Your Withdrawal Strategy Should be Coordinated with Other Sources of Fixed Retirement Income

If you have accumulated savings and a fixed dollar pension benefit or life annuity, your accumulated savings need to do double duty when it comes to maintaining a constant real dollar annual spending budget in retirement.  Your accumulated savings need to 1) fund inflation increases on the portion of your spending budget attributable to your accumulated savings and 2) fund inflation increases on the portion of your spending budget attributable to the fixed dollar pension or life annuity.  If you have fixed dollar sources of retirement income, the withdrawal strategy you use needs to be adjusted to perform this double duty or you will find that your annual spending budget will likely decrease over time as a result of inflation.  The higher the rate of future inflation and the larger percentage of your spending budget attributable to fixed dollar income, the bigger this potential problem will be. 

The standard withdrawal strategies like the 4% rule, any safe withdrawal rate rule, the Required Minimum Distribution (RMD) rule, or any of the variations of these rules, were not designed to coordinate with other fixed dollar sources of income.  I was therefore surprised to read that when asked in a recent Barron’s article which spending strategy has the most potential, Dr. Wade Pfau said,

“I’m leaning toward some combination of an income annuity and a method used by [Cornerstone Wealth Advisors’] Jonathan Guyton, whose model I simulated. It’s a complicated set of rules but adjusts spending based on the market, limiting the fluctuations in the withdrawal amount to only 10%, and only when absolutely necessary.”

I was not at all surprised that Dr. Pfau advocated purchase of an annuity as an investment strategy that mitigates longevity risk and enable retirees to be somewhat more aggressive with respect to investment of their remaining assets.  I was, however, surprised that Dr. Pfau advocated using the Guyton Rules for determining withdrawals from the remaining assets.  First of all, I am not that impressed with the Guyton Rules (which are basically a variation of the safe withdrawal rule approach).  Secondly, and more importantly, the Guyton rules fail to coordinate with a fixed income annuity to provide constant spending budgets in retirement.  See my post of July 3, 2014 for my cautions about using the Guyton Rules even if a retiree has no fixed income retirement sources of income.   

The graph below shows total spending budgets for a hypothetical 65 year old male retiree with $1,000,000 in accumulated savings and a $20,000 per year Social Security benefit.  Let’s assume the retiree decides to follow Dr. Pfau’s suggestion and determines that his essential income level is about $50,000.  Therefore, he decides to purchase an immediate fixed income annuity of $30,000 per year (to supplement his Social Security benefit of $20,000 per year).  At current annuity purchase rates, this purchase is expected to cost him $458,716 ($545 of monthly benefit per each $100,000) leaving him $541,284 in accumulated savings.  
 

(click to enlarge)

 
The retiree uses the Guyton Rules to determine withdrawals from his accumulated savings with a beginning withdrawal rate of 5.5%.  In the first year, his total spending budget is $79,771 (.055 X $541,284 = $29,771 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security).  Under the Actuarial Approach and the current recommended assumptions, his initial spending budget would be $65,762 ($15,762 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security), assuming no amounts to be left to heirs. 

Let’s further assume that actual future experience is exactly follows the recommended assumptions—4.5% annual investment return and 2.5% inflation (and exactly the budget amount is spent each year).  Under these assumptions, the Actuarial Approach produces a constant real dollar budget of $65,762 per year while the spending budget under the Guyton Rules plus annuity approach produces a declining real dollar budget from year to year.  In fact the real dollar spending budget expected under these assumptions at age 89 is only about 61% of the initial spending budget.  As noted above, this decline could be worse for higher levels of inflation or for strategies involving a higher relative portion of the budget being used to purchase the fixed income annuity. 

Most withdrawal strategies for situations that don’t involve fixed sources of retirement income have constant real dollar income throughout retirement as an objective.  It doesn’t make sense to me to change that objective just because you add fixed dollar retirement income.   At the very least, retirees should be made aware of this potential inconsistency. 

