In light of ever-increasing flat dollar premiums charged by the Pension Benefit Guaranty Corporation, changes in the IRS mortality tables used to determine minimum lump sum values scheduled for 2016 and other reasons, more defined benefit plan sponsors are likely to settle some or all of their pension plan liabilities in 2015. Settlement of pension liabilities generally involves transfer of the liability to an insurance company (through annuity purchase), lump sum window offers to participants or a combination of the two approaches. This post will provide a process that retirees can use to evaluate some of the financial implications associated with a lump sum buyout option and will illustrate the process with an example. Note that the recommended “number crunching” that follows applies equally to a pension plan participant who is retiring (or near retirement) and is being given an option to take a lump sum in lieu of a lifetime income form of payment.
Many articles have been written about the pros and cons of taking lumps sums in lieu of promised pension annuity payments. Even though pension plan participants have been choosing between lifetime income and lump sums for years, this issue gathered significant media attention several years ago when both GM and Ford opened lump sum buyout windows to some of their plan participants who had already retired. The Pension Rights Center has a web page with several articles generally encouraging retirees to reject the lump sum option.
In general, I agree with the experts who encourage retirees to stay with the annuity (payable either from an insurance company or from the plan) rather than take the lump sum. The advantages of doing so are clearly set forth in the Pension Rights Center material (and elsewhere). But, interest rates to determine lump sums are currently very low, and retirees may be legitimately tempted by the amount of the lump sum offer they may be eligible to receive and roll over to an IRA. As a retired actuary, I am always interested in crunching numbers before I make important decisions. If you receive a lump sum buyout offer, I encourage you to get some annuity quotes and use the Excluding Social Security spreadsheet on this website to give yourself some additional financial “data points” so that you can properly make your decision.
To illustrate the approach I would use, let’s assume we have a single male 65 year old retiree named Rick with accumulated savings of $500,000, a $24,000 annual pension and an annual Social Security benefit of $20,000. Rick used the spreadsheet on this website and the newly revised assumptions to develop a spending budget for 2015 (assuming zero bequest motive) of $59,523 ($15,523 from savings, $24,000 from pension and $20,000 from Social Security). Shortly thereafter, Rick receives a lump sum buyout offer of $327,200 in lieu of his life annuity payment of $24,000 per year. What should he do?
Recalculate Spending Budget
The first thing Rick does is go back to the spreadsheet to see what the impact would be on his 2015 spending budget if he had an additional $327,200 in accumulated savings (by taking the lump sum and rolling it over to his IRA) but no pension income. Under the recommended assumptions, these changes would produce a $55,985 spending budget ($35,985 from accumulated savings plus $20,000 from Social Security). Rick then plays around with the spreadsheet to determine what additional investment return he would have to earn on the lump sum amount or decreased payment period would make up for the $3,538 decrease in his spending budget. He determines that he would have to earn an additional 2% real rate of return (or approximately a 4% real annual rate of return) on the lump sum or reduce his expected payout period with respect to the lump sum by about 8 years.
Determine Cost of Immediate Annuity
The next thing Rick does is see how this lump sum offer compares with approximately how much it would cost to purchase an annuity that provides the same level of benefit as his pension. He goes to Immediateannuities.com and (as of February 18, 2015) determines that the approximate purchase price of an annuity providing $2,000 per month for him commencing next month is about $363,600 (he lives in California), or about 11% higher than the lump sum offer. If he were serious about buying an annuity with the lump sum (or if his pension annuity were not a single life annuity), he would need to obtain an actual quote. However, the information from this website is reasonably sufficient to tell Rick that the lump sum offer is probably less than the market value (or purchase price) of his pension annuity. Note that if Rick were a female, the immediateannuities.com quote is currently about 20% higher than the $327,200 lump sum offer. Since pension plan lump sum offers are based on unisex mortality assumptions (and will therefore be equal in amount for males and females of the same age with the same benefits) and annuity rates from insurance companies are higher for females than males, a pension lump sum offer will almost always be more favorable for males than females when measured as a percentage of the market value of the annuity.
Determine Cost of Deferred Annuity and Consider Partial Annuity/Partial Self Investment Approach
By looking at approximate immediate annuity costs, Rick has determined that he probably cannot take the lump sum, roll it over to an IRA and buy an immediate annuity that replaces the benefit provided by his pension. This is not terribly surprising since if an immediate annuity could be purchased for less than the lump sum cost, the plan sponsor could simply settle Rick’s pension liability at less expense by purchasing the annuity itself. Rick wonders, however, if he can elect the lump sum, roll it over to an IRA, buy a deferred annuity (also referred to as a longevity annuity or QLAC), with a portion of the lump sum and invest the remainder of the lump sum and come out ahead. He goes back to the immediateannuity website and enters “20” years for commencement of the $2,000 per month annuity. As of February 18, the amount shown to purchase this deferred annuity is $63,776. So he can spend $63,776 to replace the pension annuity payments he would have received from his pension starting at age 85 and invest the remaining $263,424 ($327,200 minus $63,776). He goes back to the “Excluding Social Security” spreadsheet and enters $763,424 in accumulated savings, $0 immediate annuity, $24,000 deferred annuity and a 20 year deferral period. Under this scenario (and recommended assumptions), his 2015 spending budget would be $57,243 ($37,243 from accumulated savings plus $20,000 from Social Security). This budget amount is more than the budget determined above with no annuity income, but less than the original 2015 budget with his pension. Rick can play around with the assumptions in the spreadsheet to see what real interest rate or expected payout period would close the gap. Again, if Rick were serious about pursuing this route, he would probably get an actual annuity quote.
Based on his thorough analysis which included the calculations above, Rick decided to keep his pension annuity. Your decision may be different based on your analysis and the amount of the lump sum you are offered. But, as always, if you are doing this analysis on your own, I encourage you to crunch your numbers and think about the three major assumptions (investment return, inflation and longevity) used in the calculations. A decision with respect to a lump sum offer could be one of the most important financial decisions you make in retirement.
Wednesday, February 18, 2015
Saturday, February 14, 2015
Recommended Assumptions for 2015—Part II
Since our post of October 11, 2013, we have been recommending use of a 5% investment return assumption and a 3% inflation assumption when using the simple spreadsheets on our website to develop a spending budget. These recommended assumptions were loosely tied to estimated assumptions “baked into” an annuity purchase rate of approximately $600 per month for a single premium of $100,000 (or $167 per each $1 of monthly income) for a 65-year old male obtained from the Incomesolutions.com website back in the Fall of 2013.
Annuity purchase rates have become more expensive since October 11, 2013. In our post of December 3, 2014, we recommended staying with the 5% investment return and 3% inflation assumptions for 2015 budget determinations even though the annuity purchase rate for a 65-year old male had increased to $571 per month per $100,000 of premium (or $175 per each $1 of monthly income). As of February 5, 2015, however, the monthly annuity purchase rate for a 65-year old male per $100,000 had increased to $549 (or $182 per each dollar of monthly income). To maintain a more comparable relationship between investment in annuities and investment in other securities, we now recommend using a 4.5% investment return assumption and a 2.5% inflation assumption for budget determinations. We continue to recommend an expected payout period equal to 95 minus current age, or life expectancy if greater.
This change in recommended assumptions should have very little impact on budget determinations for retirees with little or no fixed income annuity/pension income. It will, however, have a more significant impact for those with significant amounts of fixed income annuity/pension income or for those who are considering purchasing an annuity with some of their accumulated savings.
Annuity purchase rates have become more expensive since October 11, 2013. In our post of December 3, 2014, we recommended staying with the 5% investment return and 3% inflation assumptions for 2015 budget determinations even though the annuity purchase rate for a 65-year old male had increased to $571 per month per $100,000 of premium (or $175 per each $1 of monthly income). As of February 5, 2015, however, the monthly annuity purchase rate for a 65-year old male per $100,000 had increased to $549 (or $182 per each dollar of monthly income). To maintain a more comparable relationship between investment in annuities and investment in other securities, we now recommend using a 4.5% investment return assumption and a 2.5% inflation assumption for budget determinations. We continue to recommend an expected payout period equal to 95 minus current age, or life expectancy if greater.
