In Dirk Cotton’s post of December 11, Positive Feedback Loops: The Other Road to Ruin, he draws a clever analogy between positive feedback loops (such as in a public address system) and financial ruin in retirement and illustrates his analogy with some southern story telling about a couple named Jim and Linda. According to Dirk,
“Each year that Jim and Linda spent more than planned from their portfolio increased their probability of ruin. The continual shrinking of their portfolio value as the market fell increased it even more. Soon that probability of ruin was a lot more than the original 5%.
Their portfolio spending strategy had drifted into a positive feedback loop… wherein every year that they overspent from their savings they increased the risk of portfolio ruin, reduced their capacity to recover when the market did, and decreased the amount of spending that would be considered safe the following year, increasing the probability that they would need to overspend yet again.”
Dirk uses his analogy and example (as well as citing research by Larry Franks, Stout and Mitchell) to argue that reducing spending when investments fall significantly decreases the probability of financial ruin. While poor investment returns can certainly pose a problem for retirees, keeping spending constant (or increasing it) during a period of poor returns is the “other road to ruin.”
Dirk’s story illustrates why I advocate a dynamic spending strategy (the Actuarial Approach) that automatically adjusts for investment experience (good or poor) as well as prior spending (over or under). His post also ties in very well with my post of December 10, where I encourage retirees (and their financial advisors) who prefer “safe” withdrawal approaches (and the associated spending stability) to develop an action plan by kicking the tires on their spending strategy. They can do this by using the 5-year projection tab in our spreadsheet to determine just how far away from the actuarially determined spending budget they are willing to go in their quest for budget stability before they decide they need to make a change.
Thursday, December 17, 2015
Tuesday, December 15, 2015
Another Researcher Concludes that a Combination of Annuities and Asset Withdrawals is Generally More Effective than 100% of One or the Other
Like Dr. Wade Pfau’s research (discussed in our post of July 25, 2015), Mark Warshawsky’s research concludes that “A combination strategy of asset withdrawals and purchases of immediate life annuities provides the best balance of lifetime income and flexibility.” He illustrates the financial benefits of combining the immediate annuity purchases and asset withdrawals for a couple both age 65 who choose to annuitize 15% of their assets initially and gradually increase the portion of their annuitized assets to 25% over a twenty year period.
Mr. Warshawsky argues that single premium immediate annuities are more effective than qualified longevity annuity contracts (QLACs) and therefore, as a policy matter, should receive at least as favorable tax treatment under the Required Minimum Distribution (RMD) rules afforded QLACs. He proposes a specific change to current regulations that would make the RMD treatment consistent, in his opinion.
As has been discussed many times in my posts, I am a big fan of diversification of retirement income sources. Therefore, I applaud the research of Messrs. Pfau and Warshawsky and remind readers that the Actuarial Approach is one of the few approaches out there that properly coordinates withdrawals from invested assets with life insurance annuities (be they immediate annuities or QLACs).
Mr. Warshawsky argues that single premium immediate annuities are more effective than qualified longevity annuity contracts (QLACs) and therefore, as a policy matter, should receive at least as favorable tax treatment under the Required Minimum Distribution (RMD) rules afforded QLACs. He proposes a specific change to current regulations that would make the RMD treatment consistent, in his opinion.
As has been discussed many times in my posts, I am a big fan of diversification of retirement income sources. Therefore, I applaud the research of Messrs. Pfau and Warshawsky and remind readers that the Actuarial Approach is one of the few approaches out there that properly coordinates withdrawals from invested assets with life insurance annuities (be they immediate annuities or QLACs).
Thursday, December 10, 2015
Use Our Revised Spreadsheet to Keep Your (or Your Client’s) Safe Withdrawal Rate (SWR) Approach on Track
After our post of December 7 entitled “Is the Actuarial Approach Really the Only Financial Planning Software Capable of Helping You Formulate an Actual Financial Plan?” Michael Kitces graciously responded by indicating that, based on a quick review our spreadsheet, it did not appear to him to represent the “financial planning” he had in mind in his post. He said,
“To say ‘just recalculate your spending based on your account balance annually’ is not what I consider a viable real-world solution for most people, because it translates 100% of market volatility into an identical amount of spending volatility on a 1:1 basis, and most people can’t handle that much spending volatility. Nor do they need to. In a world where retirees only spend 3%-4% of the portfolio, there’s no reason to cut your core spending by 20% because the OTHER 97% of the portfolio has a temporary/short-term downdraft. That’s the whole point (indirectly) of the safe withdrawal rate research – when your spending is sufficiently low, you don’t have to cut spending in down markets, because you’ve left enough available to ride out the volatility.”
While I do advocate a dynamic approach that periodically adjusts a retirees’ spending budget (or budget components) for actual experience, I do see Michael’s point (and there is no question in my mind that the man is extremely bright, an excellent writer and tremendously productive) . That is why I also recommend using a budget smoothing algorithm, and I take great pains to talk about spending budgets rather than the amount to be spent in a year (which is up to the retiree and may or may not be equal to the retiree’s spending budget). In other words, the retiree can always smooth her spending either by smoothing the spending budget or by spending more or less than the spending budget determined using the Actuarial Approach without smoothing. The key advantage of the Actuarial Approach over an approach such as the Safe Withdrawal Approach is that you always know how much you can spend to keep your current assets in balance with your current liabilities (the present value of future spending budgets based on reasonable assumptions and desired spending goals). With an SWR approach (which I feel is kind of a “head-in-the sand” approach that relies on past results which may or may not be repeated), the retiree doesn’t really know when spending can (or should) be increased (or decreased) or if it should be changed, by how much, which I felt was the primary concern expressed in Michael’s post.
In response to Michael’s feedback (which is always appreciated), I have modified the 5-year projection tab in the “Excluding Social Security” spreadsheet available in this website (updated with this post to version 3.1) to allow users to input different “actual” spending amounts (such as spending under an SWR approach) to see how future “actual” investment returns and actual spending amounts affect the spending budget determined under the Actuarial Approach. Financial advisors and/or their clients can then compare their desired smoothed spending with the actuarial spending budget under various investment/spending scenarios to see if (and when) changes in the SWR spending should take place.
I will illustrate with an example. Let’s assume that Bill is a 65-year old male with accumulated savings of $800,000, an annual fixed dollar pension of $12,000 per year and Social Security of $20,000 per year. Let’s further assume that Bill wants to leave $100,000 to heirs at his demise and he wants his spending to remain constant in real dollar terms until he dies (and, for illustration purposes, he doesn’t determine a separate spending budget for essential expenses, non-essential expenses, etc. as I generally recommend). Bill goes to the input tab of the spreadsheet, where he inputs the recommended assumptions, $800,000 in accumulated savings, $12,000 in immediate life annuity amount and $100,000 as desired amount remaining at death. He also inputs 2.5% as the expected rate of inflation (which is also equal under the recommended assumptions to the desired annual rate of increase in spending budget). The input tab shows that his actuarially determined spending budget for the first year (under these assumptions and input items, excluding Social Security, income from employment and other miscellaneous income) is $42,526 ($32,526 from accumulated savings and $12,000 from the pension). He then goes to the Runout and Inflation-adjusted Runout tabs and sees that if all input assumptions are realized in the future (and the expected payment period is reduced by one each year), his annual real dollar spending budget attributable to withdrawals from savings and his fixed dollar annuity will remain at $42,526 for thirty years and he will have $47,674 in real dollar assets ($100,000 in nominal assets) to pass along to his heirs.
