Good Time for Retirees to Stress Test Their Investment/Spending Strategies

Thanks to Martin from Maine for pointing me to Bear Markets! Are They a Thing of the Past, by Greg Morris in StockCharts.com and for suggesting that some other retired readers of this website might benefit from doing some stress testing of their investment/spending strategies.  In his article, Mr. Morris quite rightly sounds a warning bell reminding us that bull markets generally turn into bear markets after a period of time and indicates that, based on his analysis, we may be close to the end of the most recent bull market.  He cites lots of scary statistics about bull and bear markets and concludes, “if the average bear market lasts about 26 months and it takes an average of 56 months to get back to where it started, that translates into a little over 5 years of going nowhere and that is not including the 1929 outlier.  Don’t even think about including the declining purchasing effects caused by inflation into the equation, it would only worsen the situation.”

Martin from Maine was sufficiently disturbed by Mr. Morris’ article that he decided to stress test his personal situation by using the spreadsheets on our website and modeling the estimated projected effects on his spending budgets for the next five years assuming a drop in his assets similar to that experienced in 2007-2009 followed by a recovery in equity investments back to “where the market started” as discussed by Mr. Morris above.   This 5-year projection required Martin to perform a little more math, as he had to roll forward his investment portfolio each year to reflect assumed withdrawals as well as assumed investment performance for the 5-year period.  Martin indicated that this extra work was very much worthwhile as he felt his family could survive such a period, albeit with some necessary belt tightening.   As a result of performing several five year forecasts and seeing the results, he claims that he is better able to sleep at night, which is always a good thing.

The rest of this blog provides an illustration of how you might go about performing your own 5-year projection/stress test.  For this illustration, we will look at a retiree named Beth, who is 70 years old.  Beth has determined that her essential expenses in retirement (including taxes) are about $45,000 per annum.  She is currently receiving a Social Security benefit of $20,000 per year, so she needs her accumulated savings to provide an additional $25,000 per year (in real dollars) to cover her essential expenses.  If she has additional assets, she can use them to provide for her non-essential expenses.

Beth currently has $750,000 in accumulated savings and no other sources of retirement income.   She has no bequest motive.  Using the recommended assumptions and the “Excluding Social Security” spreadsheet in this website, she determines that designating $500,000 as Essential Assets, she can expect to withdraw almost $25,000 per year (in real dollars) for the next 20 years.  That leaves her with $250,000 to allocate to non-essential expenses and as a general reserve fund in case her investments don’t do as well as expected.  To develop her non-essential spending budget for a year, she uses all the recommended assumptions, except she assumes that future non-essential expense budgets will remain the same in nominal dollars (she does this by inputting 0% for desired future increases with respect to this component of her total spending budget).

Because Beth has this dedicated non-essential pot of assets, she doesn’t feel the need to use the smoothing algorithm recommended in this website.  Each year, she will use the spreadsheet to determine how much essential assets she will need to support her essential expenses.  If this amount is less than needed, she will transfer money from her non-essential asset account.  If this amount is more than needed, she will transfer money to her non-essential asset account.   She has decided that for years that she has to transfer amounts from her non-essential account, she will not make a withdrawal from that account.  Finally, she invests the two accounts differently.  Her asset allocation for her essential asset account is 30% equities and 70% fixed income, while her asset allocation for her non-essential asset account is 70% equities and 30% fixed income. 

Now let’s take a look at what happens to Beth’s financial situation under conditions at little bit worse than outlined in Mr. Morris’ average bear market/recovery scenario.  Let’s assume that Beth earns the following returns on her equities:  Year 1: -40%, Year 2: -15%, Year 3: 15%, Year 4: 25% and Year 5: 36%.  Under this projected investment scenario, equities will just about get back to even at the end of the five year period.  We will also assume that Beth earns a constant 3% per annum on her fixed income investments and inflation remains at 2.5% per annum for the projection period.  Beth rebalances her investments at the beginning of each year, and for calculation simplicity we will assume that Beth spends exactly her budget amount each year.

(click to enlarge)

As shown in the chart above, Beth’s first year spending budget is $61,110.  This is the sum of her Social Security, withdrawal from essential spending and withdrawal from non-essential spending.  This total is determined at the beginning of the year before the stock market tanks.  We are assuming that Beth will spend exactly this amount, but in the real world, she is likely to cut back her spending somewhat as the year progresses.