This change in recommended assumptions should have very little impact on budget determinations for retirees with little or no fixed income annuity/pension income. It will, however, have a more significant impact for those with significant amounts of fixed income annuity/pension income or for those who are considering purchasing an annuity with some of their accumulated savings.
Wednesday, February 4, 2015
Don’t Focus on a Single Assumption When Determining Your Annual Withdrawal--All Three Matter
In his recent article, "How Retirement Plans Vastly Underestimate Inflation", Henry (Bud) Hebeler , states, "Almost every retirement planner has a default inflation rate of 3%. That can be a terrible mistake." He goes on to say, "[assuming 3% inflation is] just plain wrong considering post-World War II results as well as the way the Feds have been printing money and current jittery foreign economics. I personally believe that it would be a lot better if people used something like 4.5% which is a little more conservative than the post-World War II average."
I appreciate the passion expressed by Bud in his article, but as one who currently recommends a 3% inflation assumption, I feel obligated to push back on Bud on this one.
Readers of this site will know that the annual withdrawal rate determined under the Actuarial Approach, or most any other reasonable dynamic withdrawal approach is a function of three assumptions: (1) future asset investment return, (2) future inflation and (3) future longevity. To focus on one assumption while ignoring the other two, as Bud has done, is a fools game. I'm not going to argue with Bud about the wisdom of using historical inflation averages to project future experience in this different environment. He may be right, but that it not the point.
Yes, it is more conservative to assume higher levels of future inflation, all other things being equal, but higher assumed levels of inflation combined with even higher levels of assumed investment return and/or shorter life expectancies can produce withdrawal rates that are more aggressive (higher) than assumption combinations that involve lower assumed rates of inflation. If there are no other fixed income annuity/pension sources of income that need to be coordinated within the spending budget, it is generally sufficient to focus on real (after-inflation) levels of investment return, not nominal levels. In these situations, what should matter most to a retiree is the level of withdrawal produced by the combination of assumptions, not whether one of the three assumptions appears to be somewhat out of line with historical experience.
I am also a little surprised to see Bud fanning the inflation fires so quickly after writing his article of January 16, 2015 (discussed in our January 22 post), where he recommended withdrawals based on a 5% investment return, 3.5% inflation and IRS Publication 590 life expectancies. This combination of assumptions produced a 5.5% withdrawal rate for a 65-year retiree compared with the 4.3% withdrawal rate under the Actuarial Approach using the recommended combination of assumptions.
There is one summary statistic that a retiree can look at to obtain a measure of how conservative or aggressive her assumptions are in combination--the withdrawal rate for the current year produced by her withdrawal strategy (the amount to be withdrawn from accumulated savings divided by the beginning of year accumulated savings). The following table shows withdrawal rates produced by the Actuarial Approach under the 2015 recommended combination of assumptions at various ages (assuming no coordination with other fixed annuity/pension income and no bequest motive). Withdrawal rates at the indicated ages that are higher than those shown in the table are based on assumptions that are more aggressive in combination than the 2015 recommended assumptions. Withdrawal rates at the indicated ages that are lower than those shown in the table are more conservative in combination, all things being equal.
Having said the above, I will concede that if a retiree is developing a spending budget that involves coordinating significant amounts of fixed income annuity/pension income or real dollar bequest motive into her budget, the nominal accuracy (and not just the real relationship) of the assumptions for investment return and inflation can be important.
I appreciate the passion expressed by Bud in his article, but as one who currently recommends a 3% inflation assumption, I feel obligated to push back on Bud on this one.
Readers of this site will know that the annual withdrawal rate determined under the Actuarial Approach, or most any other reasonable dynamic withdrawal approach is a function of three assumptions: (1) future asset investment return, (2) future inflation and (3) future longevity. To focus on one assumption while ignoring the other two, as Bud has done, is a fools game. I'm not going to argue with Bud about the wisdom of using historical inflation averages to project future experience in this different environment. He may be right, but that it not the point.
Yes, it is more conservative to assume higher levels of future inflation, all other things being equal, but higher assumed levels of inflation combined with even higher levels of assumed investment return and/or shorter life expectancies can produce withdrawal rates that are more aggressive (higher) than assumption combinations that involve lower assumed rates of inflation. If there are no other fixed income annuity/pension sources of income that need to be coordinated within the spending budget, it is generally sufficient to focus on real (after-inflation) levels of investment return, not nominal levels. In these situations, what should matter most to a retiree is the level of withdrawal produced by the combination of assumptions, not whether one of the three assumptions appears to be somewhat out of line with historical experience.
I am also a little surprised to see Bud fanning the inflation fires so quickly after writing his article of January 16, 2015 (discussed in our January 22 post), where he recommended withdrawals based on a 5% investment return, 3.5% inflation and IRS Publication 590 life expectancies. This combination of assumptions produced a 5.5% withdrawal rate for a 65-year retiree compared with the 4.3% withdrawal rate under the Actuarial Approach using the recommended combination of assumptions.
There is one summary statistic that a retiree can look at to obtain a measure of how conservative or aggressive her assumptions are in combination--the withdrawal rate for the current year produced by her withdrawal strategy (the amount to be withdrawn from accumulated savings divided by the beginning of year accumulated savings). The following table shows withdrawal rates produced by the Actuarial Approach under the 2015 recommended combination of assumptions at various ages (assuming no coordination with other fixed annuity/pension income and no bequest motive). Withdrawal rates at the indicated ages that are higher than those shown in the table are based on assumptions that are more aggressive in combination than the 2015 recommended assumptions. Withdrawal rates at the indicated ages that are lower than those shown in the table are more conservative in combination, all things being equal.
Sunday, January 25, 2015
Forecasting Future Investment Experience--Please Use Monte Carlo Simulations Responsibly
Just after I finished yesterday's post, I received a question from a reader asking if I would consider doing a post on the latest article from Messrs. Blanchett, Finke and Pfau, "Retiring in a Low-Return Environment", and how the results of their latest research might affect use of the Actuarial Approach.
Since these three gentlemen consistently produce very good retirement research, I was more than happy to read their article. As it happens, I was pleased to see that their article generally reinforced the concerns I was expressing yesterday about the Monte Carlo simulations used in the "Perfect Withdrawal" post. They said,
"The generous capital market returns of the prior century bolstered a comfortable and long-lasting retirement portfolio. But they will give 21st-century clients a false sense of security and prejudice products and strategies that would do a better job of meeting retirement income goals."
This is not the first time these gentlemen have sounded the alarm about using historical rates of return and Monte Carlo modeling to develop safe withdrawal rates (SWRs) in the current economic environment. See my post of January 19, 2013 about their January 15, 2013 article, "The 4% Rule is Not Safe in a Low-Yield World." This new article supplements the older article with information supporting their assertion that future equity returns may also be lower than historical equity returns.
So, after depressing us all with their view of future investment returns, what do the authors recommend we retirees do other than use lower SWRs?
In terms of the question of what a low-return environment means if one is using the Actuarial Approach, my response is if you are using the recommended assumptions for 2015 (5% investment return, 3% inflation and a payout period of 95-current age, or life expectancy if greater) then you are already using assumptions that are consistent with a low-return environment and you don't necessarily need to change anything. The recommended assumptions are also consistent with the 2% real investment return assumption advocated by Dr. Pfau for deterministic projections. As I have indicated in previous posts, if you desire a more-front loaded spending budget pattern consistent with item 2 suggested above, you can use a lower assumption for inflation. For more discussion of the 2015 recommended assumptions, see our post of December 3 of last year.