Dr. Pfau has many readers of his blog (many, many times the number who visit this site) and has published many fine articles.   He is a revered academic scholar in the retirement area.   In light of his influence, I encourage him to “lean” away from using the Guyton Rules (or any other approach that does not reasonably coordinate with the fixed income annuity) when fixed dollar annuity/pension benefits are present in a retiree’s portfolio.    

Delaying Commencement of Social Security vs. Buying a QLAC—Which Is the Better Strategy?

May 28, 2015 Note: This post has been revised to correct some minor errors.

There is no shortage of articles out there advocating delaying commencement of Social Security as a no-brainer strategy to increase spending in retirement.  Several experts have indicated that delaying commencement of Social Security is hands down the best long-term investment money can buy. These articles encourage individuals who have retired to spend what may be a significant portion of their accumulated savings during the period of deferral in order to collect a much larger Social Security benefit down the road (typically at age 70). While I have agreed in prior posts (see the post of August 9, 2014 for example) that this deferral strategy can increase annual retiree spending budgets, it does come with its own set of risks and does not always live up to the hype used to sell it. In this post, I will compare the Social Security deferral strategy to the strategy of using roughly the same amount of accumulated savings to purchase a Qualified Longevity Annuity Contract (QLAC), which I have also discussed in prior posts (see the post of February 25, 2015 for an example).

In our post of February 25, 2015, we took a look at a hypothetical retiree, Mike, a single 65-year old male with a 401(k)/IRA balance of $750,000 and a potential Social Security benefit payable immediately of $16,800 per year.  Using the Excluding Social Security spreadsheet in this website and the recommended assumptions, Mike developed a first year spending budget of $49,427. Using the Social Security Bridge spreadsheet and the same assumptions, Mike determines that if he defers commencement of Social Security until age 70, his Social Security benefit will increase to about $26,880, and his spending budget, starting at age 65 and remaining constant in real dollars for the next 29 years, will increase from $49,427 to $51,412, an increase of $1,985 per year. He also determines that he must effectively spend a present value of $114,329 of his 401(k)/IRA balance in order to implement this strategy.

Yesterday Mike went to Immediateannuities.com to check out the amount of annual payments he could receive under a deferred annuity contract commencing at age 85 (with no death benefit) with a premium of $114,329 (the same cost as the Social Security deferral strategy). The website said that his annual benefits commencing at age 85 would be almost $60,000.  Mike is a little bit skeptical of this result as it is significantly higher than the benefit amount shown on this website just a couple of months ago. He knows that the QLAC market is not yet robust, but he decides to see what the effect on his spending budget would be if he spent $114,329 on a QLAC that gave him a benefit of $52,000 (not $60,000) starting at age 85. So he enters $635,671 ($750,000 - $114,329) as accumulated assets, an annual deferred benefit of $52,000 starting in 20 years (by entering 21 in the spreadsheet) and the recommended assumptions. The Excluding Social Security spreadsheet tells him that his spending budget under these input items would be $35,409 to which he adds his non-deferred age 65 Social Security benefit of $16,800 to get a spending budget of $52,209, or $2,782 higher than his base spending budget and $797 higher than the Social Security deferral strategy spending budget. So, based on realization of all the assumptions in these spreadsheet calculations (and the slightly lower assumption for the QLAC benefit payable at age 85), the QLAC strategy appears to be the better strategy for Mike.

But, not so fast here. We know that future experience will deviate from our assumptions. Future interest rates will change, future investment returns will not be 4.5% per annum, future inflation will not be 2.5% each year, Social Security benefits may be reduced, QLAC pricing may become more robust, etc.  There is a great deal of uncertainty about the future that makes comparison of these two approaches difficult.