Bill then goes to the 5-year projection tab. If he inputs 4.5% for annual investment returns for each future year and inputs the amounts shown in column L of the Runout tab for actual amounts spent, then the actuarially determined spendable amount will equal the amounts Bill has input for actual spending. But like Micheal Kitces, Bill is not interested in using the Actuarial Approach to determine the amount he wants to spend each year. He wants to use the 4% rule and he even wants to cheat a little and have his total non-Social Security spending budget (the sum of his withdrawal from savings and his fixed dollar pension in his first year of retirement) increase with inflation each year. So he inputs the following amounts for “actual” amount spent: $44,000 (.04 X $800,000 plus $12,000), $45,100 ($44,000 X 1.025), $46,228, $47,383, and $48,568. He also wants to stress test his investments to some degree, so he inputs -15% for year 3 (keeping actual returns at 4.5% for the other years). He sees that under this scenario in year 4, the actuarially balanced spending budget (excluding Social Security) decreases to $38,489, and the ratio of amount Bill wants to spend in year 4 to the actuarial spending budget is 123%. When Bill factors in his expected Social Security benefit into both amounts, however, this ratio is only about 115%. Is this ratio high enough to get Bill to change his spending in year 4 if this scenario were to occur? Who knows? However, Bill, with the possible assistance of his financial advisor, can use this spreadsheet to look at different investment/spend scenarios to determine what his “change thresholds” might be and what the specific changes would be if such thresholds are exceeded in the future.
I encourage you (and/or your financial advisor) to play with the new spreadsheet to help you develop a true financial plan that addresses actions you will try to take if your spending falls off the actuarially balanced track.
“To say ‘just recalculate your spending based on your account balance annually’ is not what I consider a viable real-world solution for most people, because it translates 100% of market volatility into an identical amount of spending volatility on a 1:1 basis, and most people can’t handle that much spending volatility. Nor do they need to. In a world where retirees only spend 3%-4% of the portfolio, there’s no reason to cut your core spending by 20% because the OTHER 97% of the portfolio has a temporary/short-term downdraft. That’s the whole point (indirectly) of the safe withdrawal rate research – when your spending is sufficiently low, you don’t have to cut spending in down markets, because you’ve left enough available to ride out the volatility.”
While I do advocate a dynamic approach that periodically adjusts a retirees’ spending budget (or budget components) for actual experience, I do see Michael’s point (and there is no question in my mind that the man is extremely bright, an excellent writer and tremendously productive) . That is why I also recommend using a budget smoothing algorithm, and I take great pains to talk about spending budgets rather than the amount to be spent in a year (which is up to the retiree and may or may not be equal to the retiree’s spending budget). In other words, the retiree can always smooth her spending either by smoothing the spending budget or by spending more or less than the spending budget determined using the Actuarial Approach without smoothing. The key advantage of the Actuarial Approach over an approach such as the Safe Withdrawal Approach is that you always know how much you can spend to keep your current assets in balance with your current liabilities (the present value of future spending budgets based on reasonable assumptions and desired spending goals). With an SWR approach (which I feel is kind of a “head-in-the sand” approach that relies on past results which may or may not be repeated), the retiree doesn’t really know when spending can (or should) be increased (or decreased) or if it should be changed, by how much, which I felt was the primary concern expressed in Michael’s post.
In response to Michael’s feedback (which is always appreciated), I have modified the 5-year projection tab in the “Excluding Social Security” spreadsheet available in this website (updated with this post to version 3.1) to allow users to input different “actual” spending amounts (such as spending under an SWR approach) to see how future “actual” investment returns and actual spending amounts affect the spending budget determined under the Actuarial Approach. Financial advisors and/or their clients can then compare their desired smoothed spending with the actuarial spending budget under various investment/spending scenarios to see if (and when) changes in the SWR spending should take place.
I will illustrate with an example. Let’s assume that Bill is a 65-year old male with accumulated savings of $800,000, an annual fixed dollar pension of $12,000 per year and Social Security of $20,000 per year. Let’s further assume that Bill wants to leave $100,000 to heirs at his demise and he wants his spending to remain constant in real dollar terms until he dies (and, for illustration purposes, he doesn’t determine a separate spending budget for essential expenses, non-essential expenses, etc. as I generally recommend). Bill goes to the input tab of the spreadsheet, where he inputs the recommended assumptions, $800,000 in accumulated savings, $12,000 in immediate life annuity amount and $100,000 as desired amount remaining at death. He also inputs 2.5% as the expected rate of inflation (which is also equal under the recommended assumptions to the desired annual rate of increase in spending budget). The input tab shows that his actuarially determined spending budget for the first year (under these assumptions and input items, excluding Social Security, income from employment and other miscellaneous income) is $42,526 ($32,526 from accumulated savings and $12,000 from the pension). He then goes to the Runout and Inflation-adjusted Runout tabs and sees that if all input assumptions are realized in the future (and the expected payment period is reduced by one each year), his annual real dollar spending budget attributable to withdrawals from savings and his fixed dollar annuity will remain at $42,526 for thirty years and he will have $47,674 in real dollar assets ($100,000 in nominal assets) to pass along to his heirs.
Bill then goes to the 5-year projection tab. If he inputs 4.5% for annual investment returns for each future year and inputs the amounts shown in column L of the Runout tab for actual amounts spent, then the actuarially determined spendable amount will equal the amounts Bill has input for actual spending. But like Micheal Kitces, Bill is not interested in using the Actuarial Approach to determine the amount he wants to spend each year. He wants to use the 4% rule and he even wants to cheat a little and have his total non-Social Security spending budget (the sum of his withdrawal from savings and his fixed dollar pension in his first year of retirement) increase with inflation each year. So he inputs the following amounts for “actual” amount spent: $44,000 (.04 X $800,000 plus $12,000), $45,100 ($44,000 X 1.025), $46,228, $47,383, and $48,568. He also wants to stress test his investments to some degree, so he inputs -15% for year 3 (keeping actual returns at 4.5% for the other years). He sees that under this scenario in year 4, the actuarially balanced spending budget (excluding Social Security) decreases to $38,489, and the ratio of amount Bill wants to spend in year 4 to the actuarial spending budget is 123%. When Bill factors in his expected Social Security benefit into both amounts, however, this ratio is only about 115%. Is this ratio high enough to get Bill to change his spending in year 4 if this scenario were to occur? Who knows? However, Bill, with the possible assistance of his financial advisor, can use this spreadsheet to look at different investment/spend scenarios to determine what his “change thresholds” might be and what the specific changes would be if such thresholds are exceeded in the future.