If you are using the Actuarial Approach with assumptions that are significantly more aggressive than the recommended assumptions (or an approach that produces significantly higher current withdrawal rates), you either need to believe that these researchers are being unduly pessimistic about future investment returns or you need to be prepared to reduce your future spending.
Since these three gentlemen consistently produce very good retirement research, I was more than happy to read their article. As it happens, I was pleased to see that their article generally reinforced the concerns I was expressing yesterday about the Monte Carlo simulations used in the "Perfect Withdrawal" post. They said,
"The generous capital market returns of the prior century bolstered a comfortable and long-lasting retirement portfolio. But they will give 21st-century clients a false sense of security and prejudice products and strategies that would do a better job of meeting retirement income goals."
This is not the first time these gentlemen have sounded the alarm about using historical rates of return and Monte Carlo modeling to develop safe withdrawal rates (SWRs) in the current economic environment. See my post of January 19, 2013 about their January 15, 2013 article, "The 4% Rule is Not Safe in a Low-Yield World." This new article supplements the older article with information supporting their assertion that future equity returns may also be lower than historical equity returns.
So, after depressing us all with their view of future investment returns, what do the authors recommend we retirees do other than use lower SWRs?
- Rather than plan on living until age 95, plan on living your life expectancy and hedge longevity risk by purchasing a deferred income annuity.
- Plan on decreased levels of spending as you age and be more flexible in terms of accepting decreased spending levels if investment experience is not as favorable as expected.
In terms of the question of what a low-return environment means if one is using the Actuarial Approach, my response is if you are using the recommended assumptions for 2015 (5% investment return, 3% inflation and a payout period of 95-current age, or life expectancy if greater) then you are already using assumptions that are consistent with a low-return environment and you don't necessarily need to change anything. The recommended assumptions are also consistent with the 2% real investment return assumption advocated by Dr. Pfau for deterministic projections. As I have indicated in previous posts, if you desire a more-front loaded spending budget pattern consistent with item 2 suggested above, you can use a lower assumption for inflation. For more discussion of the 2015 recommended assumptions, see our post of December 3 of last year.
If you are using the Actuarial Approach with assumptions that are significantly more aggressive than the recommended assumptions (or an approach that produces significantly higher current withdrawal rates), you either need to believe that these researchers are being unduly pessimistic about future investment returns or you need to be prepared to reduce your future spending.
Saturday, January 24, 2015
The Perfect Withdrawal Amount?
Recently two faculty members of the Trinity University Department of Finance and Decision Sciences and an independent financial advisor released a paper entitled, "The Perfect Withdrawal Amount: A Methodology for Creating Retirement Account Distribution Strategies." From my perspective, the approach set forth in this paper has many positives and a few potential negatives. Not surprisingly, I agree with aspects of the approach that are similar to the Actuarial Approach recommended in this website and generally disagree with the aspects of the approach that are dissimilar.
Items of Agreement. The authors recommend a (dynamic) process involving annual redetermination of the amount to be withdrawn based on accumulated savings, assumed rates of future return, age, risk preference and amount of bequest motive at time of redetermination. As I, the authors are critical of safe withdrawal approaches and variations of safe withdrawal approaches that incorporate "adaptive rules." The Actuarial Approach basically follows the same process recommended by the authors. In addition, it develops a budget that is coordinated with other annuity/pension income. In fact, it develops what the authors call a "Perfect Withdrawal Amount" (or perhaps "Better than Perfect" if the retiree has other fixed dollar annuity income) each year. The only difference is that the Actuarial Approach uses deterministic assumptions where risk preference is varied through the use of more or less optimistic assumptions for longevity, future investment returns and inflation. In addition, I recommend the use of a smoothing algorithm to keep budgets from being too "jumpy" from year to year.
Items of Disagreement. The authors model future investment experience using a Monte Carlo approach and the paper refers to historical equity performance from 1957 to 2013. It is not clear whether this data has been adjusted for inflation or to reflect the current economic environment. As I indicated in my post of July 15, 2014, while Monte Carlo modeling appears to be more sophisticated than deterministic projections, it is no better at projecting the future, and in fact could be much worse if the data is not properly adjusted. The authors use the period 1957 to 2013. As an example of how that period may not properly reflect the current economic environment, let's take a look at the prime rate charged by banks on short-term loans to businesses (available in Table H15 of the Federal Reserve System historical interest rates). Over the 33-year period of 1969 to 2001 (about 58% of the period used by the authors), the average prime rate was in excess of 9% per annum. By comparison, the rates for every year since 2008 have been 3.25%. Running a model 20,000 times with what could be questionable data does not give me a good feeling about the reasonableness of the projections. By comparison, the recommended investment return assumption for the Actuarial Approach is selected to be somewhat consistent with interest rates inherent in current fixed immediate annuities available on the market (with the understanding that higher investment returns generally come with higher levels of risk that should be discounted).
Bottom Line. Depending on the data used to model future experience, the author's approach may produce a reasonable annual withdrawal amount. Care should be taken to make sure that the effects of future inflation have been considered to the retiree's satisfaction. I would suggest comparing withdrawals under this approach with the withdrawals determined under the Actuarial Approach, with reasons for significant differences in results explained to the retiree.
Items of Agreement. The authors recommend a (dynamic) process involving annual redetermination of the amount to be withdrawn based on accumulated savings, assumed rates of future return, age, risk preference and amount of bequest motive at time of redetermination. As I, the authors are critical of safe withdrawal approaches and variations of safe withdrawal approaches that incorporate "adaptive rules." The Actuarial Approach basically follows the same process recommended by the authors. In addition, it develops a budget that is coordinated with other annuity/pension income. In fact, it develops what the authors call a "Perfect Withdrawal Amount" (or perhaps "Better than Perfect" if the retiree has other fixed dollar annuity income) each year. The only difference is that the Actuarial Approach uses deterministic assumptions where risk preference is varied through the use of more or less optimistic assumptions for longevity, future investment returns and inflation. In addition, I recommend the use of a smoothing algorithm to keep budgets from being too "jumpy" from year to year.
Items of Disagreement. The authors model future investment experience using a Monte Carlo approach and the paper refers to historical equity performance from 1957 to 2013. It is not clear whether this data has been adjusted for inflation or to reflect the current economic environment. As I indicated in my post of July 15, 2014, while Monte Carlo modeling appears to be more sophisticated than deterministic projections, it is no better at projecting the future, and in fact could be much worse if the data is not properly adjusted. The authors use the period 1957 to 2013. As an example of how that period may not properly reflect the current economic environment, let's take a look at the prime rate charged by banks on short-term loans to businesses (available in Table H15 of the Federal Reserve System historical interest rates). Over the 33-year period of 1969 to 2001 (about 58% of the period used by the authors), the average prime rate was in excess of 9% per annum. By comparison, the rates for every year since 2008 have been 3.25%. Running a model 20,000 times with what could be questionable data does not give me a good feeling about the reasonableness of the projections. By comparison, the recommended investment return assumption for the Actuarial Approach is selected to be somewhat consistent with interest rates inherent in current fixed immediate annuities available on the market (with the understanding that higher investment returns generally come with higher levels of risk that should be discounted).
Bottom Line. Depending on the data used to model future experience, the author's approach may produce a reasonable annual withdrawal amount. Care should be taken to make sure that the effects of future inflation have been considered to the retiree's satisfaction. I would suggest comparing withdrawals under this approach with the withdrawals determined under the Actuarial Approach, with reasons for significant differences in results explained to the retiree.
Thursday, January 22, 2015
Bud Hebeler's Autopilot Withdrawal Rule
I've been a big fan of Bud Hebeler and his Analyze Now website every since I retired and started this website. In fact, his website was one the first one I listed in the "Other Calculators/tools" section of this website.