Both strategies involve generation of mortality credits by virtue of mortality risk pooling that you don’t get when you self-insure.  These mortality credits are used to pay larger benefits to individuals who live longer (the winners, if you will) and come from payments not made to individuals who die earlier (for lack of a better term, the losers). The bet inherent in both of these strategies is won only if the individual lives longer than average. The QLAC strategy is a bigger bet in this regard than the Social Security deferral strategy with a potentially bigger mortality credit payoff for those who live past age 85. This larger mortality credit is the reason the QLAC approach appears to be the better strategy for Mike under the spreadsheet assumptions.

On the other hand, Social Security provides survivor benefits and inflation protection not provided by the QLAC. If annual inflation is 4.5% rather than 2.5%, the Social Security deferral strategy becomes the better strategy (in terms of increasing the spending budget) as QLAC payments are fixed and Social Security benefits are indexed to inflation (under current law).

There is another hand, however, with Social Security. To digress a little here, this reminds me of the old actuary joke about the actuary who used the phrase, “on the other hand” so frequently in explaining the plusses and minuses of different approaches that her client asked her firm to replace her with a “one-handed” actuary. Anyway, like it or not, there is nothing in the current Social Security law that prevents Congress from changing Social Security law with negative effects on individuals, even those who may have elected to defer commencement of benefits. As I indicated in my post of March 1, 2015, Social Security actuaries predict that benefit payments will have to be reduced by about 23% across the board if no action is taken by Congress prior to 2033. There are experts who say that the Social Security deferral approach is still a good option even if benefits are reduced by 23%.  Of course, there is nothing that guarantees the reduction will be 23% across the board. It is possible that Congress could decide that the benefits payable to retirees with lower levels of retirement income should be protected.  In that event, reductions for more affluent retirees would have to be greater than 23%. Just yesterday, for example, Chris Christie made headlines by proposing to phase out Social Security benefits for those with retirement incomes in excess of $80,000. So an individual who chooses the Social Security deferral strategy needs to be aware that there is a possibility that future Social Security benefits could be reduced or eliminated, thus negatively affecting the expected benefits of the deferral strategy, even for individuals with greater than average longevity. 

As discussed above, the QLAC market is not yet robust. There are far too few insurers in the market at this point. In addition, if you believe that interest rates are going to rise in the future, now may not be the best time to purchase a product which essentially combines long-term bond investments with mortality credits. Higher future real interest rates will favor the QLAC strategy (assuming purchase takes place in the future) relative to the Social Security deferral strategy unless the law is changed to increase actuarial adjustments for benefit deferral.

Bottom line: Both the Social Security deferral strategy and the QLAC strategy can be used to increase retiree spending budgets. The strategy that is more effective in this regard will depend on what actually happens in the future.  Not knowing what the future holds, it is just too difficult for me to proclaim a “no-brainer” winner at this time. I do believe that both strategies are worthy of consideration by retirees and/or their financial advisors, and that those interested in pursuing the QLAC strategy should keep a watchful eye on QLAC pricing in the months ahead.

What is Your Discount Rate for Immediate Life Annuities?

This post is a follow-up to my previous post in which I stated that just because many retirees do not buy annuities it doesn't necessarily follow that they are not making rational decisions.  In response to that post I heard from another actuary, Andrew, who agreed and hypothesized that the non-annuity purchasers might have higher personal discount rates than the rates used by the insurance companies to price annuities, where personal discount rates are the annual theoretical or observed rates at which people value future payments vs. cash in hand.  Andrew noted that many (mostly younger individuals who want to consume) frequently run up credit card debt on which they pay interest of 15% per annum or more, thus exhibiting relatively high personal discount rates for purchases of some items.  Presumably personal discount rates decrease somewhat as we age (and we worry more about maintaining our lifestyles rather than buying  a lot of new stuff).  But how high does one's personal discount rate have to be today in order to make not buying an immediate annuity appear to be a rational decision?  In this post, I use the spreadsheets in this website to make an estimate.
 
