I first proposed a recommended smoothing algorithm for The Actuarial Approach in my post of October 11, 2013. The purpose of the recommended smoothing algorithm was to balance the desire to have relatively constant real dollar budgets from year to year with the need to keep spending budgets reasonably on track with the "actuarial value" determined using the applicable spreadsheet from this website (generally Excluding Social Security V 2.0), recommended assumptions and the retiree's actual data as of the beginning of each year.
In general terms the recommended smoothing algorithm involves taking the budget amount from the previous year, increasing that amount by inflation (the increase in CPI) for the previous year and making sure that the resulting value is not more than 110% of and not less than 90% of that year's actuarial value. If the resulting value falls within the corridor, the inflation adjusted value is used to develop the budget for the year. If the value falls above or below the corridor limit, the applicable corridor value is used in the budget calculation.
Recently, in a conversation with Ian McGugan, reporter for the Globe and Mail in Toronto, Mr. McGugan pointed out that I wasn't terribly specific about what budget amount was being used in this smoothing calculation. Mr. McGugan (a bright guy) correctly pointed out that in the various examples contained in my website, I had inconsistently used several different amounts for the previous year's budget amount for this calculation.
I will readily admit that there was more art than science involved in developing this smoothing algorithm. For example, I don't know whether some or all retirees who may use the Actuarial Approach would be better served with a 12% or 8% corridor. Perhaps someone like Wade Pfau or some other retirement academician can utilize Monte Carlo modeling to develop an optimal corridor. Similar arguments can be made with respect to the budget (or portion of the budget) that should be subject to the corridor.
If the retiree has an immediate defined benefit pension benefit or life insurance annuity as a retirement income source, she has at least three choices with respect to how the recommended algorithm can be applied:
- to the portion of the budget attributable to accumulated savings only
- to the portion of the budget attributable to accumulated savings plus the pension/annuity, or
- to the total budget, including income from Social Security
If the retiree has no immediate pension or annuity income sources, then items 1 and 2 above will be the same.
Personally, I would prefer that the spending budget stay reasonably close to the actuarial value, so I will recommend that the 90% to 100% corridor be determined using the portion of the budget attributable to accumulated savings plus the pension/annuity rather than using the entire budget including Social Security, as it will produce a somewhat smaller corridor range, all other things being equal.
As a result of Mr. McGuggan's excellent suggestion to try not to confuse readers when possible, I have revised the examples in the June, 2014 article "Using the Actuarial Approach to Determine Your Annual Spending Budget in Retirement" to reflect the more specific recommended smoothing algorithm above.
I thank Mr. McGuggan for his feedback and encourage other readers to submit their suggestions for improvements to this website.
The title of this post is a re-working of the saying used by the mechanic in the old Fram Oil Filter TV commercials. His famous line was, "You can pay me now, or you can pay me later." A similar principle applies to spending your accumulated savings--assets you spend today will reduce the amounts available to you (or your heirs) tomorrow and visa versa. The trick, of course, is to figure out the best way to meet your spending objectives, including making your money last your lifetime. This difficult "balancing act" is what this website is all about.
It is also important to remember that most systematic withdrawal strategies produce a spending budget. As with any other budget, you are free to deviate from the budget and spend what you feel is an appropriate amount. Some systematic withdrawal strategies (like the Actuarial Approach recommended in this website) automatically adjust for such deviations. Other approaches may not.
As promised in my post of October 9, this post will discuss the systematic withdrawal approach suggested by David Zolt in his recent Journal of Financial Planning article. Readers can also find more details about his approach in his website.
In summary, Mr. Zolt uses a Hybrid safe withdrawal/actuarial approach. He incorporates Monte Carlo modeling using historical returns from 1926-2013 and then uses a deterministic approach similar to the Excluding Social Security V 2.0 spreadsheet in this website (which he calls the Target Percentage Test) to monitor whether spending remains on track during retirement. In general, if the proposed withdrawal in any year, measured as a percentage of remaining accumulated assets, falls below the Target Percentage, Mr. Zolt's approach would require the retiree forgo that year's cost of living increase. His most recent article proposes another alternative to forgoing the entire cost of living increase if the test is failed.