At the beginning of year 2, she determines what her essential withdrawal budget is (in this case the $25,000 budget from the previous year increased with assumed inflation of 2.5%, or $25,625).  She uses the spreadsheet on this website to back into how much her essential assets will have to be to produce this amount.  She determines that assets of $497,000 will give her a withdrawal for Year 2 of $25,632.  But, because her essential assets lost $47,027 and she spent $24,976, she needs to transfer $69,003 from her non-essential account to give her assets of $497,000 at the beginning of Year 2. 

She rolls forward her non-essential account by subtracting withdrawals adding investment return and subtracting any amounts transferred to the essential asset account. 

She follows this same process each year of the 5-year forecast, applying the assumed investment returns to the respective equity and fixed income portions of her essential and non-essential accounts.  At the end of the period, her essential assets and essential spending budgets are just about the same as she had expected under the run-out tab of the spreadsheet, but because of the adverse investment experience, she would have to cut back her withdrawals from her non-essential spending account (which under the recommended assumptions was $16,134 each year) and her non-essential assets are about 61,000 lower than expected. 

Beth sees from this exercise that there are no guarantees when you self-insure your retirement and invest in equities.  She also sees that she can weather a fairly significant bear market, but not without some adjustments.  She might consider the purchase of an annuity to cover more of her essential expenses or she may look at alternatives to reduce some of her essential expenses if experience is worse than the assumed scenario. 

This is a website for number crunchers, so I know that you can do this 5-year projection.  And maybe you will make better decisions (or sleep better like Martin from Maine) as a result of kicking the tires on your financial strategies. 
 

Don’t Just “Tap Your Retirement Savings”; Develop a Reasonable Spending Budget

This post is a follow-up to my post of August 31 from last year, “Managing Your Spending in Retirement—It’s Not Rocket Science” in which I set forth a four step process for managing spending:

• Step #1 --develop a reasonable spending budget. 
• Step #2-- determine your living expenses/needs.
• Step #3—compare results of Steps #1 and #2 and make necessary adjustments
• Step #4—follow this process at least once a year

In this post I will use an example to point out the benefits of following this process as opposed to applying some overly simplified spend-down strategy to your accumulated savings.  I will do this by revisiting Mary, the hypothetical retiree we looked at in the May 21 post from this year. 

This past week Anne Tergesen of The Wall Street Journal (WSJ) summarized several popular dynamic withdrawal strategies currently advocated by experts as an alternative to the 4% Rule in her article, “A Better Way to Tap Your Retirement Savings”.  None of the withdrawal strategies discussed in this article consider the retiree’s living expenses/needs or suggest that the retiree make necessary adjustments if expenses/needs don’t line up with the retiree’s spending budget.  They all involve relatively simple mathematical adjustments designed to spend down accumulated savings, with such adjustments applied the same to all retirees, independently of different life expectancy expectations, different other sources of retirement income, different desires for wealth transfers, different desires for future budget patterns, etc.  In my opinion, each of the approaches proposed in this article are clearly inferior to the four step process outlined above using the Actuarial Approach discussed in this website to develop the retiree’s spending budget/budgets. 

As discussed in our May 21 post, Mary is a 65 year old single female retiree with $1,000,000 in accumulated savings, a fixed-dollar pension benefit of $15,000 per year and she is receiving a Social Security benefit of $20,000 per year.  Mary has determined that her essential expenses are $50,000 per year.  She wants to leave $500,000 to her daughter or have that money available for long-term care or other expenses near the end of her life.   She also wants to set aside $100,000 of her accumulated savings for unexpected expenses.

In addition, for purposes of today’s illustration, we are going to assume that $7,000 of Mary’s essential annual expenses are attributable to medical expenses and prescription drugs and that Mary will be establishing a separate budget (within her total spending budget) for these expenses (because Mary expects them to increase at a faster rate in the future than her other essential expenses).  Also, we are going to assume that Mary desires to be more conservative with respect to the investments supporting her essential expenses (both her health-related expenses and her non-health related essential expenses) and has therefore decided to purchase an immediate annuity of $13,000 per year (with $6,000 per year allocated to her health related budget and $7,000 per year allocated to her non-health related essential expense budget).  

Mary’s Desired Budget Patterns

Mary expects her medical expenses to increase by inflation plus 2% and she plans to have these expenses payable for 30 years (or her life expectancy if greater), the recommended payment period under the Actuarial Approach. 