Bud writes many articles about retirement, and is featured as one of the MarketWatch Retirementors. In his most recent article, Bud touts the virtues of a fairly simple method of determining annual withdrawals from savings he calls the "Autopilot" approach. While I don't think it is necessarily better than the Actuarial Approach advocated in this website, subject to the caveats discussed below, I do think that it can provide you with another point of reference with respect to the amount of your spending budget that may be withdrawn from accumulated savings.
Bud's autopilot approach involves taking 75% of last year's budgeted withdrawal increased with inflation for the previous year and adding 25% of what Bud calls the "Planning Method" (or Planner Method). Under the Planning Method, all you need is a calculator (like the HP 12c) or an internet financial planner with financial functions, and you solve for the annual annuity payment (PMT) given the period of payments (n), the interest rate (i) and the amount of accumulated savings (PV). Bud suggests using IRS Publication 590 life expectancy tables for "n" and an interest rate of 5% and inflation of 3.5%. Note, if you are using the HP 12c calculator, you will be doing the calculations assuming beginning of year payments and an interest rate of 1.45%.
Let's take a look at Bud's suggested withdrawal rate at age 65 where the IRS 590 life expectancy is 21 years. Bud's initial withdrawal rate at age 65 using the Planning Method would be about 5.5%. By comparison, the withdrawal rate under the Actuarial Approach (using recommended assumptions) is about 4.3%. The primary difference in the two approaches results from using life expectancy of 21 years under Bud's method vs. assuming a 30 year payment period under the Actuarial Approach. We discussed why you might not want to use life expectancies for your retirement planning period in our post of Wednesday December 3, 2014, but perhaps Bud feels his conservative investment return/inflation assumptions counterbalance this somewhat unconservative longevity assumption.
The Autopilot approach also uses a different technique to smooth actual experience and spending variations. If readers like Bud's smoothing approach better than the smoothing algorithm we recommend, you could simply replace the "Planning Method" result with the result from our Excluding Social Security spreadsheet and use a combination of the two approaches.
Caveats regarding the Autopilot rule:
Bud writes many articles about retirement, and is featured as one of the MarketWatch Retirementors. In his most recent article, Bud touts the virtues of a fairly simple method of determining annual withdrawals from savings he calls the "Autopilot" approach. While I don't think it is necessarily better than the Actuarial Approach advocated in this website, subject to the caveats discussed below, I do think that it can provide you with another point of reference with respect to the amount of your spending budget that may be withdrawn from accumulated savings.
Bud's autopilot approach involves taking 75% of last year's budgeted withdrawal increased with inflation for the previous year and adding 25% of what Bud calls the "Planning Method" (or Planner Method). Under the Planning Method, all you need is a calculator (like the HP 12c) or an internet financial planner with financial functions, and you solve for the annual annuity payment (PMT) given the period of payments (n), the interest rate (i) and the amount of accumulated savings (PV). Bud suggests using IRS Publication 590 life expectancy tables for "n" and an interest rate of 5% and inflation of 3.5%. Note, if you are using the HP 12c calculator, you will be doing the calculations assuming beginning of year payments and an interest rate of 1.45%.
Let's take a look at Bud's suggested withdrawal rate at age 65 where the IRS 590 life expectancy is 21 years. Bud's initial withdrawal rate at age 65 using the Planning Method would be about 5.5%. By comparison, the withdrawal rate under the Actuarial Approach (using recommended assumptions) is about 4.3%. The primary difference in the two approaches results from using life expectancy of 21 years under Bud's method vs. assuming a 30 year payment period under the Actuarial Approach. We discussed why you might not want to use life expectancies for your retirement planning period in our post of Wednesday December 3, 2014, but perhaps Bud feels his conservative investment return/inflation assumptions counterbalance this somewhat unconservative longevity assumption.
The Autopilot approach also uses a different technique to smooth actual experience and spending variations. If readers like Bud's smoothing approach better than the smoothing algorithm we recommend, you could simply replace the "Planning Method" result with the result from our Excluding Social Security spreadsheet and use a combination of the two approaches.
Caveats regarding the Autopilot rule:
- It assumes no bequest motive
- It does not coordinate with other sources of retirement income such as immediate or deferred pension/annuities
- As discussed above, it recommends the use of life expectancy. As the retiree ages, life expectancy (in years) will decrease but not by one year for each year of advanced age, so this approach will result in longevity experience losses that will decrease future withdrawals unless these losses are offset by other experience gains.
Thursday, January 1, 2015
Happy New Year—Time to Determine Your Spending Budget for 2015
It’s that time of year again to sit down to determine your spending budget for the upcoming year. Click here to read a short explanation of the Actuarial Approach.
The rest of this post will illustrate the Actuarial Approach for Richard Retiree, the hypothetical retiree we last looked in our post of December 27, 2013 when we developed a spending budget for him for 2014. Richard retired on December 31, 2012 at age 65. His spending budget for 2014 from accumulated savings and his annuity totalled $45,766 ($30,766 plus $15,000). To this amount, he added his Social Security benefit of $20,000 (new information) to get a total spending budget for 2014 of $65,766. His accumulated savings (not counting home equity of about $200,000) as of the beginning of 2014 was $884,909 with about half of this amount to be invested in equities and about half in fixed income securities.
In addition to receiving $20,000 of Social Security benefits and $15,000 of annuity payments during 2014, Richard’s accumulated savings earned $61,944. He spent $60,000 during 2014 ($5,766 less than his budget), so his total accumulated savings at the end of 2014 are $921,853 ($884,909 + $20,000 +$15,000 + $61,944 - $60,000). He is now age 67.
Richard’s Social Security benefit for 2015 will increase by 1.7% to $20,340. He decides to apply the same percentage increase to his 2014 spending budget to determine his preliminary 2015 spending budget from accumulated savings and annuity. This amount is $46,544 (1.017 X 45,766). He then goes to the Excluding Social Security V 2.0 spreadsheet in this website and enters his beginning of 2015 accumulated asset amount of $921,853 and the number of years until age 95 (28). All other input items are unchanged from the 2014 calculation. The resulting spendable amount based on this calculation is $52,790. 90% of this amount is $47,511. If Richard wanted to follow the recommended smoothing algorithm, his budget for 2015 would be the sum of this 90% corridor amount of $47,511 plus his new Social Security amount for 2015 of $20,340, or $67,851.
But Richard has been reading articles that have convinced him that he should be more conservative in his retirement budgeting, so he decides that he will segregate $100,000 of his accumulated savings into an “Emergency Use” fund that he will not consider as assets for normal spending purposes. Therefore, he reruns the spreadsheet with assets of $821,853 and the preliminary spending amount for 2015 (the 2014 amount increased by inflation is now within 10% of the revised spreadsheet amount of $48,215. Therefore, Richard decides to stay with $46,544 as his spending budget attributable to accumulated savings and annuity, to which he adds his Social Security benefit of $20,340 to obtain a total spending budget for 2015 of $66,884.
Richard is also concerned about investing 50% of his accumulated savings in equities. While investment in equities during the last two years has resulted in significant gains to him, he worries that he might not be able to cover his essential expenses if the markets suffer significant losses. He has determined that his essential expenses total about $55,000 per year (or about $34,660 from accumulated savings and annuity income). Using the Excluding Social Security V2.0, he determines that he will need accumulated savings of about $550,000 to meet his essential expenses. Therefore, he decides that he will change his asset investment mix of the $821,853 of accumulated savings not earmarked for emergency purposes to 33% equities and 67% fixed income securities. He understands that he also has his home equity in reserve in addition to his emergency fund if he should need to pay for long-term care or other healthcare emergencies. He is comfortable with a budget for 2015 that is almost 11% higher than the amount he actually spent for 2014.
The rest of this post will illustrate the Actuarial Approach for Richard Retiree, the hypothetical retiree we last looked in our post of December 27, 2013 when we developed a spending budget for him for 2014. Richard retired on December 31, 2012 at age 65. His spending budget for 2014 from accumulated savings and his annuity totalled $45,766 ($30,766 plus $15,000). To this amount, he added his Social Security benefit of $20,000 (new information) to get a total spending budget for 2014 of $65,766. His accumulated savings (not counting home equity of about $200,000) as of the beginning of 2014 was $884,909 with about half of this amount to be invested in equities and about half in fixed income securities.