I encourage you (and/or your financial advisor) to play with the new spreadsheet to help you develop a true financial plan that addresses actions you will try to take if your spending falls off the actuarially balanced track.
Monday, December 7, 2015
Is the Actuarial Approach Really the Only Financial Planning Software Capable of Helping You Formulate an Actual Financial Plan?
This post is in response to Michael Kitces’ excellent December 7 post entitled, Is Financial Planning Software Incapable of Formulating An Actual Financial Plan? I can’t improve on what Mr. Kitces has to say or how he says it, so I will simply encourage you to read his post.
There is one statement, however, that Michael makes with which I will have to disagree:
“Answering a simple planning question like ‘how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track’ cannot be easily answered with any financial planning software available today!”
With all due respect to Mr. Kitces, I’m aware of at least one website that contains financial planning software that can easily answer these questions—this one. The Actuarial Approach utilizing the “Excluding Social Security V 3.0” spreadsheet and its 5-year projection tab is available to anyone with access to the Internet and who has Microsoft Excel. The 5-year projection tab allows retirees to see the effect on their annual spending budget (excluding income from Social Security, income from employment or miscellaneous income such as income from rental property) of variations of future investment return from the expected investment return used to determine the baseline spending budget under the Actuarial Approach. It also tells users how to adjust spending to get back on track.
I knew that the Actuarial Approach was an effective approach for developing a reasonable spending budget, but I didn’t realize that it was the only approach capable of helping you (or your financial advisor) formulate an actual financial plan. If you don’t currently use it, you might want to give it a try.
There is one statement, however, that Michael makes with which I will have to disagree:
“Answering a simple planning question like ‘how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track’ cannot be easily answered with any financial planning software available today!”
With all due respect to Mr. Kitces, I’m aware of at least one website that contains financial planning software that can easily answer these questions—this one. The Actuarial Approach utilizing the “Excluding Social Security V 3.0” spreadsheet and its 5-year projection tab is available to anyone with access to the Internet and who has Microsoft Excel. The 5-year projection tab allows retirees to see the effect on their annual spending budget (excluding income from Social Security, income from employment or miscellaneous income such as income from rental property) of variations of future investment return from the expected investment return used to determine the baseline spending budget under the Actuarial Approach. It also tells users how to adjust spending to get back on track.
I knew that the Actuarial Approach was an effective approach for developing a reasonable spending budget, but I didn’t realize that it was the only approach capable of helping you (or your financial advisor) formulate an actual financial plan. If you don’t currently use it, you might want to give it a try.
Saturday, December 5, 2015
Use the Actuarial Approach and Our Spreadsheet to Address QLAC “Challenges”
Almost eighteen months after the IRS released final regulations on Qualified Longevity Annuity Contracts (QLACs), the market for these insurance products has become more robust, and retirement experts are becoming more aware of the potential advantages associated with QLACs. See, for example, my post of November 24, 2015. On the other hand, retirement experts and financial advisors are also discovering that integrating these products with a retiree’s withdrawals from accumulated savings can present some challenges. I discussed the potential pluses and minuses of QLACs in my post of July 12, 2015. Last month, The Stanford Center on Longevity, in coordination with the Society of Actuaries’ Committee on Post-Retirement Needs and Risks, published interim results of Phase 3 of their series on optimal retirement income solutions in DC plans entitled, “Using QLACs to Design Retirement Income Solutions.” This report correctly notes that buying QLACs complicates the spending budgeting process to some degree by introducing the potential for a discontinuity before and after the date that the QLAC payments are to commence (assumed to be age 85 in the report). The report cites three key challenges for retirees and their advisors when buying QLACs:
Before he finalizes his spending budget for the year, he decides that he would like to see what the effect might be if he were to buy a QLAC with some of his IRA money. So he goes to Immediateannuities.com and determines that if he pays an immediate premium of $100,000 he could receive a single life annuity commencing at age 85 of $4,406 per month ($52,872 per year) with no benefit payable to him or his heirs if he dies prior to age 85. He then goes back to the spreadsheet on this website and enters $700,000 instead of $800,000 in accumulated savings ($800,000 – the $100,000 premium for the QLAC), $52,872 in Annual Deferred Annuity benefit to commence in the future and 21 as the Deferred Annuity commencement year. All the other input items remain the same as above. The spreadsheet tells him that $38,337 of his accumulated savings (5.48% of $700,000) may be spent during the year and his total spending budget would be $58,337 ($38,337 + $20,000 from Social Security, or about 6.5% higher than his spending budget without the QLAC). He looks at the inflation-adjusted runout tab and sees that if all the assumptions are realized in the future (and inflation is 2.5% per annum), the sum of the withdrawal from savings plus the fixed dollar benefit from the QLAC is expected to be $38,337 in each of the next 30 years. He also sees that his expected accumulated savings is only $85,184 at age 85 when payments from the QLAC are to commence as compared with inflation-adjusted assets of $319,524 at age 85 if he didn’t buy the QLAC. Thus, while buying the QLAC can increase Max’s real dollar spending budget, it comes at the cost of increased spending from accumulated savings and therefore lower expected accumulated savings in later years, all things being equal. Max also looks at the effect on his spending budget of starting his QLAC at age 80 rather than 85 and the effect of buying a QLAC with various death benefits, by inserting the different benefit amounts payable under different payment forms for a $100,000 premium from Immediateannuities.com.
Despite the possibility of having lower accumulated savings in later years, Max likes the increase in his real dollar spending budget that he can achieve with the single life QLAC with no death benefit payable starting at age 85, and decides to see what the effect would be if he paid $125,000 for a QLAC (the maximum under the IRS for Max under current regulations) rather than $100,000. So he enters $675,000 in accumulated assets ($800,000 - $125,000), a $66,096 deferred annuity amount (from Immediateannuities.com) and 21 as the commencement year. The program tell him that the “goal cannot be achieved”, which means that under the input assumptions, total constant dollar spending from withdrawals and the QLAC for the entire input period cannot be achieved (input accumulated savings are insufficient to meet the constant dollar spending goal). Max has a number of options at this point, including living with a possibility that there will be a discontinuity in his real dollar spending budget at (or after) age 85. For example, if he inputs 20 years for the “expected payout period”, zero deferred annuity and $675,000 of accumulated assets, he can expected, under the recommended assumptions to have an annual real dollar spending budget (not including Social Security) of $40,300 prior to age 85 and a fixed dollar benefit from the QLAC of $66,096 ($40,336 in real dollars at age 85 and decreasing thereafter, not including Social Security).
So, let’s assume that Max chooses the no death benefit QLAC commencing at age 85 with the $100,000 premium. Every year in the future, he will re-run the spreadsheet with new numbers and assumptions. Depending on his actual investment experience, he could run into one or more years in which he sees “goal not achieved” if he suffers significant investment losses. For example, if he inputs a -20% investment return in the first year of the 5-year projection (in the 5-year projection tab), he will see “value” which is equivalent in the 5 year projection tab to “goal not achieved.” If this possibility is bothersome to Max, he has a number of alternatives, including choosing to buy a QLAC that pays lower benefits or investing his accumulated savings more conservatively to avoid significant losses.
