Social Security to Maximize Retirement Resources

John B. Shoven and Sita N. Slavov
Stanford Institute for Economic Policy Research (SIEPR)
http://siepr.stanford.edu/system/files/shared/documents/Efficient_Retirement_Design-March_2013b.pdf
  
The authors conclude "with today's life expectancies and today's extremely low interest rates, it is almost to everyone's interest to delay the commencement of Social Security.  For many people, it is the value maximizing strategy."  The authors also discuss value-maximizing strategies for when to claim benefits for two-earner couples, and suggest that individuals consider delaying commencement of Social Security benefits either by spending other accumulated assets after retirement and before Social Security commencement, by continuing to work, or through a combination of the two.  An excellent read for anyone who has not yet commenced Social Security benefits (or who is still able to defer their Social Security benefit commencement date).

Readers are reminded that this website contains a simple spreadsheet that enables retirees to model using their accumulated savings to "bridge" the period between retirement and commencement of Social Security benefits while attempting to maintain constant total spendable income in real dollars.

Plan on Living to 95

In my previous post, I referred once again to withdrawal strategy risk--the risk of either withdrawing too much or too little each year.  If we only knew when we were going to die, planning would be so much easier.  Some retirees believe that it is sufficient and appropriate to base withdrawals on their current life expectancy.  As we will see in this post, the very significant downside of this strategy is that withdrawals may not keep pace with inflation (or may even decrease in dollar amount) if you have the good fortune of outliving the life expectancy you used for planning purposes when you first retired.  Based on the Society of Actuary mortality tables, it is much more prudent to assume that you will live to your mid-90s (unless you have already reached your 90s) rather than use published life expectancies when developing your spending budget.

The exhibits below are based on Society of Actuaries Annuity-2000 male mortality tables with mortality projection.  These tables are available in this website at this link.  In both exhibits, the hypothetical retiree is assumed to have $500,000 at retirement at age 65 and desires to have constant real dollar withdrawals throughout retirement.  In the first exhibit, the individual retiring at age 65 assumes he will live exactly the number of years equal to his life expectancy (in this case 21.9 years).  Every fifth year thereafter he adjusts his spending plan based on his revised life expectancy.  His assets are assumed to grow at 5% per year and inflation is assumed to be 3% per year.  He is assumed to use the methodology outlined in this website for his withdrawal strategy with no other annuity income and no amounts left to heirs at death.

The first exhibit shows that if he lives to age 80, his annual withdrawal will only be 75% of his initial withdrawal in real dollar terms and if he lives to age 85, his annual withdrawal will only be about 54% of his initial withdrawal in real dollar terms.

By contrast, if his withdrawal strategy is such that he can live with a 30% chance of outliving his savings (by assuming that he will die at age 93 for the first 15 years, 94 if he makes it to 80 and 95 if he makes it to 85), he will be able to keep his spending constant in real dollar terms for 15 years.  Even if he takes this more conservative approach, however, he is still at risk of lower real dollar withdrawals after age 80.  But arguably he may be in a better position at his advanced ages to live with decreased real dollar retirement income.

According to the Society of Actuaries tables, Females generally have a 30% chance of living to approximately 95 until they reach age 80, at which time their expected age at death increases past age 95 in much the same way as anticipated for males.

Marketwatch, July 2, 2013

3 reasons retirees don’t spend
Adam Wolf

In my March, 2010 article describing the actuarial process set forth in this website, I discussed several risks associated with not sufficiently annuitizing accumulated retirement savings.  I talked about withdrawal strategy risk-- the risk of either withdrawing too much or too little each year.  Most experts focus on the risk of withdrawing too much, but in this article, Mr. Wolf focuses on the risk of withdrawing too little.

I agree with Mr. Wolf that, "Knowing your options can help you enjoy the retirement you saved so hard to provide for."  And knowing the options of How Much Can I Afford To Spend In Retirement is what this website is all about.

Risky Business:  Living Longer Without Income for Life
(American Academy of Actuaries, June 19, 2013)

A discussion paper released by the American Academy of Actuary’s Lifetime Income Risk Joint Task Force. "The discussion paper focuses on the issue of ensuring retirees secure income that lasts their entire lifetime and discusses potential solutions through changes in education, plan design, and federal retirement policy."

"What can be done to lower these [unnecessarily high hurdles to finding the right lifetime income solutions] and better prepare current and future retirees to secure and manage their lifetime income needs."

It is nice to see the Academy taking action on this important topic.

The discussion paper advocates expanding financial literacy and education for prospective retirees, refocusing plan design on lifetime income needs and implementing Federal retirement policies to support lifetime income needs.

While I believe that investing some or all of a retiree's accumulated retirement savings in a life insurance annuity product can be part of a reasonable retirement strategy, it appears to me that the discussion paper over-emphasizes the use of these products relative to other approaches.  While managed structured-income payments are briefly mentioned as a source of lifetime income, the paper points out that such approaches are not guaranteed, and they are not included as part of the paper's discussion of potential solutions through changes in education, plan design and federal retirement policy.