In addition to receiving $20,000 of Social Security benefits and $15,000 of annuity payments during 2014, Richard’s accumulated savings earned $61,944. He spent $60,000 during 2014 ($5,766 less than his budget), so his total accumulated savings at the end of 2014 are $921,853 ($884,909 + $20,000 +$15,000 + $61,944 - $60,000). He is now age 67.
Richard’s Social Security benefit for 2015 will increase by 1.7% to $20,340. He decides to apply the same percentage increase to his 2014 spending budget to determine his preliminary 2015 spending budget from accumulated savings and annuity. This amount is $46,544 (1.017 X 45,766). He then goes to the Excluding Social Security V 2.0 spreadsheet in this website and enters his beginning of 2015 accumulated asset amount of $921,853 and the number of years until age 95 (28). All other input items are unchanged from the 2014 calculation. The resulting spendable amount based on this calculation is $52,790. 90% of this amount is $47,511. If Richard wanted to follow the recommended smoothing algorithm, his budget for 2015 would be the sum of this 90% corridor amount of $47,511 plus his new Social Security amount for 2015 of $20,340, or $67,851.
But Richard has been reading articles that have convinced him that he should be more conservative in his retirement budgeting, so he decides that he will segregate $100,000 of his accumulated savings into an “Emergency Use” fund that he will not consider as assets for normal spending purposes. Therefore, he reruns the spreadsheet with assets of $821,853 and the preliminary spending amount for 2015 (the 2014 amount increased by inflation is now within 10% of the revised spreadsheet amount of $48,215. Therefore, Richard decides to stay with $46,544 as his spending budget attributable to accumulated savings and annuity, to which he adds his Social Security benefit of $20,340 to obtain a total spending budget for 2015 of $66,884.
Richard is also concerned about investing 50% of his accumulated savings in equities. While investment in equities during the last two years has resulted in significant gains to him, he worries that he might not be able to cover his essential expenses if the markets suffer significant losses. He has determined that his essential expenses total about $55,000 per year (or about $34,660 from accumulated savings and annuity income). Using the Excluding Social Security V2.0, he determines that he will need accumulated savings of about $550,000 to meet his essential expenses. Therefore, he decides that he will change his asset investment mix of the $821,853 of accumulated savings not earmarked for emergency purposes to 33% equities and 67% fixed income securities. He understands that he also has his home equity in reserve in addition to his emergency fund if he should need to pay for long-term care or other healthcare emergencies. He is comfortable with a budget for 2015 that is almost 11% higher than the amount he actually spent for 2014.
Tuesday, December 16, 2014
Milevsky Probability of Portfolio Ruin Calculator
Thanks to Dirk Cotton for the shout-out in his December 5 post, Think Like a Bayesian Pig. Another excellent post from Mr. Cotton, and the comments that follow his post are also very worthwhile reading.
At the bottom of his post, Dirk provides a link to a 2005 paper by Moshe A. Milevsky and Chris Robinson, and in the comment section, he provides a link to the Milevsky Probabililty of Portfolio Ruin Calculator.
I must admit that the work done by Milevsky and Robinson was unfamiliar to me. So, thanks to Dirk for bringing it to my attention. While the paper is somewhat technical, the Probability of Ruin Calculator associated with the paper is not all that complicated, and it turns out to be a very powerful tool in my opinion. I was so impressed with it that I am including it in the "Other Calculators/Tools" section of this website. I believe that that the Milevsky tool can provide retirees and financial planners with another valid point of reference (in addition to the approach recommended in this website and other approaches) to be used in developing a spending budget, particularly if the retiree has no other fixed dollar sources of retirement income (like fixed dollar pensions/annuities) or significant bequest motives. The remainder of this post will discuss the Milevsky/Robinson approach and how I think it can best be used for budgeting in retirement under certain circumstances.
Milevsky/Robinson Approach
As opposed to the deterministic approach for investment returns and expected payout periods baked into the simple spreadsheet provided on this website, Milevsky and Robinson advocate an approach that successfully reflects the fact that both investment rates of return and the time until death are stochastic in nature (have certain probability distributions). By making certain assumptions about the probability distributions, they develop probabilities of sustainable real dollar spending rates for various combinations of life expectancy, expected real rates of return and portfolio risk (measured by the standard deviation of the distribution of returns).
When using Milevsky's Probability of Portfolio Ruin Calculator, the user should note that the expected portfolio rate of return (an arithmetic mean over the remaining lifetime) input is a real (after-inflation) percentage. Thus, the expected rate of return comparable to the real rate recommended in this website is 2% (which is approximately the real rate implied by a 5% per annum nominal investment return and 3% per annum inflation). Also note that the spreadsheet anticipates inputting a whole number of years remaining in retirement equal to the retiree's remaining life expectancy. Inputting expected rate of return, portfolio standard deviation, withdrawal rate (a percentage of accumulated savings at the current age with such product increasing by inflation in subsequent years) and remaining life expectancy at the current age, the spreadsheet produces a probability of ruin (running out of money prior to death) and it's complement (not running out of money prior to death).
Keeping in mind that since there is approximately a 50% probability of outliving one's life expectancy, any probability of ruin less than 50% means that the retiree is more likely than not to die before running out of money (assuming no future changes in spending occur). A probability of ruin of 25% means that the retiree is about three times more likely (75%/25%) than not to die before running out of money (assuming no future change in spending occur). Since many retirees are almost as worried about not spending enough as those who are worried about spending too much, it does not bother me to develop a spending budget based on a 25% probability of ruin. As I have previously indicated in this website, developing a spending budget for retirement is a "balancing act." It is also important to note that the term "ruin" here may be a misnomer and may more appropriately be considered as a probability that real dollar spending may need to be reduced in the very later years of life as a result of living well beyond one's life expectancy. This possibility may not be a disaster, but may actually be more consistent with studies that show declining spending needs at older ages.
I compared results of the Milevsky's Probability of Portfolio Ruin Calculator (using assumptions described below) with the results of the simple spreadsheet in this website (Excluding Social Security V 2.0) using the recommended assumptions. If I input a 2% real expected rate of return in Milevsky's spreadsheet, 5% standard deviation, male life expectancy based on the average of the 2010 Social Security and 2012 Individual Annuity Mortality Tables available on the Society of Actuaries website (a link to which resides in the "Other Calculators/Tools" section of this website) and solve for the withdrawal rate that produces approximately a 25% probability of "ruin", I come very close to the withdrawal rates produced using the Excluding Social Security V 2.0 spreadsheet and the recommended assumptions at most ages. There is some significant deviation at the very older ages, as I recommend using life expectancy if age plus life expectancy is greater than 95. When I reach my late 80's I may switch to the Milevsky approach depending on how concerned I become at that point about outliving my savings. Females, who have longer life expectancy, may also wish to look at the Milevsky approach when they reach their mid-80s.
Those of you out there who play with this spreadsheet may find it of interest that inputting a 4.4% withdrawal rate and 20-year life expectancy and an 8% withdrawal rate and 9 year life expectancy will produce about a 25% probability of ruin for each of the following combinations of expected real investment return/standard deviations: 2%/5%, 3%/11.5%, 4%/15.5%, 5%/19%, 6%/21.7% and 7%/24.5%. This result shows that achieving higher real rates of return by taking on more risk may not increase your retirement budget.
How to best use the Milevsky Spreadsheet (In My Opinion)
As alluded to above, while the Milevsky spreadsheet is a powerful tool that provides retirees with another data point in planning for retirement, it does have some weaknesses. It does not, for example, coordinate the spending budget with fixed immediate or deferred annuities/pensions and it does not reflect bequest motives.