I’ve used Max to illustrate how the Actuarial Approach and its simple spreadsheet can be used (along with QLAC quotes from Immediateannuities.com or from some other source) to address the three “challenges” associated with buying QLACs described above. The authors at The Stanford Center on Longevity state that “Integrated SWP/QLAC strategies are ‘easier said than done’.” I agree. However, if you like the basic concept of a QLAC, I encourage you to play with our spreadsheet to determine how much QLAC you may want to buy and to use the spreadsheet and the Actuarial Approach to coordinate your pre-and post QLAC commencement periods. Almost all other systematic withdrawal approaches are not even in the same league as the Actuarial Approach in terms of effectively addressing the three challenges discussed in the Stanford/SoA interim paper.
- Determining the percentage of initial assets devoted to the QLAC.
- Developing a SWP [Systematic Withdrawal Plan like the Actuarial Approach] withdrawal and asset allocation that minimizes disruptions in the amount of income between ages 84 and 85.
- Deciding whether the QLAC pays a death benefit before age 85, with the resulting drop in expected retirement income.
Before he finalizes his spending budget for the year, he decides that he would like to see what the effect might be if he were to buy a QLAC with some of his IRA money. So he goes to Immediateannuities.com and determines that if he pays an immediate premium of $100,000 he could receive a single life annuity commencing at age 85 of $4,406 per month ($52,872 per year) with no benefit payable to him or his heirs if he dies prior to age 85. He then goes back to the spreadsheet on this website and enters $700,000 instead of $800,000 in accumulated savings ($800,000 – the $100,000 premium for the QLAC), $52,872 in Annual Deferred Annuity benefit to commence in the future and 21 as the Deferred Annuity commencement year. All the other input items remain the same as above. The spreadsheet tells him that $38,337 of his accumulated savings (5.48% of $700,000) may be spent during the year and his total spending budget would be $58,337 ($38,337 + $20,000 from Social Security, or about 6.5% higher than his spending budget without the QLAC). He looks at the inflation-adjusted runout tab and sees that if all the assumptions are realized in the future (and inflation is 2.5% per annum), the sum of the withdrawal from savings plus the fixed dollar benefit from the QLAC is expected to be $38,337 in each of the next 30 years. He also sees that his expected accumulated savings is only $85,184 at age 85 when payments from the QLAC are to commence as compared with inflation-adjusted assets of $319,524 at age 85 if he didn’t buy the QLAC. Thus, while buying the QLAC can increase Max’s real dollar spending budget, it comes at the cost of increased spending from accumulated savings and therefore lower expected accumulated savings in later years, all things being equal. Max also looks at the effect on his spending budget of starting his QLAC at age 80 rather than 85 and the effect of buying a QLAC with various death benefits, by inserting the different benefit amounts payable under different payment forms for a $100,000 premium from Immediateannuities.com.
Despite the possibility of having lower accumulated savings in later years, Max likes the increase in his real dollar spending budget that he can achieve with the single life QLAC with no death benefit payable starting at age 85, and decides to see what the effect would be if he paid $125,000 for a QLAC (the maximum under the IRS for Max under current regulations) rather than $100,000. So he enters $675,000 in accumulated assets ($800,000 - $125,000), a $66,096 deferred annuity amount (from Immediateannuities.com) and 21 as the commencement year. The program tell him that the “goal cannot be achieved”, which means that under the input assumptions, total constant dollar spending from withdrawals and the QLAC for the entire input period cannot be achieved (input accumulated savings are insufficient to meet the constant dollar spending goal). Max has a number of options at this point, including living with a possibility that there will be a discontinuity in his real dollar spending budget at (or after) age 85. For example, if he inputs 20 years for the “expected payout period”, zero deferred annuity and $675,000 of accumulated assets, he can expected, under the recommended assumptions to have an annual real dollar spending budget (not including Social Security) of $40,300 prior to age 85 and a fixed dollar benefit from the QLAC of $66,096 ($40,336 in real dollars at age 85 and decreasing thereafter, not including Social Security).
So, let’s assume that Max chooses the no death benefit QLAC commencing at age 85 with the $100,000 premium. Every year in the future, he will re-run the spreadsheet with new numbers and assumptions. Depending on his actual investment experience, he could run into one or more years in which he sees “goal not achieved” if he suffers significant investment losses. For example, if he inputs a -20% investment return in the first year of the 5-year projection (in the 5-year projection tab), he will see “value” which is equivalent in the 5 year projection tab to “goal not achieved.” If this possibility is bothersome to Max, he has a number of alternatives, including choosing to buy a QLAC that pays lower benefits or investing his accumulated savings more conservatively to avoid significant losses.
I’ve used Max to illustrate how the Actuarial Approach and its simple spreadsheet can be used (along with QLAC quotes from Immediateannuities.com or from some other source) to address the three “challenges” associated with buying QLACs described above. The authors at The Stanford Center on Longevity state that “Integrated SWP/QLAC strategies are ‘easier said than done’.” I agree. However, if you like the basic concept of a QLAC, I encourage you to play with our spreadsheet to determine how much QLAC you may want to buy and to use the spreadsheet and the Actuarial Approach to coordinate your pre-and post QLAC commencement periods. Almost all other systematic withdrawal approaches are not even in the same league as the Actuarial Approach in terms of effectively addressing the three challenges discussed in the Stanford/SoA interim paper.
Monday, November 30, 2015
5 Ways to Increase Your Near-Term Retirement Spending Budget
In our post of August 31, 2014, Managing Your Spending in Retirement—it’s Not Rocket Science, we set forth a simple four-step process for managing spending:
Step 1: Develop a reasonable spending budget
Step 2: Determine your spending needs/living expenses for the upcoming year
Step 3: Compare results of Steps 1 and 2 and make necessary adjustments to bring them into balance (i.e., reducing expenses, increasing the budget or some combination of these two actions), and
Step 4: Rinse and repeat at least once a year.
For purposes of this post, we will assume that you have crunched your numbers, the result of Step 2 is larger than the result of Step 1 and you would prefer to increase your near-term spending budget rather than decrease your current living expenses. We will look at some of your options. Remember, however, that since you can either spend more in the near-term or you (or your heirs) can spend more later, you may not be all that comfortable increasing your risk of possible real dollar spending reductions as you get older under some of the more aggressive approaches below. You can use the spending spreadsheets in this website to quantify the possible effects on your current spending budget of adopting these approaches.
Of course it is also important to remember that in addition to increasing the risk of declining real dollar spending later in retirement as a result of too much spending early in retirement, spending budgets can also go up or down temporarily as a result of investment performance. If you want to stress test your spending budget for variations in investment performance, you can model future experience with the 5-year projection tab in the “Excluding Social Security V 3.0” spreadsheet.