The first case study in Mr. Zolt's recent article describes how his approach could work for a couple, both age 63 with $650,000 in accumulated retirement assets, total Social Security benefits of $3,000 per month and a fixed dollar $1,000 per month benefit from a pension plan. Based on his Monte Carlo analysis, Mr. Zolt determines that this couple has a "superb" chance of making the money last with an initial withdrawal rate of 5.7% if they are willing to forgo cost-of-living increases whenever the proposed withdrawal for the year measured as a percentage of accumulated assets exceeds the Target Percentage for this couple. By comparison, if we input this couple's data in our Excluding Social Security V 2.0 spreadsheet and use our recommended assumptions , we would get an initial withdrawal rate of 3.57%. There are two reasons why Mr. Zolt's initial withdrawal rate is much higher than ours for the same couple: 1) We use different assumptions for future experience and 2) The Actuarial Approach attempts to keep total retirement income (including income from the fixed dollar pension) constant from year to year in real dollars.
Using Mr. Zolt's Target Percentage spreadsheet, we can determine that if payments are to last 32 years and increase by 3% per annum, the couple's assets must earn a minimum of 7.7% per annum. Tables 1 and 2 below compare spending budgets every five years produced by Mr. Zolt's approach (assuming the target percentage is determined using 7.7% investment return, 3% cost of living increases and payment for 32 years) vs. the Actuarial Approach (using recommended assumptions) assuming future experience is either 5% investment and 3% inflation (Table 1) or 7.7% investment return and 3% inflation (Table 2). Table 3 compares spending budgets assuming future experience of 7.7% per annum and 3% inflation, but changes the assumptions used under the Actuarial Approach to 7.7% investment return and 3% inflation while Table 4 assumes future experience of 5% per annum and 3% inflation, but the assumptions used under the Actuarial Approach are changed to 5% investment return and 0% inflation. Under all four tables, the retired couple is assumed to spend exactly the spending budget under either approach each year.
Under the assumptions for future experience in Table 1, spending budgets decline significantly in real terms under the Target Percentage Approach. The couple's money does, however, last the entire 32 years. Under the Actuarial Approach and recommended assumptions, spending budgets remain constant from year to year in real dollar terms. Under the assumptions for future experience in Table 2, spending budgets decline somewhat under the Target Percentage Approach as the approach does not adjust spending from accumulated savings to make up for inflation erosion of the fixed dollar pension benefit. Under the Actuarial Approach (using recommended assumptions), the more favorable investment experience produces significant increases in the spending budget in later years.
The purpose of Tables 3 and 4 is to illustrate that similar results can be achieved under the Actuarial Approach by varying assumptions used to determine the annual spending budgets from the recommended assumptions.
Which approach is right for you? There is no easy answer to this question. Both approaches are dynamic in that spending budgets may need to be increased or decreased during retirement since both approaches involve annual checking to see how last year's spending budget increased with inflation compares with an actuarially determined target. The Actuarial Approach using recommended assumptions assumes future investment returns will be 2% real, while Mr. Zolt's approach uses a real rate of return closer to 4.7%. His approach also does not consider the effects of inflation on other fixed dollar income (such as pensions or annuity contracts) or amounts desired to be left to heirs. There is nothing mathematically superior about either approach. While Mr. Zolt's approach can be made more conservative by using more conservative target percentages, his reliance on historical rates of return makes his approach less conservative (more likely to involve decreasing real dollar spending budgets in future years) than the Actuarial Approach (which tends to tie investment return assumptions more closely to interest rates inherent in current immediate annuity contracts). This may be ok for some retirees, as long as they understand that higher amounts spent early in retirement mean smaller spending budgets later, all things being equal. Other retirees, however, may be less concerned if the spending budget increases in later years as a result of more favorable than assumed experience. Being a retired actuary, I tend to favor the more conservative approach. But, in the end, the bottom line of this post is the same as its title, and it is up to you to determine how conservative you want to be in determining your spending budget (and your actual spending) from year to year.
In his October 22 blog post, Michael Kitces points out several of the problems associated with Monte Carlo modeling and determination of "safe withdrawal rates" based on assumptions about future experience that will not be realized. Mr. Kitces suggests that the solution lies in "reframing" the model outcomes. He says, "consider what happens if we actually call it a probability of adjustment, instead of a probability of failure. When we frame the outcomes as failures, the nature [sic] response from clients is to think up terrible images of what failure might look like, and then seek to avoid it at all costs. But when we frame the outcomes as “adjustments” it leads to very different – and much more productive – conversations instead, such as “How big would the adjustment be? When would I have to make the adjustment? How will I know when it’s time to adjust?”