In his post, Dirk Cotton says that the Probability of Ruin Calculator is also an actuarial approach. I'm going to mildly object to this claim. I would say that it may be used as part of an actuarial approach, but by itself, it is more like an alternative Safe Withdrawal Rate generator, particularly if it is only used once at the retiree's initial retirement age. I understand that Dirk is not actually suggesting this, but to be clear, to be considered an actuarial approach, it should involve an annual re-measurement (although not necessarily annual redetermination of the actual budget amount). This is how I would use the Milevsky approach if I did not have other fixed dollar retirement income sources and bequest motives (and I wanted another data point to consider): Step 1: Calculate the withdrawal rate at initial retirement consistent with a 25% probability of ruin, a 2% expected investment return, a 5% standard deviation and a reasonable life expectancy for me (not necessarily based on the mortality of individuals who purchase life annuities). Step 2: Multiply the withdrawal rate determined in Step 1 by my accumulated savings at initial retirement. This is my spending budget for year 1. Step 3: In year two, increase the dollar amount determined in the previous year by the increase in inflation over the previous year. Revisit the spreadsheet using an updated life expectancy (but generally the same other assumptions and probability of ruin used in the first year) and multiply the resulting withdrawal rate by an update of actual accumulated savings (i.e., current year's assets). If the spending budget for the previous year is within 10% of the product of the updated withdrawal percentage and updated assets, just stay with the spending budget for the previous year increased with inflation. If not, use the corridor value. Step 4: Repeat Step 3 each year. Note that this basically the same approach (involving the same smoothing algorithm) recommended for the Actuarial Approach in this website.
At the bottom of his post, Dirk provides a link to a 2005 paper by Moshe A. Milevsky and Chris Robinson, and in the comment section, he provides a link to the Milevsky Probabililty of Portfolio Ruin Calculator.
I must admit that the work done by Milevsky and Robinson was unfamiliar to me. So, thanks to Dirk for bringing it to my attention. While the paper is somewhat technical, the Probability of Ruin Calculator associated with the paper is not all that complicated, and it turns out to be a very powerful tool in my opinion. I was so impressed with it that I am including it in the "Other Calculators/Tools" section of this website. I believe that that the Milevsky tool can provide retirees and financial planners with another valid point of reference (in addition to the approach recommended in this website and other approaches) to be used in developing a spending budget, particularly if the retiree has no other fixed dollar sources of retirement income (like fixed dollar pensions/annuities) or significant bequest motives. The remainder of this post will discuss the Milevsky/Robinson approach and how I think it can best be used for budgeting in retirement under certain circumstances.
Milevsky/Robinson Approach
As opposed to the deterministic approach for investment returns and expected payout periods baked into the simple spreadsheet provided on this website, Milevsky and Robinson advocate an approach that successfully reflects the fact that both investment rates of return and the time until death are stochastic in nature (have certain probability distributions). By making certain assumptions about the probability distributions, they develop probabilities of sustainable real dollar spending rates for various combinations of life expectancy, expected real rates of return and portfolio risk (measured by the standard deviation of the distribution of returns).
When using Milevsky's Probability of Portfolio Ruin Calculator, the user should note that the expected portfolio rate of return (an arithmetic mean over the remaining lifetime) input is a real (after-inflation) percentage. Thus, the expected rate of return comparable to the real rate recommended in this website is 2% (which is approximately the real rate implied by a 5% per annum nominal investment return and 3% per annum inflation). Also note that the spreadsheet anticipates inputting a whole number of years remaining in retirement equal to the retiree's remaining life expectancy. Inputting expected rate of return, portfolio standard deviation, withdrawal rate (a percentage of accumulated savings at the current age with such product increasing by inflation in subsequent years) and remaining life expectancy at the current age, the spreadsheet produces a probability of ruin (running out of money prior to death) and it's complement (not running out of money prior to death).
Keeping in mind that since there is approximately a 50% probability of outliving one's life expectancy, any probability of ruin less than 50% means that the retiree is more likely than not to die before running out of money (assuming no future changes in spending occur). A probability of ruin of 25% means that the retiree is about three times more likely (75%/25%) than not to die before running out of money (assuming no future change in spending occur). Since many retirees are almost as worried about not spending enough as those who are worried about spending too much, it does not bother me to develop a spending budget based on a 25% probability of ruin. As I have previously indicated in this website, developing a spending budget for retirement is a "balancing act." It is also important to note that the term "ruin" here may be a misnomer and may more appropriately be considered as a probability that real dollar spending may need to be reduced in the very later years of life as a result of living well beyond one's life expectancy. This possibility may not be a disaster, but may actually be more consistent with studies that show declining spending needs at older ages.
I compared results of the Milevsky's Probability of Portfolio Ruin Calculator (using assumptions described below) with the results of the simple spreadsheet in this website (Excluding Social Security V 2.0) using the recommended assumptions. If I input a 2% real expected rate of return in Milevsky's spreadsheet, 5% standard deviation, male life expectancy based on the average of the 2010 Social Security and 2012 Individual Annuity Mortality Tables available on the Society of Actuaries website (a link to which resides in the "Other Calculators/Tools" section of this website) and solve for the withdrawal rate that produces approximately a 25% probability of "ruin", I come very close to the withdrawal rates produced using the Excluding Social Security V 2.0 spreadsheet and the recommended assumptions at most ages. There is some significant deviation at the very older ages, as I recommend using life expectancy if age plus life expectancy is greater than 95. When I reach my late 80's I may switch to the Milevsky approach depending on how concerned I become at that point about outliving my savings. Females, who have longer life expectancy, may also wish to look at the Milevsky approach when they reach their mid-80s.
Those of you out there who play with this spreadsheet may find it of interest that inputting a 4.4% withdrawal rate and 20-year life expectancy and an 8% withdrawal rate and 9 year life expectancy will produce about a 25% probability of ruin for each of the following combinations of expected real investment return/standard deviations: 2%/5%, 3%/11.5%, 4%/15.5%, 5%/19%, 6%/21.7% and 7%/24.5%. This result shows that achieving higher real rates of return by taking on more risk may not increase your retirement budget.
How to best use the Milevsky Spreadsheet (In My Opinion)
As alluded to above, while the Milevsky spreadsheet is a powerful tool that provides retirees with another data point in planning for retirement, it does have some weaknesses. It does not, for example, coordinate the spending budget with fixed immediate or deferred annuities/pensions and it does not reflect bequest motives.
In his post, Dirk Cotton says that the Probability of Ruin Calculator is also an actuarial approach. I'm going to mildly object to this claim. I would say that it may be used as part of an actuarial approach, but by itself, it is more like an alternative Safe Withdrawal Rate generator, particularly if it is only used once at the retiree's initial retirement age. I understand that Dirk is not actually suggesting this, but to be clear, to be considered an actuarial approach, it should involve an annual re-measurement (although not necessarily annual redetermination of the actual budget amount). This is how I would use the Milevsky approach if I did not have other fixed dollar retirement income sources and bequest motives (and I wanted another data point to consider): Step 1: Calculate the withdrawal rate at initial retirement consistent with a 25% probability of ruin, a 2% expected investment return, a 5% standard deviation and a reasonable life expectancy for me (not necessarily based on the mortality of individuals who purchase life annuities). Step 2: Multiply the withdrawal rate determined in Step 1 by my accumulated savings at initial retirement. This is my spending budget for year 1. Step 3: In year two, increase the dollar amount determined in the previous year by the increase in inflation over the previous year. Revisit the spreadsheet using an updated life expectancy (but generally the same other assumptions and probability of ruin used in the first year) and multiply the resulting withdrawal rate by an update of actual accumulated savings (i.e., current year's assets). If the spending budget for the previous year is within 10% of the product of the updated withdrawal percentage and updated assets, just stay with the spending budget for the previous year increased with inflation. If not, use the corridor value. Step 4: Repeat Step 3 each year. Note that this basically the same approach (involving the same smoothing algorithm) recommended for the Actuarial Approach in this website.