While a good start, I would like to see the Academy take a broader view of the potential solutions to the problems facing current and future retirees.  My specific recommendations to the Academy in this regard include:

1. The Academy should acknowledge that retirees may want to use some or all of their accumulated savings to provide for their retirement income needs through a structured series of payments rather than through guaranteed lifetime income insurance products.  And, those who make this choice need better guidance than the 4% withdrawal rule set forth in the discussion draft.  As I have indicated countless times, I believe the actuarial approach recommended in this website is one such better approach, particularly if the retiree wishes to coordinate the structured series of payments with other fixed annuity income.
2. Lifetime income products that provide fixed dollar payments do provide payments for life (and therefore appear to address one of the paper's definitions of Lifetime Income Risk), but those payments will be eroded by future inflation.  Therefore, income may become inadequate over time (and may not address another of the paper's definitions of Lifetime Income Risk).  Communication of such fixed dollar amounts in defined contribution plans may be misleading because it can overstate real dollar income throughout retirement and it may also be misleading if participants do not elect to purchase an annuity at retirement.  The Academy may wish to consider these factors when discussing this issue with policymakers.
3. Retirement planning generally does not end at retirement.  It is an ongoing process involving periodic assessment of many factors.  Education changes and potential solutions proposed by the Academy should address this reality.
4. As noted in the discussion paper, the risk pooling argument in favor of investing in insured annuities is compelling.  But this argument must also be weighed against anti-selection and profits built into insurance company pricing.  The Academy may wish to explore ways to make these items more transparent to consumers.
5. Given its relationship with the insurance industry, the Academy may wish to consider exploring whether it should be disclosing a potential conflict of interest when discussing the pros and cons of life insurance annuity products in accordance with Precept 7 of the profession's Code of Conduct.
    

The Consequences of Saving Too Much for Retirement
David Ning (US News, May 29, 2013)

"The future is unknown, so it's always good to be conservative with your money, but you can go too far. Make a carefully thought out plan to make sure you're saving enough, but don't save too much. Money isn't just for hoarding, it’s for spending too."

I agree with Mr. Ning. It is critical, however, to make sure that you are indeed on track to "save enough" before you decide that you have saved too much and you should be spending more.
The table below might help you determine whether you are on track or not. It shows the approximate multiple of final year's pay in accumulated savings needed to provide real dollar annual income during retirement that is expected to replace a specific percentage of your income prior to retirement (when added to income from Social Security). This table is based on the methodology set forth in the article in this website entitled How Much Accumulated Savings Will I Need To Replace My Pre-Retirement Standard of Living? and the following assumptions:

1. Social Security Normal Retirement Age 66
2. Social Security will replace 28% of final pay at assumed retirement age/benefit commencement age of 65 and 39.6% of final pay at assumed retirement age/benefit commencement age of 70 and will be increased by inflation of 3% per year after assumed retirement/benefit commencement.
3. Investment return on accumulated savings of 5% per annum after retirement. Inflation increases of 3% per annum.
4. No other sources of retirement income (other than accumulated savings and Social Security)
5. Death occurs at age 95
6. No amounts intended to be left to heirs on death
   

These are just approximate amounts of accumulated savings needed based on the assumptions above.  Changing any of these assumptions would change the multiples needed.   For example, if a person had defined benefit income or had fixed annuity income, the amounts needed would be reduced.  In addition, if a person decided to purchase a life annuity with some or all of her accumulated savings at retirement, multiples of pay needed may be less as insurance company pricing is based on an assumption of death closer to average life expectancy.  In addition, Social Security benefits may replace lower or higher percentages than assumed for this table.

But the bottom line is that if you don't have other significant pension income and you want to approximately maintain your standard of living in retirement, you probably don't need to be terribly concerned about the problem of "over-saving" until your accumulated savings start to exceed something like ten times your current compensation.

Achieving a Higher Safe Withdrawal Rate with the Target Percentage Adjustment 
David M. Zolt (Journal of Financial Planning)

Nice article by Mr. Zolt, who is a financial planner and another member of the Society of Actuaries.

"A much higher initial withdrawal rate than previously thought possible can be achieved without increasing the probability of failure as long as the retiree reduces or eliminates the inflation increase for years indicated by the Target Percentage™.   The Target Percentage is developed and used to determine whether the portfolio is ahead of or behind target at any point during retirement. If the portfolio is ahead of target, the full inflation increase is taken in that year. If the portfolio is behind target, the inflation increase for that year is reduced or eliminated."

I like the approach suggested by Mr. Zolt because it is not as static ("set and forget" as defined by Wade Pfau) as the traditional safe withdrawal rate method.  Adjustments to withdrawals are made (as frequently as annually) to take into account "good" and "bad" years and to keep the spending plan from veering off the tracks.