Step 1: Develop a reasonable spending budget
Step 2: Determine your spending needs/living expenses for the upcoming year
Step 3: Compare results of Steps 1 and 2 and make necessary adjustments to bring them into balance (i.e., reducing expenses, increasing the budget or some combination of these two actions), and
Step 4: Rinse and repeat at least once a year.
For purposes of this post, we will assume that you have crunched your numbers, the result of Step 2 is larger than the result of Step 1 and you would prefer to increase your near-term spending budget rather than decrease your current living expenses. We will look at some of your options. Remember, however, that since you can either spend more in the near-term or you (or your heirs) can spend more later, you may not be all that comfortable increasing your risk of possible real dollar spending reductions as you get older under some of the more aggressive approaches below. You can use the spending spreadsheets in this website to quantify the possible effects on your current spending budget of adopting these approaches.
- Find part-time work or other sources of income. Perhaps the best way to increase your current spending budget is to go out and find additional sources of income. This can involve a part-time job such as becoming an Uber driver or additional income from renting out one of your rooms through an organization like Airbnb. If you are lucky, it may involve an inheritance from one of your relatives or friends. It can also involve reverse mortgages or funds you expect to receive in the future from the sale of your home or from other assets.
- Defer commencement of Social Security and/or purchase immediate or deferred annuities. As discussed in previous posts, implementing these approaches (which involve mortality pooling credits) can enable you to increase your near-term spending budgets because some or all of the future expenses you previously needed plan for will be covered by these lifetime guarantees.
- Use more aggressive assumptions. The recommended assumptions for determining a spending budget for 2015 under the Actuarial Approach were: 4.5% investment return, 2.5% inflation and an expected age at death of 95 (or life expectancy if greater). The rationale for selecting these assumptions was discussed in more detail in our post of February 14, 2015, but suffice to say that many investment advisers would find a 4.5% annual rate of investment return (2% real) to be relatively conservative for most investment portfolios. Also, until you reach your late 80s, the recommended expected lifetime assumption is longer than life expectancy, which could also be perceived as a conservative assumption. I stand by my recommended assumptions (for the reasons noted in the February 14 post), but if you are willing to increase your risk of future real dollar spending decreases, you can develop your budget by running the spreadsheets in this website with higher assumed real rates of investment return and/or lower expected payment periods.
- Use more aggressive assumptions only for non-essential expenses. This is a variant of item 3 for individuals who aren’t comfortable taking the risk of being too aggressive for all expenses, particularly essential expenses, but are more comfortable assuming an increased risk of declining future real dollar non-essential expense budgets. Some experts believe that such expenses generally decline with age.
- Increase your budget by X%. This final option is equivalent to making a conscious decision that you are going to spend what you want as long as it is within x% of your calculated budget. Clearly if you do this on a consistent basis, you are more likely to experience decreases in future real dollar spending budgets, but this may not be a significant issue for you.
Of course it is also important to remember that in addition to increasing the risk of declining real dollar spending later in retirement as a result of too much spending early in retirement, spending budgets can also go up or down temporarily as a result of investment performance. If you want to stress test your spending budget for variations in investment performance, you can model future experience with the 5-year projection tab in the “Excluding Social Security V 3.0” spreadsheet.
Tuesday, November 24, 2015
Retirement Researcher Endorses Qualified Longevity Annuity Contracts
In his recent article in Advisors Perspectives, Why Advisors Should Use Deferred Income Annuities, Dr. Michael Finke touts the benefits of including Qualified Longevity Annuity Contracts (QLACs) in a retirement portfolio. Dr. Finke is a Professor and Director, Retirement Planning and Living at Texas Tech University.
I agree with the points made by Dr. Finke, as his article is very similar to my post on the pluses and minuses of QLACs on July 12, 2015. Readers who want to dive deeper into QLACs can also revisit my posts of May 28, 2015, April 26, 2015, February 25, 2015, July 31, 2014 and July 26, 2014 for further discussion.
As I have indicated many times in this blog, The Actuarial Approach is probably one of the only strategic withdrawal approaches that easily and properly coordinates withdrawals from investments with benefits payable from a QLAC.
Year end is coming soon. Next month I will be re-visiting my recommended assumptions for developing 2016 spending budgets.
Let me take this opportunity to wish all my readers a happy and safe Thanksgiving.
I agree with the points made by Dr. Finke, as his article is very similar to my post on the pluses and minuses of QLACs on July 12, 2015. Readers who want to dive deeper into QLACs can also revisit my posts of May 28, 2015, April 26, 2015, February 25, 2015, July 31, 2014 and July 26, 2014 for further discussion.
As I have indicated many times in this blog, The Actuarial Approach is probably one of the only strategic withdrawal approaches that easily and properly coordinates withdrawals from investments with benefits payable from a QLAC.
Year end is coming soon. Next month I will be re-visiting my recommended assumptions for developing 2016 spending budgets.
Let me take this opportunity to wish all my readers a happy and safe Thanksgiving.
Wednesday, November 18, 2015
Actuary Discovers Chinks in Monte Carlo Modeling Armor
In his recent article in Advisor Perspectives, fellow actuary Joe Tomlinson raises serious credibility concerns about Monte Carlo simulations that use historical data to calculate the expected equity premium for stocks when such simulations are used to determine how much wealth to spend down during retirement. Mr. Tomlinson points out that out limited statistical evidence regarding equity premiums produces levels of uncertainty that are unacceptable to most clients.
As I have indicated in prior posts (see for example my posts of July 15 of last year and January 24th and 25th of this year), I am not a buyer of the supposed superiority of Monte Carlo modeling as a tool for developing reasonable spending budgets for retirees. These Monte Carlo models are also frequently used to develop static withdrawal strategies (see my last post for discussion of the superiority of dynamic over static approaches). Mr. Tomlinson article confirms some of my major concerns about using Monte Carlo simulations and static approaches.
While the simple spreadsheets provided in this website can accommodate higher equity premium investment return assumptions, I recommend (at least for determining essential expense budgets) that retirees use an investment return assumption that is approximately equivalent to interest rates baked into single premium immediate life annuities at the time of determination. For example, an immediate monthly life annuity of $582 ( yesterday from Income Solutions.com) for a 65-year old male with a life expectancy of 274 months under the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality projection translates into approximately a 4.5% annual interest rate. As I have previously indicated, including riskier assets in your portfolio (such as equities) can increase your expected rate of return, but it will also generally increase variability and therefore may not increase your annual spending budget over the long-run.
The Actuarial Approach is a dynamic approach that involves periodic (usually annually) remeasurement of the retiree’s assets and liabilities and possible periodic adjustments to the spending budget, not a one-and-done static approach developed using Monte Carlo modelling. I caution you to question the data used in Monte Carlo simulations producing a spending budget for you that significantly differs from the budget you (or your financial advisor) develop using the Actuarial Approach.
Budget Pun of the Day (My first and probably my last one): You’ll feel Stuck with your debt if you don’t properly Budge it.