Mary expects her non-medical essential expenses to increase by inflation each year and she also plans to have these expenses also payable for 30 years (or her life expectancy if greater).

With respect to non-essential expenses, Mary is comfortable assuming that these expenses will not increase with inflation and will be based on her life expectancy (initially 24 years).  She realizes that this desired pattern will produce a lower non-essential expense budget (in both real and nominal terms) for her as she ages if all assumptions are realized. 

Number Crunching Under the Actuarial Approach

As noted above, Mary decides to buy an immediate annuity that gives her $13,000 in annual benefit.  This annuity costs her $205,629 at current annuity prices and leaves her with remaining accumulated assets of $794,371 ($1,000,000 - $205,629).

Mary uses the Excluding Social Security spreadsheet available in this website to determine that $107,500 of her accumulated savings plus a $6,000 per year fixed income annuity is expected to give her an annual spending budget of $6,988 per year increasing by 4.5% per year (based on the recommended assumptions and no amounts left to heirs).  This is close to her $7,000 per year estimate of health related expenses that are expected to increase by inflation plus 2% each year. 

Mary uses the spreadsheet again to solve for how much of her accumulated savings she will need to cover her non-health related essential expenses and her bequest motive/long-term care reserve.  Her target for this calculation is about $23,000 (to which she will add her Social Security benefit of $20,000).  She enters $22,000 for the fixed annuity ($15,000 pension plus the $7,000 recently purchased annuity allocated to non-health essential expenses), the recommended assumptions and $500,000 to heirs and determines that $288,000 of her accumulated savings will give her a constant real-dollar spending budget of $23,012 annually, to which she will add her Social Security benefit of $20,000 per year to give her an expected non-health essential budget of $43,012 per year (and $500,000 to her heir) if all assumptions are realized and Mary spends exactly her budgeted amount each year. 

Mary also has a separate budget for unexpected expenses in the amount of $100,000.

After budgeting for her future health related expenses, her non-health related essential expenses (including the desired amount to be left to her heir) and her future unexpected expenses, Mary has $298,871 of accumulated savings left ($794,371 - $107,500 - $288,000 - $100,000) for her non-essential budget.  She enters that amount in the spreadsheet with a 24 year payout period and 0% annual increases (and the other recommended assumptions) to develop a non-essential spending budget for her first year of retirement of $19,730. 

Her total spending budget for her first year of retirement, then, is $69,730 plus whatever amount she decides to spend from her unexpected budget account.  Assuming no withdrawals from her unexpected budget account, her $69,730 budget for her first year of retirement comes from the following sources:

• Social Security: $20,000 
• Pension:           $15,000
• Life Annuity:    $13,000
• Savings:           $21,730
• Total:               $69,730

The total amount Mary expects to withdraw from her accumulated savings of $21,730 represents 2.74% of her accumulated assets of $794,371 (but only 0.35% of her non-health essential accumulated savings, only 0.92% of her health budget accumulated savings and 6.60% of her non-essential spending accumulated savings. 

By comparison, because the 4% Rule is just an accumulated savings withdrawal strategy (and not a budget setting strategy) that ignores the existence of Mary’s Pension and Life Annuity, it would suggest that Mary withdraw $31,775 from savings in addition to amounts she expects to receive from her pension, annuity and Social Security.   This would result in too much withdrawn from Mary’s essential budget accounts and too little withdrawn from her non-essential budget account to meet her spending objectives.  Using the Guyton Decision Rules with a 5% initial withdrawal rate would make things even worse in terms of meeting Mary’s objectives. 

Here is Mary’s Actuarial Balance Sheet under the Actuarial Approach.  The assumptions used to determine present values are the same as the assumptions used to develop the individual budget amounts.

(Click to enlarge)

Future Adjustments
 
In the future, lots of things will change.   These changes will include investment returns different from expected, spending different from budgets, inflation different from assumed, changes in mortality expectations, different expectations with respect to essential and non-essential spending, different expectations with respect to desired patterns of future budgets, different desires with respect to amounts left to heirs or expectations regarding long-term care, etc.  Since Mary is  re-visiting her retirement budget every year, she will be able to change her budget to accommodate these changes.  For example, if investment experience is more favorable than assumed, she can choose to beef up her amount left to heirs/reserve for future long-term care budget if that makes sense to her rather than increase her non-essential budget.  Unlike under the spend-down strategies featured in the WSJ article, Mary will have a significant amount of flexibility dealing with these changes in the future. 