Based on immediate annuity quotes from Immediateannuities.com, a 65-year old male can purchase a monthly life annuity of $545 ($6,540 per annum) today for $100,000.  Using the Excluding Social Security spreadsheet found in the Articles and Spreadsheet section of this website and entering $100,000 of accumulated savings,  a 22-year payout period (a little bit less than the life expectancy for a 65-year old male using 2012 Individual Annuity Society of Actuaries tables with 1% per year mortality improvement), a 3.8% interest rate and 0% increases in future benefits, you get annual payments of $6,540, the same amount provided under the immediate annuity quote for $100,000.  But if you self-insure your retirement, you will not be eligible to share in the mortality pooling (longevity premium) that will occur if you purchase the annuity contract.  Granted, you (your heirs) will receive benefits if you self-insure and die prior to reaching your life expectancy, but no money will be available to you after you reach your life expectancy as it would under the insurance contract.  Therefore in order to make a reasonable comparison we should adjust this 3.8% interest rate to reflect the mortality premium provided by the annuity. 

If we follow the probabilities of survival in the SoA tables for a 65-year old male (45% survival for 25 years, 24% for 30 years and extrapolate (using my estimates) down to 1% survival at 42 years, plug each scenario into the Excluding Social Security spreadsheet (using 3.8% interest) and probability weight the outcomes (assuming 100% survival prior to 22 years), you get a resulting weighted annual payment of $5,636.  This amount is approximately the same as the result you would get by inputting $100,000 of accumulated savings, a 28-year payment period and a 3.8% investment return.  As a final step, we solve for the interest rate that would give us payments of $6,540 for $100,000 in savings and a 28 year payment period to find the discount rate inherent in the insurance contract including an estimate for the longevity premium.  This interest rate is about 5.25%.

Given that individuals may be concerned about insurance company default, inflation risk, liquidity risk, risk of dying too soon, insurance company profits, risk of buying an annuity at historically low interest rates, etc. , they may be expected to increase their personal discount rate for buying an immediate annuity.  Based on the rough estimates above, it appears that a 65 year old male who elects not to purchase an immediate annuity today has a personal discount rate with respect to this purchase greater than roughly 5.25%.  Thanks, Andrew, for raising the issue of personal discount rates. 

Researchers Claim Many Individuals Aren’t Smart Enough to Manage Assets in Retirement

While I frequently advocate diversification of retirement income sources as a risk-mitigation strategy in retirement (see for example my post of July 12, 2014), I’m not a big fan of government mandated annuitization of an individual’s retirement assets.   I’d like to believe that individuals who have managed their finances during their working careers will be able to continue to do so in retirement without government involvement (see for example my post of August 31, 2014).  Understandably, however, not everyone agrees with me.  The most recent example of this is a March, 2015 research paper from the Center for Retirement Research at Boston College entitled, “Are Cognitive Constraints a Barrier to Annuitization?”

This research paper presents the results of a study of individuals who were asked to value a $100 change in their monthly Social Security benefit (both the cost they would be willing to pay for an additional $100 and the price they would be willing to receive to give up $100).  The study showed that the respondents had difficulty in valuing this change and the magnitude of their difficulty was correlated to the respondent’s cognitive ability.  Even though buying or selling Social Security benefits is not possible, the researchers use the results of this hypothetical exercise to conclude that “policymakers need to be aware that many individuals, on their own, are unable to make good decisions about managing money in retirement”, thereby supporting “US policymakers [who] have expressed interest in encouraging annuitization of balances in 401(k) plans...”

The study does not provide sufficient details to verify how the benchmark value of a $100 change in Social Security benefit of $16,855 was determined.  The paper indicates that this value was determined using “mortality and interest rate assumptions from the Social Security Administration’s Trustees,” but it does not provide the age or sex of the hypothetical recipient(s).  If we are talking about a 65 year old male with approximately a 23 year life expectancy (based on the SoA 2012 Individual Mortality Table and a 1% per year mortality improvement) and the current recommended assumptions for the Excluding Social Security spreadsheet provided in this website, we are looking at a value in excess of $22,000.  The current CORI Retirement Index value for an inflation indexed $100 per month lifetime annuity for a 65 year old is in excess of $25,000.