As I have indicated in prior posts (see for example my posts of July 15 of last year and January 24th and 25th of this year), I am not a buyer of the supposed superiority of Monte Carlo modeling as a tool for developing reasonable spending budgets for retirees. These Monte Carlo models are also frequently used to develop static withdrawal strategies (see my last post for discussion of the superiority of dynamic over static approaches). Mr. Tomlinson article confirms some of my major concerns about using Monte Carlo simulations and static approaches.
While the simple spreadsheets provided in this website can accommodate higher equity premium investment return assumptions, I recommend (at least for determining essential expense budgets) that retirees use an investment return assumption that is approximately equivalent to interest rates baked into single premium immediate life annuities at the time of determination. For example, an immediate monthly life annuity of $582 ( yesterday from Income Solutions.com) for a 65-year old male with a life expectancy of 274 months under the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality projection translates into approximately a 4.5% annual interest rate. As I have previously indicated, including riskier assets in your portfolio (such as equities) can increase your expected rate of return, but it will also generally increase variability and therefore may not increase your annual spending budget over the long-run.
The Actuarial Approach is a dynamic approach that involves periodic (usually annually) remeasurement of the retiree’s assets and liabilities and possible periodic adjustments to the spending budget, not a one-and-done static approach developed using Monte Carlo modelling. I caution you to question the data used in Monte Carlo simulations producing a spending budget for you that significantly differs from the budget you (or your financial advisor) develop using the Actuarial Approach.
Budget Pun of the Day (My first and probably my last one): You’ll feel Stuck with your debt if you don’t properly Budge it.
Tuesday, November 17, 2015
Retirement Researcher Quantifies Benefits of Dynamic Withdrawal Strategies
Thanks to Nelson Murphy for drawing my attention to an article in the Summer, 2015 edition of The Journal of Retirement Research, by David Blanchett, Head of Retirement Research for Morningstar Investment Management. The article is entitled, “Dynamic Choice and Optimal Annuitization.” This article is fairly technical, but I found the investment of time and energy required to wade through it to be generally worthwhile.
As a result of his analysis, Mr. Blanchett concludes that “there is a significant potential benefit to retirees who implement dynamic strategies.” He defines static strategies as those where the retiree makes decisions only at retirement (such as the 4% withdrawal rule or other types of safe withdrawal rule approaches) and dynamic strategies as those that involve intelligent changes during retirement (such as the approach advocated in this website). He also looked at dynamic vs. static annuitization strategies, but the differences in these two types of strategies was not as significant.
The dynamic withdrawal strategy used by Mr. Blanchett is approximately mathematically equivalent to the approach advocated in this website (assuming the retiree has no fixed dollar immediate or deferred annuities, no fixed dollar pension benefits and no specific bequest motive) and the same assumptions are used for investment return, inflation and mortality. If, instead of using the recommended assumptions in this website, you use Mr. Blanchett’s assumptions of 3% investment return, 2.5% inflation and life expectancy based on the Society of Actuaries 2012 Individual Annuity Mortality Table (without mortality improvement), you will develop roughly the same withdrawal rates shown in Exhibit 1 of Mr. Blanchett’s article.
Through his simulations, Mr. Blanchett also develops optimal levels of annuitization for retirees with different shortfall preferences, different bequest motives and different expected life expectancies. Of course the results of any analysis like this are dependent on the assumptions used and the assumed portfolio investment mix over the life of the retiree. The future economic assumptions employed by Mr. Blanchett include a 2.5% inflation rate, 3% bond yields, 9% per annum equity returns (with a standard deviation of 9.4%) and 50 basis point annual fee. The retiree is assumed to maintain a 40% equity/60% fixed income portfolio throughout retirement. While the optimal level of annuitization developed by Mr. Blanchett using these assumptions was lower with the dynamic withdrawal strategy than with the static withdrawal strategy, there were still some scenarios where annuitization was still optimal. Even though he assumed a 6.5% annual real rate of return on equities, on average annuitization was optimal for at least 25% of the retiree’s portfolio (in addition to Social Security) under these modeling assumptions as shown in his Exhibit 2.
Mr. Blanchett concludes that “implementing a dynamic withdrawal strategy alone (without annuities) resulted in higher levels of utility-adjusted wealth than a static withdrawal strategy that included both optimal immediate annuitization as well as dynamic annuitization.” He also concludes that delaying purchase of annuities for a while does not significantly affect outcomes for retirees compared with immediate purchase of annuities at retirement.
Bottom line: There were two things I liked about Mr. Blanchett’s research: 1) He favored a dynamic withdrawal approach very similar to the approach advocated in this website and 2) depending on their preferences and circumstances, retirees should consider investment of some percentage of their retirement portfolio in annuities.
As a result of his analysis, Mr. Blanchett concludes that “there is a significant potential benefit to retirees who implement dynamic strategies.” He defines static strategies as those where the retiree makes decisions only at retirement (such as the 4% withdrawal rule or other types of safe withdrawal rule approaches) and dynamic strategies as those that involve intelligent changes during retirement (such as the approach advocated in this website). He also looked at dynamic vs. static annuitization strategies, but the differences in these two types of strategies was not as significant.
The dynamic withdrawal strategy used by Mr. Blanchett is approximately mathematically equivalent to the approach advocated in this website (assuming the retiree has no fixed dollar immediate or deferred annuities, no fixed dollar pension benefits and no specific bequest motive) and the same assumptions are used for investment return, inflation and mortality. If, instead of using the recommended assumptions in this website, you use Mr. Blanchett’s assumptions of 3% investment return, 2.5% inflation and life expectancy based on the Society of Actuaries 2012 Individual Annuity Mortality Table (without mortality improvement), you will develop roughly the same withdrawal rates shown in Exhibit 1 of Mr. Blanchett’s article.
Through his simulations, Mr. Blanchett also develops optimal levels of annuitization for retirees with different shortfall preferences, different bequest motives and different expected life expectancies. Of course the results of any analysis like this are dependent on the assumptions used and the assumed portfolio investment mix over the life of the retiree. The future economic assumptions employed by Mr. Blanchett include a 2.5% inflation rate, 3% bond yields, 9% per annum equity returns (with a standard deviation of 9.4%) and 50 basis point annual fee. The retiree is assumed to maintain a 40% equity/60% fixed income portfolio throughout retirement. While the optimal level of annuitization developed by Mr. Blanchett using these assumptions was lower with the dynamic withdrawal strategy than with the static withdrawal strategy, there were still some scenarios where annuitization was still optimal. Even though he assumed a 6.5% annual real rate of return on equities, on average annuitization was optimal for at least 25% of the retiree’s portfolio (in addition to Social Security) under these modeling assumptions as shown in his Exhibit 2.
Mr. Blanchett concludes that “implementing a dynamic withdrawal strategy alone (without annuities) resulted in higher levels of utility-adjusted wealth than a static withdrawal strategy that included both optimal immediate annuitization as well as dynamic annuitization.” He also concludes that delaying purchase of annuities for a while does not significantly affect outcomes for retirees compared with immediate purchase of annuities at retirement.