Note that Mr. Zolt's approach (or something similar) can easily be accomplished using the suggested process and spreadsheet found on this website.  As an example, let's assume that a retiree would like to have a higher initial withdrawal rate and is comfortable with future increases of CPI minus 1% rather than full CPI increases.  Let's further assume that she believes the best estimate assumptions for future experience are 5% annual investment return, 3% per year inflation and a 30-year withdrawal period.  Also assume no annuity income and no bequest motive.    The retiree runs the New and Improved Spending Calculator on this site with her best estimate assumptions which determines an initial withdrawal rate of 4.34%.  She doesn't like that rate and determines that she can live with lower inflation protection (1% per year less), so she inputs 2% annual desired increases in the spreadsheet (but retains the 3% inflation assumption to measure the potential effect on future inflation-adjusted withdrawals).  This yields an initial withdrawal rate of 4.92%, which is much more to her liking (about 13% higher compared with Mr. Zolt's 10%).  She also looks at the inflation-adjusted runout tab on the spreadsheet and sees that if experience is exactly as assumed, her withdrawals will decrease in inflation adjusted dollars (by almost 25% in year 30).

As discussed in the original March, 2010 article in this website, our hypothetical retiree needs to employ an algorythm (rules) to adjust for actual experience and changes in assumptions and other input items each year.   She likes Mr. Zolt's basic approach so she decides that she will use the following rules to determine subsequent year's withdrawals:

1. If the preliminary withdrawal rate falls inside the "corridor", she will increase her withdrawal amount for the previous year by CPI-1%
2. If the preliminary withdrawal rate falls above the high end of the corridor, she will increase her withdrawal amount for the previous year by the full CPI.
3. If the preliminary withdrawal rate falls below the low end of the corridor, she will withdraw the greater of i) the average of the preliminary withdrawal rate and the expected withdrawal rate or ii) the same dollar amount withdrawn for the previous year (i.e., no CPI increase).

For this purpose, the preliminary withdrawal rate is the rate produced by running the spreadsheet at the beginning of the year based on assumptions and new asset data as of that date (and presumably continuing with desired increases of CPI minus 1%), the expected withdrawal rate is the rate for year two shown in Column M of the previous year's run-out tab and the corridor could be something like 95% to 105% of the expected withdrawal rate.

Note that I am not necessarily advocating this approach.  I'm only illustrating that something similar to what Mr. Zolt suggests can be accomplished with the tools set forth in this website.

Mr. Zolt has graciously provided the following spreadsheet for those who would like to build their own target percentages. [Target_Percentage_Calc_2013_05_24.xls]

Want a Happy Retirement?  Don't Just Guess About What You'll Need 
Chuck Saletta (DailyFinance, May 13, 2013)

"In its research, EBRI found that people who either used online retirement calculators or who worked with financial advisers were far more prepared to have a successful retirement than those who didn't. On the flip side, those who relied primarily on guessing at how much they'd need to cover their expenses wound up far worse prepared for their retirement than the typical person."

Not sure that the EBRI research actually measured happiness, but the conclusions in this article are 100% consistent with the themes expressed in this website--In these days when individuals are much more responsible for their own retirement, you need to do the retirement math--you need to crunch your numbers based on your financial situation.  And how much you can spend in retirement is just the other side of the retirement planning coin of how much you need to save to replace your pre-retirement standard of living.

DoL Proposes to Include "Lifetime Income Illustrations in Benefit Statements

DoL Proposes to Include "Lifetime Income Illustrations in Benefit Statements
(Groom Law Group, May 9, 2013)

The Department of Labor recently published an Advance Notice of Proposed Rulemaking (ANPRM) soliciting comments on their proposals to mandate inclusion of lifetime income illustrations for 401(k) plan participants and other defined contribution plans.  This Groom Law Group summary is a good explanation of the proposed changes to current requirements.

Here is a link to the DoL's ANPRM
http://www.gpo.gov/fdsys/pkg/FR-2013-05-08/pdf/2013-10636.pdf

Here is our response to the ANPRM
http://howmuchcaniaffordtospendinretirement.webs.com/EBSA_benefit_statement_proposals.pdf

Is the 4% Rule Folly?
(AdvisorOne, April 29, 2013)

Another excellent article by Michael Finke, professor and coordinator of the doctoral program in personal financial planning at Texas Tech University debunking the 4% Rule.  Mr. Finke criticizes the "shortfall analysis" used to develop the 4% Rule and concludes that use of this rule by individuals or advisors has a tendency to result in a more conservative spending strategy than necessary.  Mr. Finke says, "That money in the bank [at death] over and above the desired legacy is the money left on the table in the game of retirement living."

Finke refers to a 2008 study by Olivia Mitchell and others which estimated, "that the average retiree could improve expected happiness in retirement by as much as 50% by adopting a blended annuitization and investment strategy."

Participants Need a Retirement Income Plan
(Plan Sponsor, May 2, 2013)

I agree with Bryan Hodges that, "Individuals need a process for converting their resources into income in retirement."  He proposes a six step process that is more "holistic" (more comprehensive and more focused on pre-retirement planning) than the actuarial process to determine a spending budget in retirement described in this website.  For further discussion of holistic retirement planning, readers may find this link to be helpful.
http://www.cabourneandassoc.com/news/hp2.html

Mr. Hodges also refers to "sequence of return" risk.  Dr. Wade Pfau has a nice explanation of this term in a recent post.
http://www.marketwatch.com/story/retirement-the-sequence-of-returns-2013-02-08