Sunday, December 7, 2014
Demystifying the Spending Spreadsheets on This Website
From time to time, we get questions about our spending spreadsheets. In an effort to provide retirees who visit this site with a higher level of comfort with the spreadsheets, this post will attempt to explain them in more detail.
We provide two simple Excel spreadsheets in this website for the purpose of helping you develop your annual spending budget in retirement as part of what we call “The Actuarial Approach.” The spreadsheets are located in the “Articles/Spreadsheet” section. The first one (Excluding Social Security V 2.0) generally applies if you are currently receiving Social Security benefits and develops a total spending amount (from accumulated savings and any immediate or deferred annuity or pension income for which you may be eligible). To obtain your total spending budget for the year, you take the result from this spreadsheet (or a smoothed result based on our recommended smoothing algorithm or some other smoothing algorithm) and add income you expect to receive from other sources in the next year such as your Social Security benefit, other inflation-indexed annuity/pension benefits, expected earnings from employment, etc.
The second spreadsheet (Social Security Bridge) applies if you are not currently receiving Social Security benefits but would like to coordinate your current retirement spending with Social Security benefits you expect to receive in the future.
The Total Spendable Amount shown in the Results section of the Input tab is the answer to the mathematic problem, "What total spendable amount (from accumulated savings and annuities) may be spent in the current year, to be increased each subsequent year by a constant percentage so that accumulated assets will exactly equal the amount desired to be left to heirs at the end of the expected payout period?"
Please be patient when downloading the Excel spreadsheets. Sometimes it can take a while. If you are requested to provide a password, simply click "cancel" and the spreadsheet should appear.
If you are having trouble seeing all the cells in the spreadsheet once it has downloaded (or you want to see a year-by-year runout of your accumulated savings based on the input items), be sure to maximize the spreadsheet window (by clicking on the “maximize” box in the top right-hand corner of the spreadsheet).
The Excluding Social Security V 2.0 has three tabs in the spreadsheet. The Social Security Bridge spreadsheet only has two tabs. As noted above, if you can’t see the tabs at the bottom of the spreadsheets, you need to maximize the spreadsheet window. After you do this, you should see the tabs labeled, “Input”, “Runout” and “Inflation-adjusted Runout.” The Social Security Bridge spreadsheet does not have an inflation-adjusted runout tab.
The input sheet allows you to enter your data and assumptions used in the calculations. Once you enter these items, results are shown in the bottom portion of the spreadsheet.
The Runout tab shows results in nominal (non-inflation-indexed) dollars. The first year of the Runout spreadsheet shows the beginning of year balance of accumulated savings that you entered, the amount to be withdrawn (payment) from accumulated savings for that year, expected investment return (interest) on the beginning of year balance, any immediate life annuity income for the year, the total spendable amount (from accumulated savings and pension/annuity) for the year and the accumulated savings withdrawal as a percentage of the beginning of year balance. Similar amounts are shown for each subsequent year based on the expected payout period you entered in the input sheet. The run-out is based on the assumptions discussed at the top of the spreadsheet. If you want, you can check to see that the end of year accumulated savings is equal to the beginning of year accumulated savings minus the amount withdrawn during the year plus the expected investment return for the year. Note that the Runout spreadsheet is somewhat self-checking. At the end of the expected payout period you entered, the end of year balance for that year should exactly match the amount you entered in the input spreadsheet for the “desired amount of savings to be left at death.”
The inflation-adjusted Runout sheet (in Excluding Social Security V 2.0 only) adjusts the expected year by year results shown in the Runout sheet for inflation based on the assumption for inflation that you input as the last input item on the input sheet. If you input the same rate for “annual desired increase in payments” and “expected annual rate of inflation”, the total inflation-adjusted spendable amount shown in Column L should remain the same throughout the expected payment period.
Below are screen shots from the Excluding Social Security V 2.0 spreadsheet showing the input, and its two Runout sheets. The data and assumptions used are shown in the Input sheet.
As discussed above, the Runout sheet for this example shows an end of year accumulated savings balance of $10,000 at the end of the 30th year (the amount inputted for desired savings remaining at death), and the Inflation-Adjusted Runout sheet shows a total inflation adjusted spending amount that remains constant throughout the 30-year expected payment period of $40,259 per year.
We provide two simple Excel spreadsheets in this website for the purpose of helping you develop your annual spending budget in retirement as part of what we call “The Actuarial Approach.” The spreadsheets are located in the “Articles/Spreadsheet” section. The first one (Excluding Social Security V 2.0) generally applies if you are currently receiving Social Security benefits and develops a total spending amount (from accumulated savings and any immediate or deferred annuity or pension income for which you may be eligible). To obtain your total spending budget for the year, you take the result from this spreadsheet (or a smoothed result based on our recommended smoothing algorithm or some other smoothing algorithm) and add income you expect to receive from other sources in the next year such as your Social Security benefit, other inflation-indexed annuity/pension benefits, expected earnings from employment, etc.
The second spreadsheet (Social Security Bridge) applies if you are not currently receiving Social Security benefits but would like to coordinate your current retirement spending with Social Security benefits you expect to receive in the future.
The Total Spendable Amount shown in the Results section of the Input tab is the answer to the mathematic problem, "What total spendable amount (from accumulated savings and annuities) may be spent in the current year, to be increased each subsequent year by a constant percentage so that accumulated assets will exactly equal the amount desired to be left to heirs at the end of the expected payout period?"
Please be patient when downloading the Excel spreadsheets. Sometimes it can take a while. If you are requested to provide a password, simply click "cancel" and the spreadsheet should appear.
If you are having trouble seeing all the cells in the spreadsheet once it has downloaded (or you want to see a year-by-year runout of your accumulated savings based on the input items), be sure to maximize the spreadsheet window (by clicking on the “maximize” box in the top right-hand corner of the spreadsheet).
The Excluding Social Security V 2.0 has three tabs in the spreadsheet. The Social Security Bridge spreadsheet only has two tabs. As noted above, if you can’t see the tabs at the bottom of the spreadsheets, you need to maximize the spreadsheet window. After you do this, you should see the tabs labeled, “Input”, “Runout” and “Inflation-adjusted Runout.” The Social Security Bridge spreadsheet does not have an inflation-adjusted runout tab.
The input sheet allows you to enter your data and assumptions used in the calculations. Once you enter these items, results are shown in the bottom portion of the spreadsheet.
The Runout tab shows results in nominal (non-inflation-indexed) dollars. The first year of the Runout spreadsheet shows the beginning of year balance of accumulated savings that you entered, the amount to be withdrawn (payment) from accumulated savings for that year, expected investment return (interest) on the beginning of year balance, any immediate life annuity income for the year, the total spendable amount (from accumulated savings and pension/annuity) for the year and the accumulated savings withdrawal as a percentage of the beginning of year balance. Similar amounts are shown for each subsequent year based on the expected payout period you entered in the input sheet. The run-out is based on the assumptions discussed at the top of the spreadsheet. If you want, you can check to see that the end of year accumulated savings is equal to the beginning of year accumulated savings minus the amount withdrawn during the year plus the expected investment return for the year. Note that the Runout spreadsheet is somewhat self-checking. At the end of the expected payout period you entered, the end of year balance for that year should exactly match the amount you entered in the input spreadsheet for the “desired amount of savings to be left at death.”
The inflation-adjusted Runout sheet (in Excluding Social Security V 2.0 only) adjusts the expected year by year results shown in the Runout sheet for inflation based on the assumption for inflation that you input as the last input item on the input sheet. If you input the same rate for “annual desired increase in payments” and “expected annual rate of inflation”, the total inflation-adjusted spendable amount shown in Column L should remain the same throughout the expected payment period.