Can These Other Approaches Do What The Actuarial Approach Does?

The short answer to this question is a resounding NO.  The approaches outlined in the WSJ article are spend-down strategies.  I recommend that they not be used if you want to develop a spending budget that reflects your individual situation and spending objectives. 

Another Example of Why You Want to Use the Actuarial Approach

In this post we are going to revisit our hypothetical retiree, Mike, whom we talked about in our posts of April 16, 2015 and February 25, 2015.  As you may recall, Mike is a single 65 year-old male retiree who is eligible to receive a Social Security benefit of $16,800 per annum and he also has accumulated savings of $750,000 but no other sources of retirement income.   As we saw in the previous posts, if Mike uses the Excluding Social Security spreadsheet from this website and the recommended assumptions (and no amount to be left to heirs), he will develop an initial spending budget of $49,427 ($16,800 from Social Security plus a $32,627 withdrawal from his accumulated savings).  If all the recommended assumptions are unchanged and exactly realized each year in the future and Mike spends exactly his spending budget each year, his spending budget would be expected to remain constant in real dollar terms until he reaches about age 90.  If he survives past age 90, his spending budget would be expected to decline somewhat as his age plus his life expectancy starts to exceed 95 (under the mortality assumptions in the 2012 Society of Actuaries Individual Annuitant mortality table with 1% projection). 

Here is Mike’s Actuarial Balance Sheet as of his 65th birthday for this base case.  Present values are determined using the recommended spreadsheet assumptions (4.5% discount rate, 2.5% inflation increases and death at age 95)

(click to enlarge)

As indicated in the previous posts, Mike is not pleased with his spending budget and he has looked at a number of alternatives to increase early year spending.  Mike knows that his life expectancy is 23 years under the Society of Actuaries mortality table.  Therefore, he knows that assuming a 30-year payout period is likely to be conservative and leave money unspent upon his death.   He also knows, however, that if he uses his life expectancy as the expected payout period, his spending budgets will decline in future years as life expectancy does not decrease by one year for each year that a retiree ages (see our post of December 3, 2014 for a graph of this effect).  Mike is also aware of experts who say that many retirees spend less in real dollar terms as they age.  So, Mike feels that there is some conservatism built into the recommended assumptions that he can exploit to increase his near-term spending budgets. 

Mike’s first step is to see how much his essential spending is.  He determines that his essential spending needs are about $40,000 per year.  With respect to his essential spending, however, Mike feels that it is important to be conservative both with respect to the expected payment period of 30 years and with respect to the desire to maintain constant purchasing power.  With a little playing around with the Excluding Social Security spreadsheet and QLAC purchase rates from Immediateannuities.com, Mike sees that if he designates $415,000 of his accumulated savings to essential spending, his entire Social Security benefit and spends $70,000 to purchase a deferred annuity starting at age 85 (with no benefit for death prior to that age), he can generate an initial essential spending budget of $40,074 ($16,800 from Social Security plus $23,274 from accumulated savings) that is expected to remain constant in real dollars over the next 30 years. 

This leaves Mike with $265,000 in accumulated savings ($750,000 - $415,000 dedicated to essential spending - $70,000 for purchase of the QLAC).  With respect to this $265,000 that he has decided to dedicate to non-essential spending, Mike is more willing to front-load this spending.  He decides that he will target his spending over his remaining life expectancy (not 30 years) and he will not build in any increases for future inflation.  Using the Excluding Social Security spreadsheet, he enters 23 for expected payout and 0% for desired increases due to inflation.   This gives him an initial non-essential spending budget of $17,924 and a total initial spending budget of $57,998 ($40,074 essential plus $17,924 non-essential).  This spending budget is approximately 17% higher than his base spending budget 0f $49,427.

Mike knows that his total spending budget will decline in real terms from year to year if all assumptions are realized.  In fact, he estimates that his non-essential spending budget will only be about $5,100 in real dollar terms at age 89.
Here is Mike’s Revised Actuarial Balance Sheet reflecting purchase of the QLAC.  

(click to enlarge)

It is important to note that even though Mike only spent $70,000 for the QLAC, the present value of benefits expected to be received under that contract is about $120,000 as Mike is assuming that he will live until age 95 (not his life expectancy assumed by the insurance company).  Thus, from a pure budget perspective (and not necessarily from an investment perspective), the purchase of the QLAC is a smart move.   He is using the mortality premium from the insurance contract to more cheaply fund future essential expenses than he can with his accumulated savings. 