He also expresses concerns about surpluses that are ignored in the safe withdrawal rate determination, saying, "it’s not just the probability of failure that’s misnamed. It’s also the probability of success, which is more like a probability of Excess. It’s the likelihood of having excess money left over, and sadly makes no distinction about how much will be left over! A Monte Carlo analysis in traditional retirement planning software treats having $1 left over the same as $1M and the same as $10M – they’re all “successes” – yet clients would react to this very differently. When you call it a probability of “excess” it again raises the question “how much of an excess are we talking about?” and a more productive conversation."
While I agree with Mr. Kitces' assessment of the problems, in my opinion, reframing the outcome is not the answer. The actuarial approach suggested in this website automatically provides valuable input for Mr. Kitces "productive conversations." As indicated in my previous post, retirees need to wean themselves off the safe withdrawal rate Kool-Aid and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.
This month's Journal of Financial Planning celebrates the twentieth anniversary of publication of the article, "Determining Withdrawal Rates Using Historical Data", by William P. Bengen. This article formed the basis for what is now known as the "4% Rule" or "4% Withdrawal Rule."
In this month's Journal article, Jonathan Guyton, CFP, offers his thoughts on the original research performed by Mr. Bengen, and Mr. Guyton's article contains glowing praise from many others for Mr. Bengen's research. According to Mr. Guyton, "Bill Bengen framed a deceptively complex question and crafted and elegant simple answer that remains relevant two decades later for hundreds of thousands of financial advisers and easily 100 million retirees."
As someone who doesn't understand the appeal of the 4% Rule, or it's many safe withdrawal rate progeny, please forgive me if I don't enthusiastically join in this celebration.
Based on historical returns provided by Ibbotson Associates' Stocks, Bonds, Bills and Inflation 1992 Yearbook, Mr. Bengen noted that hypothetical individuals who retired in each year from 1926 to 1976 who invested at least 50% of their assets in equities and who withdrew 4% of accumulated assets in the first year of retirement and increased that amount by inflation each year would be expected to have their assets last at least 30 years (Figure 1b of Mr. Bengen's article). As a result of this analysis of these historical returns, Mr. Bengen concluded that it was "safe" going forward for almost all retirees to withdraw 4% of accumulated assets in the first year of retirement and increase that first year amount by inflation for subsequent years if they invested at least 50% of their assets in equities and rebalance their portfolio each year. In fact, Mr. Bengen said, "It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible and in no cases less than 50 percent."
I agree with the concerns expressed about the 4% Rule expressed by researcher Nobel Laureate, William Sharpe in his article, "Staying Flexible on Retirement Spending" (highlighted in my second post in 2010) where he points out the problems inherent in combining a fixed spending strategy with investment of a portfolio with variable returns.
I list what I believe to be the many shortfalls of the 4% Rule in this website and in my recently published article in the Journal of Personal Finance. For brevity sake, I will not be re listing them here. Suffice to say that the 4% Rule requires the retiree to have faith that historical performance is a good indicator of future experience and the retiree should "stay the course" irrespective of actual investment returns or spending. By comparison, the Actuarial Approach advocated in this website suggests looking to see whether the retiree is "on track" on an annual basis and making appropriate adjustments.
In the twenty years following release of Mr. Bengen's original research, many researchers have suggested modifications to the 4% Rule to deal with its significant shortcomings and to refine the assumptions and methodology (Monte Carlo modeling) used to forecast future experience. In fact, an example of such refinement is also featured in this month's Journal of Financial Planning entitled, Retirement Planning by Targeting Safe Withdrawal Rates, by David Zolt, CFP, EA, ASA, MAAA. This is an update of Mr. Zolt's original article which I discussed in my post of May 23rd of last year. Like many suggested modifications to Mr. Bengen's original work, Mr. Zolt has dealt with some of the problems, but his approach and various tables are much more complicated than Mr. Bengen's "elegant simple answer." I will be discussing Mr. Zolt's approach in a subsequent post.
Bottom line: Retirees who invest in risky assets should not expect those assets to produce a fixed level of real income in retirement as implied by the 4% Rule or other safe withdrawal rate approaches. They need to use a dynamic withdrawal approach (like the Actuarial Approach advocated in this website) and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.
Last year, Merrill Lynch and Age Wave released a report titled, "Family & Retirement: The Elephant in the Room." Figure 16 of this report listed the results of a survey describing the greatest worries different generations had about living a long life. The top two worries cited by both the "Silent Generation" and the "Baby Boomer Generation" were "running out of money to live comfortably" and "being a burden on my family" (which is arguably partially related to the worry of running out of money). In fact, these two concerns were cited by more than 60% of the survey respondents.