In any event, it looks like most of the study’s participants (and perhaps even the study’s authors) undervalued a $100 change in the Social Security benefit in comparison to the value based on current annuity pricing models.  For numerous reasons (the “annuity puzzle”) that seem to baffle academics, economists and researchers, many individuals don’t value annuities as highly as the life insurance companies that sell them.   This fact doesn’t by itself mean that these individuals “may not be making rational well informed decisions.”  Besides, from a policy perspective, if many individuals place less value on annuities than their actuarial cost, how much sense does it make to force them to buy something at that higher cost that they don’t necessarily want?

On the other hand, I have no problem if the government’s (Department of Labor’s) role in “encouraging annuitization” is limited to providing useful information to educate individuals on the potential benefits of annuitization of defined contribution balances or on the considerations in selecting annuities vs. lump sums in defined benefit plans (see my post of February 18, 2015 for examples of information that might be helpful for the latter).   I’m all in favor of making more educational material available to retirees of all cognitive ability levels. 

The Final Say on Spending Rules—Not

Laurence Siegel has followed up his provocatively titled piece, “The Only Spending Rule Article You Will Ever Need” (discussed in our post of March 22, 2015) with an article in Advisors Perspectives entitled “The Final Say on Spending Rules.”  As previously discussed, I agree with a lot of what Mr. Siegel has to say, for example:

1. “with risky investments, there is no such thing as a safe withdrawal rate (other than zero).” 
2. The “magic formula”—“It’s not a single formula, but a procedure.”
3. It is important to periodically (annually) balance the market value of the retiree’s assets with the market value of her liabilities (present value of future constant real-dollar spending), with such market value of liabilities determined on a basis that is reasonably consistent with life insurance annuity pricing.
4. Retirees who combine the purchase of life annuities (immediate or deferred) with conventional investing can benefit from risk pooling to cover some or all of their longevity risk. 

Where we disagree (other than over what I assume is Mr. Siegel’s tongue-in-cheek title, since he himself acknowledges that “there is much more to decumulation than just [the two methods he discusses in his article]:”

1. I believe developing a spending budget is part art and part science, and if the Actuarial Approach is used, it somewhat self-correcting from year to year.  Therefore, I am not distressed if the matching of assets and liabilities referred to in item 3 above is not exactly determined based on the discount rate (or yield curve) inherent in the individual retiree’s annuity purchase rate.  Additionally, I am not distressed if the retiree chooses to apply a reasonable smoothing algorithm to the budget calculated in item 3 above from year to year in a desire to avoid fluctuations or if the retiree chooses to spend more or less than the spending budget in a given year (see my previous post). 
2. Mr. Siegel’s “magic formula” isn’t very sophisticated and doesn’t coordinate with other potential fixed dollar sources of retirement income such as pension benefits or immediate or deferred life annuity income.  I’m not saying that the simple spreadsheets included in this website are particularly sophisticated either, but at least they permit a retiree or advisor to determine a spending budget that is coordinated with other sources of retirement income and the retiree’s bequest motive.  No.  The simple spreadsheets provided in this website aren’t magical.  They are just simple math and their Run-Out tabs show the components of future expected spending budgets (excluding Social Security or other inflation indexed sources of retirement income) and the expected decumulation of invested assets over the input payout period.  

Spending More or Less Than Your Spending Budget

This website is all about helping retirees develop a reasonable spending budget in retirement.   Notwithstanding, we understand that there may be many years in retirement where your actual spending may not match your budgeted spending.  This is ok as long as you realize that over-spending now can result in a smaller real dollar spending budgets in the future and vice versa.  We have addressed this concept in many of our previous posts including “You Can Spend it Now or You (or Your Heirs) Can Spend it Later” and “Budgeting Around ‘Lumpy’ Expenses.”