Bottom line: There were two things I liked about Mr. Blanchett’s research: 1) He favored a dynamic withdrawal approach very similar to the approach advocated in this website and 2) depending on their preferences and circumstances, retirees should consider investment of some percentage of their retirement portfolio in annuities.
Thursday, November 5, 2015
Social Security Reform—Some Solutions are More Sustainable than Others
As discussed in my posts of March 1 and May 3 of this year, I occasionally get drawn into commenting on US Social Security System financing issues. While these issues are somewhat technical, I believe they are important and, in the long run, can affect many of the individuals who visit my site looking for advice regarding budgeting in retirement. Therefore this post will be another Social Security financing article with the purpose of warning my U.S. readers about frequently made claims regarding the long-term sustainability of specific reform proposals. As we get closer to 2034 (the trust fund exhaustion date expected for Social Security under the intermediate assumption set selected by Social Security actuaries and the System’s Trustees in the most recent Trustees’ report), we are seeing a rash of proposals to solve the System’s financial problems. Many of these proposals quantify just how much of the System’s “funding problem” will be solved by a specific reform proposal. For example, in the American Academy of Actuaries recently released “Social Security Game,” the Academy states that raising the payroll tax from 6.2% to 7.4% (for both employees and employers) “will solve 85% of the problem". Further, if you combine that change with a 1% decrease in the cost of living increase, the Social Security Game will tell you, “Congratulations, You have won the game by fixing Social Security.”
While I understand the Academy’s desire to engage the public in a discussion about Social Security’s reform options, I am concerned that statements such as these can mislead the public and our policymakers. I was frankly surprised (and more than a little disappointed) that my profession (a profession that claims to serve the public, one that stresses sustainability in our financial systems and one that has stated it “believes that any modification to the Social Security system should include “sustainable solvency” as a primary goal) is ignoring the concept of “sustainable solvency” and is claiming in this “Game” that eliminating Social Security’s current 75-year actuarial deficit will solve Social Security’s financial problems. It should be noted that the Academy is not the only organization to utilize the 75-year actuarial deficit in this manner.
While reducing the 75-year actuarial deficit is a reasonable first step, there are two problems with any proposed reform
options that simply reduce Social Security’s 75-year actuarial deficit to zero:
We need look no further than the 1983 Amendments to Social Security (which eliminated the 75-year actuarial deficit in existence at that time) for an example of how these two problems interacted to put us in the financial position in which we presently find ourselves. Social Security Administration Actuarial Note Number 2015.8 tells us that of the total increase in the 75-year actuarial deficit of 2.69% of taxable payroll since 1983, 70% of the increase (or 1.90% of taxable payroll) was attributable to changes in the valuation date (problem #1 above), leaving 30% (or .79% of payroll) attributable to all other causes. Since no action was taken in response to these emerging deficits over the past 31 years (problem #2 above), we are now looking at projected trust fund exhaustion in 2034 under the best estimate assumptions.
As a result of these two problems, Social Security is now looking at a shortfall of projected revenues compared with projected expenditures. And we have unlimited supply of possible actions that Congress can adopt to address this shortfall, generally involving some combination of revenue increases and expenditure decreases. Because it was discussed on page 25 of this year’s annual Trustees’ Report, I’m going to focus on two alternative reforms involving only tax increases. I’m doing this to illustrate reform option concepts, not to recommend that reform options should only involve tax increases. The same concepts generally apply if expenditure reductions or combinations of revenue increases and expenditure decreases are adopted.
The graph below shows two alternative tax rate scenarios that would be expected, if all the intermediate assumptions made in the 2015 Trustees’ report were exactly realized over the next 75 years, to cover projected System benefits over the next 75 years, leaving almost no trust fund at the end of 2089. Under the “wait for trust fund exhaustion” alternative, we would keep the tax rate at its current combined employer-employee level of 12.4% until 2034 at which time it would increase to 16.1% and then gradually increase thereafter (I have assumed straight-line increases) to 17.4% in 2089. I have also assumed that the necessary tax rate for years thereafter would remain at the 17.4% level. The second option shown in this graph is the “75-year solution (2015)” which reduces the 2015 75-year actuarial deficit to zero by increasing the current tax rate from 12.4% to 15.02% in 2015. Since this solution only lasts for 75 years, the graph shows that the tax rate would also need to be increased in the year 2090 to 17.4% when the trust fund accumulated under this option would be expected to be depleted. This graph illustrates a very important financial principle: the magic of compound interest. Even for a program that many experts claim is a pay-as-you-go system, you can pre-fund your liabilities. By contributing 15.02% for 75 years, you can avoid higher tax rates for the period 2035 to 2089. The concepts illustrated in this graph are also used by individuals who argue that fixing the system now can avoid higher tax rates or lower benefit levels later on. Of course this same argument can be employed by those who would like to see smaller periodic adjustments to the program rather than infrequent large increases (to address Problem #2).
In an effort to deal with Problem #1 above, the Office of the Actuary of the Social Security Administration developed the concept of “sustainable solvency.” Under this concept, “the projected trust fund ratio is positive throughout the 75-year projection period and is either stable or rising at the end of the period (emphasis added).” As with other ways to solve system problems, there are a number of ways that sustainable solvency can be achieved. For example, in addition to a 75-year solution, you could adopt additional tax rate increases that take effect 65 or 70 years from now so that the relatively low trust fund ratios at the end of the period remain stable at the end of the 75-year period. Because there exist many different ways to achieve sustainable solvency, the Trustees’ Reports do not quantify changes necessary to achieve it. Also, for this reason, organizations like the American Academy of Actuaries focus only on communicating the presumably more quantifiable 75-year solutions. It should be noted, however, that even though adoption of a reform package that achieves sustainable solvency will address Problem #1 above, it does not address Problem #2 above.
The graph below modifies the graph above by inserting a third line, labeled “sustainable solvency solution (2015)”. This line is estimated by me. As discussed above, there are many different approaches that could achieve sustainable solvency, but I have selected one (a level tax rate similar to the approach used for The Canada Pension Plan) that I would expect to meet the criteria for sustainable solvency under the assumptions described above. This approach would involve an immediate 3.6% of taxable payroll increase in the current tax rate of 12.4% to about 16%. By comparison, the 2015 Trustees’ report indicates that the shortfall over the infinite projection period is 3.9% of taxable payroll. Note also that this graph could have a fourth line representing a combination of the 75-year solution and periodic increases after 2015 to address the expected deficits that would occur as a result of Problem #1. This line would be expected to start at about the 15% of pay level and slowly increase as deficits are recognized. This fourth line would be expected to end above the sustainable solvency (2015) line and below the 75-year solution line.