Could Mike use a conservative approach for his essential spending and a less conservative approach for his non-essential spending and still obtain his desired increased spending budget with the 4% Rule, any safe withdrawal rate rule, or the Guyton decision rules?  Not bloody likely.  That is why smart retirees and their financial advisors should chooose the Actuarial Approach rather than some “simple” rule of thumb. 

The Actuarial Approach—Periodic Matching of a Retiree’s Assets and Liabilities

As I said in my previous post, any spending approach that does not periodically match a retiree’s assets with her liabilities runs a significant risk of failing to achieve the retiree’s spending objectives.   What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.

This post will illustrate, with an example, the matching of assets and liabilities achieved by the Actuarial Approach advocated in this website. 

Let’s assume that we have a hypothetical retiree named Mary who is age 65.  She has $1,000,000 in accumulated savings, a fixed dollar pension of $15,000 per year, a Social Security benefit of $20,000 per year and no other sources of income.  She has determined that her essential expenses in retirement will be about $50,000 per year.   Since believes that these essential expenses will stay reasonably constant in real dollar terms from year to year.   She would also like to leave around $500,000 (in future dollars) to her daughter at her death or have that money available for long-term care or extra medical bills if needed.  She also believes that she will need something like $100,000 for unexpected expenses not included in her essential expense budget, such as purchases of new automobiles or gifts to her daughter. 

Mary goes to the “Excluding Social Security” spreadsheet to see how much of her accumulated savings it will take, together with her pension and her Social Security benefit to cover her $50,000 annual real dollar essential expense budget and still leave her with $500,000 at her expected death.  She enters $600,000 in accumulated savings, $15,000 in annual pension, $500,000 to be left to heirs at death and the recommended assumptions (including a desired annual increase rate applicable to future budgets attributable to savings and pension of 2.5% per annum).  The resulting spending budget when Social Security is added is $51,401.  Since this is close to her estimate of essential expenses she decides she will dedicate $600,000 of her accumulated savings to her “essential expenses” budget along with her pension and her Social Security benefits.  She may even invest these essential expense assets differently than her other accumulated savings. 

To cover unexpected expenses, Mary dedicates $100,000 of her assets to this budget item.  Since she feels that the amount she desires to leave to her daughter at her death can serve several purposes, Mary does not feel it is necessary to dedicate additional assets to cover rising health costs or long-term care expenses.  Finally, Mary wishes to travel early in her retirement and have an active social life.  She dedicates her remaining $300,000 of accumulated savings toward non-essential spending but she wishes to front-load this budget item.  Therefore, she enters $300,000 in the Excluding Social Security spreadsheet with 0% increase in the annual desired increase.  The result for the first year is a non-essential spending budget of $17,624.  Mary knows that this budget item will not increase in nominal terms from year to year and therefore will represent a declining real spending budget as she ages.

Mary’s first year spending budget is $69,025 (a total of $51,401 from Social Security, her pension and her essential assets) plus $17,624 from her non-essential assets.   The exhibit below shows Mary’s Actuarial Balance Sheet as of her date of retirement.  The present values are based on the recommended assumptions and results from the Excluding Social Security spreadsheet. 

Click to enlarge

Mary will revisit her spending budget thought process at the beginning of each new year.  She will use the Excluding Social Security spreadsheet and enter new data and new assumptions.  Investment experience may deviate from the assumptions she used.  Her spending may deviate from her budget.  Assumptions may be changed.  Her objectives and liabilities may change (or she may refine what is essential and what is not essential).  If she continues to use the Actuarial Approach, she has the flexibility to make informed adjustments in her budgets.  Each year, she will balance her assets and her liabilities.  If she uses the recommended smoothing algorithm, assets and liabilities may not be perfectly matched, but she knows that the match will be close enough. 

Mary knows that she has to crunch a few more numbers under the Actuarial Approach than she would have to under the 4% withdrawal rule or some other variation of this rule, but Mary feels much more comfortable with the control she has over her spending budget using this much more sophisticated (and not that much more complicated) approach.  Mary also finds comfort in the fact that the approach she is using is consistent with basic actuarial principles and is not just some simple rule of thumb approach.  

Want to Really Take the Guess-Work Out of Your Retirement Spending Budget?