We are revisiting this concept today primarily as a result of a post that appeared in the Huff Post Financial Education blog entitled, “Baby Boomer’s Retirement Strategy:  Binge Spending Or Nothing At All.” In this post, the author refers to a recent study by Hearts and Wallets which showed that “28 percent of older Americans took no retirement income from their personal assets...Another one-quarter took 8 percent or more…”  The author interviewed Laura Varas, a partner and co-founder of Hearts and Wallets, who hypothesized that a significant portion of older Americans may be fasting and binging with their retirement assets on purpose rather than spending these assets in a systematic manner.   The term used in the article for over-spending is spending in “chunks,” and Varas concludes that "Knowing how to spend safely in chunks is something they [retirees] want."

As we said in our post on budgeting around lumpy expenses, there are several ways to use the Actuarial Approach to deal with unusual and unplanned expenses.  One of the suggested approaches is to carve out some of your current assets in anticipation that this portion of your assets will be dedicated to the lumpy expense expected in the future (thereby reducing your current spending budget).  Another approach is to simply treat over-spending the same as unfavorable investment experience or changes in assumptions and apply the smoothing algorithm recommended in this website. 

While the Actuarial Approach can help retirees deal with spending in “chunks”, it is important to note that the over-arching rule for spending in retirement is you can spend it now or you (or your heirs) can spend it later.  This rule also applies to retirees who use the Actuarial Approach.  If you are using our recommended smoothing algorithm to smooth investment experience, changes in assumptions or deviations from spending and the smoothed budget amount is consistently below the actuarial value produced by the spreadsheet, you may be borrowing from future budgets.  If you are spending more than your spending budget in a year, you may be borrowing from future budgets.  If you follow the recommended longevity assumption of planning on living until age 95 or your life expectancy if greater and you live past age 89, you will have borrowed from real dollar budgets after age 90.  Unfortunately, there are no guarantees when you choose to self-insure some or all of your retirement income, not even if you use the Actuarial Approach. 

The Actuarial Approach—A Dominating Dynamic Spending Strategy

Over at The Retirement Café, Dirk Cotton has provided two informative posts which compare various spending strategies.   The first is dated February 20, 2015 entitled, “Dominated Strategies and Dynamic Spending” and the second (a follow-up to the first) is dated March 17, 2015 entitled “Dominated Strategies, Logically Unsound Strategies, Problematic Strategies and Strategies that Make Me Queasy”

In the first post, Dirk uses game theory (and not the knowledge he may have gained by avidly reading the 50 Shades of Grey trilogy) to determine that Dynamic Spending Strategies (like the Actuarial Approach) “dominate” safe withdrawal rate strategies.  In his March 17 post he continues to eliminate strategies from his “Sound Strategies” list by crossing out strategies that are logically unsound, problematic or that make him feel queasy.   Nice posts, Dirk. 

The Annually Recalculated Virtual Annuity—Pretty Darn Similar to the Actuarial Approach

Thanks to Wade Pfau for bringing to my attention the article in the January/February 2015 Financial Analysts Journal entitled, “The Only Spending Rule Article You Will Ever Need” by M. Barton Waring and Laurence B. Siegel.  The authors believe that, “constructing a spending rule is itself an annuitization problem at heart but does not require purchasing an actual annuity…”  The name the authors give to their recommended spending rule is the Annually Recalculated Virtual Annuity (ARVA).   
 
I agree with most of this article, as it is basically the same as the approach I have been advocating for over ten years, the last five of which are documented in this website. 

About the only aspect of the authors’ article with which I am not in complete agreement is the authors’ aversion to smoothing of the spending budget from year to year.  The authors argue that smoothing is “the actuarial mistake that has caused so much difficulty for pension plans” and “It is important to control consumption risk with investment policy, not with accounting tricks like smoothing.”  While I agree that over-smoothing can be a problem, I believe the recommended smoothing algorithm advocated in this website does a pretty good job of balancing retiree needs to have some acceptable degree of spending stability with the need to remain on track with the correct actuarially determined value, and in my opinion is consistent with “the small amount of smoothing” described in footnote 13 of the article.  Further, I find it somewhat hypocritical of the authors to cling so steadfastly to their “no smoothing” mantra at the same time that they play fast and loose with longevity risk by stating, “As with any stream of cash flows, the shape of the cash flow payments to a retiree can be engineered to be anything the retiree wants…”.  After all, as I said in my previous post, any spending rule is designed to give the retiree a budget, and it is ultimately up to the retiree to determine how closely that budget will be followed in the current year. 