Conclusion—Some Solutions are More Sustainable than Others
In its Public Policy White Paper, Sustainability in American Financial Security Programs, the Academy’s Public Interest Committee said, “Sustainability is enhanced when the funding source and the benefits promised remain balanced over the lifetime of the program.” I agree and further believe that Social Security solutions that anticipate significant tax increases in the future (other than perhaps ones to phase in tax increases over a relatively short time period) to support promised benefit levels are less sustainable than approaches that don’t. For this reason, I caution readers to question 75 (or lower)-year solutions, and, as part of the next round of system reform, I encourage policymakers to adopt an automatic approach designed to maintain the balance between system assets and liabilities in the future. As suggested in my May/June, 2015 Contingencies article, we can learn a lot about sustainable solutions in the U.S. from the actions taken almost 20 years ago to reform The Canada Pension Plan. In furtherance of its mission, I also encourage the Academy to advocate these more sustainable solutions rather than appearing to endorse problematic 75-year “solutions” in their “Game.”
While I understand the Academy’s desire to engage the public in a discussion about Social Security’s reform options, I am concerned that statements such as these can mislead the public and our policymakers. I was frankly surprised (and more than a little disappointed) that my profession (a profession that claims to serve the public, one that stresses sustainability in our financial systems and one that has stated it “believes that any modification to the Social Security system should include “sustainable solvency” as a primary goal) is ignoring the concept of “sustainable solvency” and is claiming in this “Game” that eliminating Social Security’s current 75-year actuarial deficit will solve Social Security’s financial problems. It should be noted that the Academy is not the only organization to utilize the 75-year actuarial deficit in this manner.
While reducing the 75-year actuarial deficit is a reasonable first step, there are two problems with any proposed reform
options that simply reduce Social Security’s 75-year actuarial deficit to zero:
- Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period. Over time, these deficits will emerge in the actuary’s annual calculations.
- There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities. Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources.
We need look no further than the 1983 Amendments to Social Security (which eliminated the 75-year actuarial deficit in existence at that time) for an example of how these two problems interacted to put us in the financial position in which we presently find ourselves. Social Security Administration Actuarial Note Number 2015.8 tells us that of the total increase in the 75-year actuarial deficit of 2.69% of taxable payroll since 1983, 70% of the increase (or 1.90% of taxable payroll) was attributable to changes in the valuation date (problem #1 above), leaving 30% (or .79% of payroll) attributable to all other causes. Since no action was taken in response to these emerging deficits over the past 31 years (problem #2 above), we are now looking at projected trust fund exhaustion in 2034 under the best estimate assumptions.
As a result of these two problems, Social Security is now looking at a shortfall of projected revenues compared with projected expenditures. And we have unlimited supply of possible actions that Congress can adopt to address this shortfall, generally involving some combination of revenue increases and expenditure decreases. Because it was discussed on page 25 of this year’s annual Trustees’ Report, I’m going to focus on two alternative reforms involving only tax increases. I’m doing this to illustrate reform option concepts, not to recommend that reform options should only involve tax increases. The same concepts generally apply if expenditure reductions or combinations of revenue increases and expenditure decreases are adopted.
The graph below shows two alternative tax rate scenarios that would be expected, if all the intermediate assumptions made in the 2015 Trustees’ report were exactly realized over the next 75 years, to cover projected System benefits over the next 75 years, leaving almost no trust fund at the end of 2089. Under the “wait for trust fund exhaustion” alternative, we would keep the tax rate at its current combined employer-employee level of 12.4% until 2034 at which time it would increase to 16.1% and then gradually increase thereafter (I have assumed straight-line increases) to 17.4% in 2089. I have also assumed that the necessary tax rate for years thereafter would remain at the 17.4% level. The second option shown in this graph is the “75-year solution (2015)” which reduces the 2015 75-year actuarial deficit to zero by increasing the current tax rate from 12.4% to 15.02% in 2015. Since this solution only lasts for 75 years, the graph shows that the tax rate would also need to be increased in the year 2090 to 17.4% when the trust fund accumulated under this option would be expected to be depleted. This graph illustrates a very important financial principle: the magic of compound interest. Even for a program that many experts claim is a pay-as-you-go system, you can pre-fund your liabilities. By contributing 15.02% for 75 years, you can avoid higher tax rates for the period 2035 to 2089. The concepts illustrated in this graph are also used by individuals who argue that fixing the system now can avoid higher tax rates or lower benefit levels later on. Of course this same argument can be employed by those who would like to see smaller periodic adjustments to the program rather than infrequent large increases (to address Problem #2).
 |
| (click to enlarge) |
In an effort to deal with Problem #1 above, the Office of the Actuary of the Social Security Administration developed the concept of “sustainable solvency.” Under this concept, “the projected trust fund ratio is positive throughout the 75-year projection period and is either stable or rising at the end of the period (emphasis added).” As with other ways to solve system problems, there are a number of ways that sustainable solvency can be achieved. For example, in addition to a 75-year solution, you could adopt additional tax rate increases that take effect 65 or 70 years from now so that the relatively low trust fund ratios at the end of the period remain stable at the end of the 75-year period. Because there exist many different ways to achieve sustainable solvency, the Trustees’ Reports do not quantify changes necessary to achieve it. Also, for this reason, organizations like the American Academy of Actuaries focus only on communicating the presumably more quantifiable 75-year solutions. It should be noted, however, that even though adoption of a reform package that achieves sustainable solvency will address Problem #1 above, it does not address Problem #2 above.
The graph below modifies the graph above by inserting a third line, labeled “sustainable solvency solution (2015)”. This line is estimated by me. As discussed above, there are many different approaches that could achieve sustainable solvency, but I have selected one (a level tax rate similar to the approach used for The Canada Pension Plan) that I would expect to meet the criteria for sustainable solvency under the assumptions described above. This approach would involve an immediate 3.6% of taxable payroll increase in the current tax rate of 12.4% to about 16%. By comparison, the 2015 Trustees’ report indicates that the shortfall over the infinite projection period is 3.9% of taxable payroll. Note also that this graph could have a fourth line representing a combination of the 75-year solution and periodic increases after 2015 to address the expected deficits that would occur as a result of Problem #1. This line would be expected to start at about the 15% of pay level and slowly increase as deficits are recognized. This fourth line would be expected to end above the sustainable solvency (2015) line and below the 75-year solution line.
 |
| (click to enlarge) |
Conclusion—Some Solutions are More Sustainable than Others
In its Public Policy White Paper, Sustainability in American Financial Security Programs, the Academy’s Public Interest Committee said, “Sustainability is enhanced when the funding source and the benefits promised remain balanced over the lifetime of the program.” I agree and further believe that Social Security solutions that anticipate significant tax increases in the future (other than perhaps ones to phase in tax increases over a relatively short time period) to support promised benefit levels are less sustainable than approaches that don’t. For this reason, I caution readers to question 75 (or lower)-year solutions, and, as part of the next round of system reform, I encourage policymakers to adopt an automatic approach designed to maintain the balance between system assets and liabilities in the future. As suggested in my May/June, 2015 Contingencies article, we can learn a lot about sustainable solutions in the U.S. from the actions taken almost 20 years ago to reform The Canada Pension Plan. In furtherance of its mission, I also encourage the Academy to advocate these more sustainable solutions rather than appearing to endorse problematic 75-year “solutions” in their “Game.”
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