Below are screen shots from the Excluding Social Security V 2.0 spreadsheet showing the input, and its two Runout sheets. The data and assumptions used are shown in the Input sheet.
As discussed above, the Runout sheet for this example shows an end of year accumulated savings balance of $10,000 at the end of the 30th year (the amount inputted for desired savings remaining at death), and the Inflation-Adjusted Runout sheet shows a total inflation adjusted spending amount that remains constant throughout the 30-year expected payment period of $40,259 per year.
Input
(click to enlarge)
Runout
(click to enlarge)
Inflation-adjusted Runout
 |
| (click to enlarge) |
Wednesday, December 3, 2014
Revisiting Recommended Assumptions
As discussed in our posts of July 12, 2013 and October 11, 2013, and in the Journal of Personal Finance paper (originally written in February, 2014), we have been recommending the following assumptions for annual budget determinations under the Actuarial Approach:
The remainder of this post will discuss the rationale for continuing these recommended assumptions.
Investment Return and Inflation Assumptions
In prior discussions, I have tied the expected future nominal expected rate of investment return on accumulated assets to the approximate interest rate "baked into" immediate annuity purchases. For this purpose, I have used the immediate annuity purchase rates made available on the Income Solutions website.
According to this website, as of November 26, 2014, a premium of $100,000 could purchase a monthly immediate annuity of $571 for a 65 year old male and $544 for a 65 year old female. Assuming a life expectancy at age 65 of 22.9 years for a 65-year old male and 24.9 years for a 65-year old female (based on the Society of Actuaries 2012 Individual Annuity Mortality Table with 1% per year mortality improvement, a link to which is available in the "Other Calculators/Tools" section of this website), I have determined that the interest rate inherent in these annuity purchase rates is about 4.3%. This rate is slightly lower than the 4.6% rate I approximated last February using the same approach. This change may be due to the use of more conservative mortality assumptions, declining interest rates or some combination of the two.
While I have no problem if a retiree wants to use an investment return assumption lower than 5% (particularly if the retiree is heavily invested in fixed income securities), I continue to believe that an annual 5% nominal return can be reasonably justified by retirees with relatively diversified investment portfolios. I would caution, however, against assuming higher nominal (or real) investment returns based on increased investment in equities as those strategies carry more risk that should be reflected in the assumption.
Consistent with Wade Pfau's research, I believe budgeting should assume a real rate of return of about 2% per annum, so I am retaining the 3% per annum inflation assumption combined with the 5% investment return assumption as my recommended economic assumptions for 2015 budgeting.
Mortality
As discussed above, the Society of Actuaries has released several new mortality tables which show significant mortality improvement has taken place in recent years. For example, life expectancy for a 65-year old male has increased by about a year under the new Individual Annuity Mortality Table (with 1% annual improvement). Under this revised table, a 65-year old male has about a 24% probability of surviving until age 95, while this probability is about 33% for a 65-year old female. Note, however, that this new table is based on mortality experience for individuals who buy immediate annuities from insurance companies and presumably have better than average health. By comparison, life expectancies under the 2010 Social Security tables (with 1% mortality improvement), with experience based on essentially the U.S. population are 17.6 years for 65-year old males and 20.4 years for 65-year old females, respectively. While some argument can be made for increasing the "live to 95" assumption by a year (at least for females), I continue to believe that this assumption is reasonable. Of course, if you are already in your late 80s, you need to look at longer possible payment periods.
If you are the rare retiree who has a good idea when you are going to die, feel free to use your knowledge in your budgeting. If you are like most of us, you should plan to live longer than your life expectancy, at least relatively early in your retirement. The problem with doing this is that this increases the probability that you will die with more (unspent) assets than you desired. To some extent, this is simply the cost of not buying an annuity.
The chart below shows projected budget amounts (in inflation-adjusted dollars) for a 65-year old retiree with $600,000 in accumulated assets under the Actuarial Approach (and recommended smoothing) using two different approaches for determining the remaining payout period. The first approach uses the retiree's life expectancy (based on the SoA 2012 Individual Annuity Table) while the second approach uses the "live until 95" approach recommended in this website. Investments are assumed to earn 5% per annum, inflation is assumed to be 3% per annum and the retiree is assumed to spend exactly the budget amount each year. This chart illustrates the problem with using one's life expectancy each year and having the misfortune? of surviving.
- Expected annual rate of return on savings: 5% (a nominal interest rate)
- Annual desired increase in payments/inflation: 3%,
- Expected payout period (in years): Until age 95 or life expectancy if longer.
The remainder of this post will discuss the rationale for continuing these recommended assumptions.
Investment Return and Inflation Assumptions
In prior discussions, I have tied the expected future nominal expected rate of investment return on accumulated assets to the approximate interest rate "baked into" immediate annuity purchases. For this purpose, I have used the immediate annuity purchase rates made available on the Income Solutions website.
According to this website, as of November 26, 2014, a premium of $100,000 could purchase a monthly immediate annuity of $571 for a 65 year old male and $544 for a 65 year old female. Assuming a life expectancy at age 65 of 22.9 years for a 65-year old male and 24.9 years for a 65-year old female (based on the Society of Actuaries 2012 Individual Annuity Mortality Table with 1% per year mortality improvement, a link to which is available in the "Other Calculators/Tools" section of this website), I have determined that the interest rate inherent in these annuity purchase rates is about 4.3%. This rate is slightly lower than the 4.6% rate I approximated last February using the same approach. This change may be due to the use of more conservative mortality assumptions, declining interest rates or some combination of the two.
While I have no problem if a retiree wants to use an investment return assumption lower than 5% (particularly if the retiree is heavily invested in fixed income securities), I continue to believe that an annual 5% nominal return can be reasonably justified by retirees with relatively diversified investment portfolios. I would caution, however, against assuming higher nominal (or real) investment returns based on increased investment in equities as those strategies carry more risk that should be reflected in the assumption.
Consistent with Wade Pfau's research, I believe budgeting should assume a real rate of return of about 2% per annum, so I am retaining the 3% per annum inflation assumption combined with the 5% investment return assumption as my recommended economic assumptions for 2015 budgeting.
Mortality
As discussed above, the Society of Actuaries has released several new mortality tables which show significant mortality improvement has taken place in recent years. For example, life expectancy for a 65-year old male has increased by about a year under the new Individual Annuity Mortality Table (with 1% annual improvement). Under this revised table, a 65-year old male has about a 24% probability of surviving until age 95, while this probability is about 33% for a 65-year old female. Note, however, that this new table is based on mortality experience for individuals who buy immediate annuities from insurance companies and presumably have better than average health. By comparison, life expectancies under the 2010 Social Security tables (with 1% mortality improvement), with experience based on essentially the U.S. population are 17.6 years for 65-year old males and 20.4 years for 65-year old females, respectively. While some argument can be made for increasing the "live to 95" assumption by a year (at least for females), I continue to believe that this assumption is reasonable. Of course, if you are already in your late 80s, you need to look at longer possible payment periods.
If you are the rare retiree who has a good idea when you are going to die, feel free to use your knowledge in your budgeting. If you are like most of us, you should plan to live longer than your life expectancy, at least relatively early in your retirement. The problem with doing this is that this increases the probability that you will die with more (unspent) assets than you desired. To some extent, this is simply the cost of not buying an annuity.
The chart below shows projected budget amounts (in inflation-adjusted dollars) for a 65-year old retiree with $600,000 in accumulated assets under the Actuarial Approach (and recommended smoothing) using two different approaches for determining the remaining payout period. The first approach uses the retiree's life expectancy (based on the SoA 2012 Individual Annuity Table) while the second approach uses the "live until 95" approach recommended in this website. Investments are assumed to earn 5% per annum, inflation is assumed to be 3% per annum and the retiree is assumed to spend exactly the budget amount each year. This chart illustrates the problem with using one's life expectancy each year and having the misfortune? of surviving.
(click to enlarge)
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