I will point out that while this article is entitled “The Only Spending Rule Article You Will Ever Need”, the article itself doesn’t provide much in the way of simple spreadsheets (like we provide in this website) to implement the rule, particularly if a retiree has other sources of retirement income such as immediate or deferred annuities/pensions with which spending from accumulated savings needs to be coordinated.

Retirement Researcher Confirms Actuarial Methods Spend Down Wealth More Efficiently

In his March 16 paper, “Making Sense Out of Variable Spending Strategies for Retirees”, Dr. Wade Pfau examines ten key variable rate spending strategies (including the Actuarial Method advocated in this website) with the goal of comparing the strategies and evaluating them against certain criteria.  Instead of examining the “failure rate” of the strategies, Dr. Pfau looks at distributions of spending and wealth decumulation outcomes using Monte Carlo simulations assuming hypothetical retirees are comfortable with an X% chance that spending levels fall below a threshold of Y real dollars by year Z of retirement (where X,Y and Z can vary).  

Dr. Pfau separates the ten strategies into two main groups:  decision rule methods and actuarial methods.  He further separates the actuarial methods into four approaches with the Actuarial Approach advocated in this website included in the PMT Formula category (because the formula used in the spending rate determination is mathematically equivalent to the result obtained by using the PMT function in Excel if the retiree has no pension/annuity income with which to coordinate).  Based on his research, Dr. Pfau concludes that the actuarial methods “are all shown to spend down wealth more efficiently” than the decision rule methods. 

I applaud Dr. Pfau’s efforts to examine the various strategies available to retirees and their advisors using the XYZ metric he has developed and Monte Carlo simulations.  It is important to remember, however, that developing a reasonable spending budget in retirement is equal parts art and science, as no one knows what the future holds.  In addition, a spending budget is just that—a budget.  Almost no retiree I know spends exactly her budget each year.

For simplification purposes, Dr. Pfau’s analysis assumes the hypothetical retirees used in his Monte Carlo simulations have no other sources of retirement income other than accumulated wealth.  He does note that the “XYZ” measurement calculation “can incorporate Social Security and other income sources as well…”  If you do have other sources of retirement income (such as annuity income from a pension plan or insurance contract) that are not indexed to inflation or are not currently in payment status these other sources can significantly affect current spending of accumulated savings.  Of course, the simple spreadsheets provided in this website automatically consider these other sources to provide you with a coordinated spending budget, whereas the other “actuarial methods” examined by Dr. Pfau do not

How Secure is Your Social Security?

This website is all about developing a reasonable spending budget in retirement.  For the last five years, I’ve recommended a spend-down strategy for self-managed assets in order to develop an overall spending budget that is coordinated with all sources of retirement income, including Social Security.  The Actuarial Approach advocated in this website is based on the premise that current law benefits will not be reduced for those retirees who are currently receiving or who are close to receiving Social Security.  In light of Social Security’s financial problem, there are reasons to question this premise. 

For many retirees in the United States, Social Security is the most important retirement income source they have.  It would be nice to know that we can count on the system to continue to provide the same real dollar level of benefits as long as we live.  But we read articles almost every day pointing to Social Security’s financial problems.  As retirees, should we worry about these problems?  Many “experts” tell us that historically, system financial problems have generally been resolved without reducing benefits for those who have already retired or who are close to retirement.  While this provides us with some level of comfort, we also know that there is nothing in the Social Security law that prevents Congress from reducing benefits of those who are already in pay status.  The issue of whether our Social Security benefits will be reduced (and if so, by how much) is an important one for retirees because we will need to make appropriate adjustments in our retirement plans and spending budgets.  Unfortunately, reductions in future Social Security benefits may be yet another risk we need to address when managing our retirement.