Once again we read in the popular press about the 4% Rule and the tinkering that will be necessary to make this rule (or some form of this rule) possibly work in retirement.   In his May 13, 2015 article, 4 Reasons Why the 4% Rule Isn’t a Hard and Fast Rule, David Ning tells us that spending needs to be adjusted in retirement.  His “hard and fast” advice for doing this is that “you will be tempted to spend more in bull markets” and “you should decrease spending in bear markets.”  In her May 8 article in The New York Times, New Math for Retirees and the 4% Withdrawal Rule, Tara Siegel Bernard quotes several industry experts with various opinions about the 4% rule and different adjustments that might make the rule work.  The experts in this area continue their search (using their Monte Carlo modeling) for a Holy Grail spending rule to replace the now-suspect 4% Rule.  So, what is a poor retiree to do now without a clear, simple spending rule of thumb?

Sorry folks, but a retiree’s budget problem is basically an actuarial problem that requires an actuarial solution.  The retiree (or the retiree’s advisor) needs to periodically match the retiree’s assets with her liabilities.  What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.  Any simple spending rule of thumb that doesn’t attempt to match these assets and liabilities (and most common approaches don’t) runs a significant risk of not meeting the retiree’s spending objectives.

Ok, we’ll does this actuarial solution come in the form of a simple rule of thumb like the 4% Rule?  No.  It doesn’t.   And while periodically matching assets and liabilities requires some number crunching, the Actuarial Approach and spreadsheets set forth in this website do most of the work for you.  The process is relatively straightforward and doesn’t require you to be an actuary.

As we said in our post of August 2, 2014, Are You “Most People”?, the Actuarial Approach is not for everyone.  It for someone who wants more than a questionable simple rule of thumb who is willing to do a little number crunching for the purpose of taking the guess-work out of developing a reasonable spending budget.

Brief Explanation of How to Use the Actuarial Approach, Revised

The June, 2014 explanation of how to use the Actuarial Approach has been revised to incorporate necessary adjustments to the general process for those retirees who want to “front-load” their spending budgets instead of developing a spending budget that is expected to remain constant in real dollar terms from year to year.  Here is a link to the revised explanation.

16th Annual Transamerica Retirement Survey of Workers

The Transamerica Center for Retirement Study has released its annual survey of workers of all ages on the subject of retirement, entitled Retirement Throughout the Ages: Expectations and Preparations of American Workers. This survey provides lots of interesting information, and the Center uses this information to make recommendations to workers, employers and policymakers (pages 18, 19 and 20). 

Consistent with results from prior years, "outliving my savings and investments" was cited by workers of all ages as their most frequently cited fear (page 31).  Of course, addressing this fear by developing a reasonable spending budget in retirement is what this website is all about.

Of particular interest to me, in light of my previous post about the need to strengthen Social Security financing, were the results shown on page 36--that 47% of surveyed individuals in their 60s reported that Social Security will be their primary source of income in retirement and the results shown on page 32 that many individuals are concerned about the future of Social Security. But, despite these fairly disturbing results, the Center's Recommendations to Policymakers fail to mention any action to fix Social Security at all. As I said in my previous post, I believe the first step toward increasing workers' retirement outlook in the future should be to make sure that Social Security, the foundation of retirement security for most Americans, is solid. 

A Better Financing Approach for Social Security

In my post of March 1, 2015, I briefly discussed Social Security’s financial problem. In this post, I will once again mount my steed and tilt at the Social Security financing windmills by advocating adoption of a more actuarial approach to solving the problem. Readers who desire more background on the problem, the confusion resulting from the different approaches used to measure the size of the problem, how the problem came about and how Canada solved a similar problem can read my article in the May/June issue of Contingencies Magazine, the magazine for the actuarial profession.
  
Briefly, the 1983 Amendments to Social Security solved the financial problem that existed at that time, which was measured using the 75-year Actuarial Balance. This measurement is still around today and is widely quoted in the press as representing the size of the problem that needs to be solved today, but it was defective as a measure of the size of the problem in 1983, and it remains defective today. The 75-year Actuarial Balance calculation fails to reflect the future deficits expected after the end of the 75-year projection period.  For this reason, the Social Security actuaries have proposed a stronger measure they refer to as “Sustainable Solvency” which would also require, at the time of a measurement, that trust fund ratios at the end of the 75 year projection period be expected to remain stable or on an upward trend. Unlike the 75-year Actuarial Balance calculation, the stronger requirement for Sustainable Solvency is not well quantified in the annual Trustee’s Report and therefore, it tends to get ignored when discussing reform options. 

As noted in the article, Canada faced a similar financing problem with The Canada Pension Plan and implemented sweeping reforms in 1997. These reforms included self-sustaining provisions (automatic adjustments) to safeguard desired levels of funding, which resulted in Sustainable Solvency not only at the time of adoption of the changes, but also provided a mechanism for maintaining Sustainable Solvency in the future. I call this even stronger requirement, “Self-Sustaining Sustainable Solvency.” Actuaries, who work with the concept of automatic adjustments every day, may simply call this approach “actuarial financing.” I believe that the approach adopted in Canada provides a good blue-print for similar action in the U.S. 

From time to time, we hear someone call for a national conversation on retirement in light of the retirement “crisis” in this country. Without a doubt, the first step in addressing this issue has to be making sure that Social Security, the foundation of retirement security for most Americans, is solid. I believe adoption of actuarial financing for Social Security is important for keeping that foundation strong for the future. 

I want to thank Jean-Claude Menard, Chief Actuary for The Canada Pension Plan, for his thoughtful comments on an initial draft of the article and for his patience with me in explaining the process used in Canada. 

Regarding the Don Quixote reference above, this is not the first time that I have advocated consideration of a more actuarial approach for Social Security financing (anticipating a tax rate expected to remain level indefinitely). Back in 1982 when the National Commission on Social Security Reform was working on what would become the 1983 Amendments, I wrote a paper that was subsequently published in the 1983 Transactions of Society of Actuaries entitled, “A Better Financial Approach for Social Security.” While this paper may be available from the SoA library, it is very difficult to find (and probably worth a lot of money).  If you are interested in reading my thoughts on Social Security financing from around that time, a staff member of the Conference of Consulting Actuaries was able to provide me with a pdf version of the transcript of my paper and presentation, “Social Security--There Will Be No Long-Term Solvency With Pay-As-You-Financing” from a 1984 meeting of what was then the Conference of Actuaries in Public Practice. 

Revisiting the Guyton Decision Rules

To err is human, and I am very human.  In this post I will issue not one but two corrections of errors made in prior posts.

In our post of April 18, 2015, we showed a graph that compared the expected pattern of future spending budgets for a hypothetical age 65 male retiree who buys a fixed income annuity (Single Premium Income Annuity, or SPIA) under the Actuarial Approach (assuming desired increases in the annual budget equal to the assumed future annual rate of inflation) with budgets produced using the Guyton Decision Rules.  Budget amounts shown were total budgets, including Social Security, payments from the annuity and withdrawals from accumulated savings. 

Subsequent to the April 18th post, I received a nice note from Dr. Wade Pfau indicating that I appeared to have incorrectly applied the Guyton Decision Rules in the example.  Instead of increasing the prior year’s budget with inflation (the preliminary withdrawal amount for the year), the Guyton Decision Rules impose a 10% reduction in the withdrawal amount for a year in which the preliminary withdrawal amount divided by accumulated savings at the beginning of the relevant year exceeds 120% of the initial withdrawal rate.  Mr. Guyton refers to this decision rule as the “capital preservation rule.”  I correctly applied this reduction, but I was unaware, however, that this capital preservation rule is not applied if the retiree is “within 15 years of the maximum planning age.”

Graph #1 below corrects the graph provided in the April 18th post by ceasing application of Mr. Guyton’s capital preservation rule at age 80.   I will also add a warning to my post of July 3, 2014 cautioning those who may visit that post that the graph shown is not based on a correct interpretation of the Guyton Decision Rules.

Graph 1 (click to enlarge)

Dr. Pfau also indicated that since many retirees like higher real dollar spending early in retirement, it wasn’t so obvious to him that the constant spending budget produced under the Actuarial Approach was more desirable.  I’m was actually a little surprised to hear this from Dr. Pfau, as most withdrawal strategies appear to have constant real dollar spending as an objective, and I was somewhat curious as what there was about buying a fixed income annuity that would significantly change someone’s spending objective.  But, be that as it may, as indicated in my previous post, it is easy to change the shape of expected future real dollar budgets under the Actuarial Approach to satisfy a retiree’s objectives.  For example, Graph #2 shows expected future real dollar spending budgets if the same hypothetical retiree makes the conscious decision to front-load his spending budget by inputting 0% desired increases in the portion of his total spending budget attributable to accumulated savings and annuity payments (the Social Security component of his spending budget would still be expected to increase by the inflation assumption of 2.5% per annum).