This post will briefly discuss Social Security’s financing problem, how likely it is that this financing problem will lead to benefit reductions for retirees in pay status, when reductions may occur, and how large the reductions might be.

The Problem

Under “intermediate assumptions” in the 2014 OASDI Trustees Report and assuming no future changes in the system, Social Security’s actuaries project that in the year 2033, the combined OASDI trust funds (if they were combined) will be exhausted.  The combined trust funds are currently about $2.8 billion.  Under the same assumptions, the actuaries project that the system’s 2034 cost rate will be about 17.03% of taxable payroll and the system’s income rate will only be 13.18% of taxable payroll, a shortfall of 3.85% of taxable payroll.  Absent Congressional action prior to 2034, benefits to those receiving payments at that time would have to be reduced by almost 23% across the board.  Technically, full benefits would still be paid, but they would be delayed so the effect would be the same as a cut in benefits.  Note that this is the “default option” if Congress does not act prior to trust fund exhaustion. 

It is also important to note that these projections are based on lots of assumptions.  If actual experience differs from the assumptions, the size of the shortfall could be larger or smaller and/or the exhaustion date earlier or later than 2033. 

Will Benefits be Reduced for Those in Pay Status?

Well, this is the $64,000 question isn’t it?  Will Congress and the President find some other solution to the problem in the next 18 years that doesn’t involve benefit reductions for those in pay status or for those who are close to being in pay status.   The solution could involve payroll tax increases, general revenue financing, benefit reductions for those not in pay status or combinations of these or other actions.   

For example, if Congress waits until the last minute to address this issue and does not want the default option to go into effect in 2034, it could increase the combined employer/employee tax rate of 12.4% of taxable wages (6.2% for workers and 6.2% for employers) by 3.85% or by approximately 31%.  It is important to note that if no changes are made to the system in the next 19 years and Congress decides in 2034 to limit benefit reductions only to future beneficiaries, the only option would be the 31% tax rate increase (or raise some other form of additional system revenue).   Similarly, if no changes are made to the system in the next 19 years and Congress decides at that time that it can only increase taxes by 1% each on workers and employers, then benefits in pay status will have to be reduced by at least 11% across the board. 

Given recent Congressional actions, there is certainly a non-zero probability that it will not address this problem prior to trust fund exhaustion.  Rather than raise payroll or income taxes or cut benefits, Congress may be willing to follow Thelma and Louise’s example and simply drive the Social Security car over the cliff into the Grand Canyon.

Even if Congress does act prior to trust fund exhaustion, there is a non-zero probability that such action will involve some type of benefit reduction for beneficiaries in pay status.  Congress may feel that a fair solution to the problem should involve a certain amount of shared pain from all the system’s stakeholders.  And while earlier action can reduce the size of the problem somewhat, the magnitude of tax increases/benefit reductions required to solve the problem will still be substantial if they are totally borne by those who are not in pay status.  Don’t be misled by the actuarial deficit of 2.88% in the 2014 OASDI Trustees Report.  Just one look at the graph on page 12 of the report will convince you that the long-range size of the problem is a lot closer to 4% of taxable payroll. 

How Large Might the Reductions Be?

As noted above, if Congress does nothing prior to 2034, the default option is to effectively reduce benefits in pay status by 23% across the board.  If Congress does take action prior to 2034, across the board reductions are likely to be somewhat less.  However, even though the average reduction in benefits might be less than 23%, it is quite possible that certain types of beneficiaries could be hit harder than others.  For example, Congress may reduce some spousal benefits or may reduce benefits for more wealthy retirees.  There is no way of knowing at this time what Congress will do. 

In conclusion, retirees (especially the more wealthy ones) may find it prudent to consider the possibility of future Social Security benefit reductions when developing their retirement spending budgets.