Graph 2 (click to enlarge)

While the spending budgets shown in Graph 2 for the two approaches are close, the important distinction between the two approaches is that the decision to front-load under the Actuarial Approach is a conscious one where the retiree is fully aware of the out-year implications if future experience is close to assumed experience on average (and the retiree is aware that he has made a commitment not to give himself inflation increases in future years, at least with respect to the portion of his spending budget attributable to the annuity and withdrawals).  The same cannot be said if he uses the Guyton Decision Rules because the retiree doesn’t know what the assumptions for future experience are under that approach.

Even though ceasing application of Guyton’s capital preservation rule when the retiree is within 15 years of the maximum planning age may improve the Guyton’s Decision Rules, I am still not a fan of them.  They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy.   As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive.  If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed.   For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement).  If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions).  After the 15th year, there are no cut backs, but there is a risk of running out of money.  Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.”  Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives.  Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities (the present value of the future expected/desired withdrawals and annuity payments) under a reasonable set of assumptions about the future.

As a further illustration of how the Guyton Rules fail to coordinate with other fixed income sources of retirement income, Graph #3 shows expected future real dollar spending budgets for our hypothetical retiree under the assumption that instead of buying the immediate annuity at 65 (SPIA), he spends $150,000 of his accumulated savings on a deferred income annuity (DIA) with benefits commencing at age 80.  According to today’s Immediateannuities.com website, he would be eligible to receive payments of $40,776 for life starting at age 80 (and nothing if he dies prior to age 80) for a premium of $150,000.  Using the Excluding Social Security spreadsheet on this site and inputting the recommended assumptions, $850,000 in accumulated assets ($1,000,000 minus the $150,000 used to purchase the DIA), $40,776 in deferred annuity payments and 16 years as the deferred annuity commencement year [Note, since the retiree in this instance is age 65 in year 1, he is assumed to reach age 80 in year 16, 15 years later.  This is correction #2 of this post as I myself haGraph 1 (click to enlarge)ve made the mistake of inputting 15 years for a deferred annuity starting at age 80 or twenty years for a deferred annuity starting at age 85 for a 65 year old retiree in prior posts discussing deferred annuities/QLACs].  Finally, this graph also assumes that the retiree makes the decision to front-load spending in the same manner as for Graph #2 by inputting 0% desired increases in future spending budgets attributable to the annuity and withdrawals from accumulated savings.  

Graph #3 (click to enlarge)

Graph #3 shows that the Actuarial Approach produces an expected total spending budget pattern that is comparable to the pattern it produced in Graph #2, while the expected spending budget pattern produced by the Guyton Spending Rules under these assumptions doesn’t appear to be consistent with the retiree’s front loaded spending objectives.

Expected Real Dollar Spending Budget Shaping

As indicated in previous posts, retirees and their financial advisors can use the Actuarial Approach to provide different patterns of future expected real dollar spending budgets.  If the user of the "Excluding Social Security" spreadsheet on this website inputs the recommended assumptions and sets the desired increase in payments equal to the inflation assumption, annual future budgets (including Social Security) are expected to remain constant in real dollar terms from year to year until the retiree reaches almost age 90  (when age plus life expectancy starts to exceed 95) if all assumptions are realized, assumptions are not changed and actual spending exactly equals budgeted spending.  As discussed in our previous post,  unlike under many other withdrawal strategies, this is true under the Actuarial Approach even if the retiree has other fixed dollar sources of retirement income such as pension income or immediate or deferred annuity income. 

There is a school of thought that says that spending generally declines in real terms as we age.  See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject.  In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption.   In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used.  Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate. 

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter.  While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis.  Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem. 

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater.  I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive.  For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase.  In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%).  He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget.  In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%).  After 10 years, he will just use 1.5% (assumed inflation minus 1%).  In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above.  For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.   
     
The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter).  The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year).  While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).  

(click to enlarge)

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later.  If you want to "front-load" your spending, you can do this in several ways.  You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement.  The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income.  You should also have a sense of what the out-year implications may be of a decision to front-load your spending.  I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard.  If you aren't using the Actuarial Approach and you/your financial advisor aren't  adequately addressing these issues, you may wish to consider switching to the Actuarial Approach.  At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.