The September issue of the AARP Bulletin contained an article about the five steps to a happy retirement, including Step Number 5--Make Your Money Last by Jane Bryant Quinn. I have to say that this article was unfortunately one of the most confusing articles from Ms. Quinn that I have read. She initially indicates that the 4% Rule is the gold standard for financial planners. According to Ms. Quinn, "If you stick to that rule and are properly invested, your money should last for at least 30 years and, in most cases, much longer. You should be financially safe." She then asks a number of experts what they think and, not surprisingly, the safe withdrawal rates vary from 2.5% to 5.5%. She closes by advising retirees to "prepare to be nimble", "stay the course" and "begin again with the money you have left if you sell when the market falls and miss the upturn." With advice like this, no wonder many retirees are confused and worried about running out of money or becoming a burden on their families.
One of the big problems with the 4% Rule and other "safe" withdrawal strategies is that after the first year, you have no real way of knowing whether you are still "on track." In addition, these approaches are based on assumptions that may not apply to your specific situation. To be less confused and worried about overspending (or underspending) your accumulated savings, you should use the Actuarial Approach recommended in this website.
The Actuarial Approach automatically adjusts for actual experience as it emerges and annually lets you know whether you can increase your spending or whether you should decrease your spending based on your personal situation and objectives.
In his September 23 post, Neal Frankle touts the benefits of the 4% Constant Withdrawal Approach (together with increased investment in equities) as a way to easily and significantly increase income in retirement.
To use the favorite phrase of perhaps the most famous actuary of the 20th Century, Robert J. Myers, I am constrained to disagree. I outline the shortcomings of the 4% Constant Withdrawal Approach in my February, 2014 article (published in Volume 13 Issue 2 of the Journal of Personal Finance, p. 51). In summary, the method:
- Doesn't coordinate well with other sources of retirement income,
- Doesn't smooth results from year to year,
- Doesn't attempt to provide constant real dollar income from year to year, and
- Produces far too low withdrawals in later years of retirement, resulting in under spending and larger than intended amounts left to heirs at death.
As an example of the last bullet, under the recommended assumptions for the Actuarial Approach (and assuming no other retirement income), the withdrawal rate for a 30-year expected payout period is 4.34%, for a 20-year period is 5.97% and for a 10-year period is 10.89%. Therefore, a constant 4% withdrawal approach would not be expected to significantly boost retirement income as a retiree ages when compared with withdrawals expected under the Actuarial Approach.
It is always nice to get a compliment--even if it comes from a friend. Out of the blue last week, my friend, Steve Vernon, Research Scholar for the Stanford Center on Longevity and blogger for CBS MoneyWatch, decided to say a couple of nice things in his blog about our website and the Actuarial Approach for determining a spending budget. His posts are A simple tool for figuring retirement income and How much can I spend in retirement?
As usual, Steve does an excellent job of discussing his topic in a straight-forward and understandable (i.e., non-actuarial) manner. I just have just a couple of "clarifying" comments:
Steve indicates that you can input the amount of Social Security in the spreadsheet tool. This isn't the case. The "Excluding Social Security V 2.0" Excel spreadsheet is designed to produce a number that you can add to any inflation-indexed income you receive, such as Social Security, to determine your spending budget.
While Steve discusses the need to periodically adjust withdrawals to reflect events that have occurred (which I believe is more important than the sophistication level of the spending tool employed), he does not discuss the smoothing algorithm I recommend in this website. I believe that it is important to smooth the gains and losses that will occur in the future in a reasonable manner. And I believe the smoothing algorithm we recommend is an important part of the Actuarial Approach.
Lastly, although it makes for a good story, I did not develop the Actuarial Approach and website to figure out my own retirement spending budget (although I certainly do use it). As a defined benefit pension actuary, I became concerned about how individuals will have to "self-insure" their retirement in a defined contribution (401(k)) world over ten years ago while I was still working. At that time, I pitched my ideas to Dallas Salisbury and others at the Employee Benefit Research Institute (EBRI), AARP and other organizations representing retirees as well as my own professional actuarial organizations. I thought that my approach could help retirees better manage the risks involved in determining how much they could afford to spend each year. Apparently, these organizations disagreed. When I did receive feedback, I was told that my approach was either too complicated or not complicated enough. This feedback was a source of frustration for me. When I was close to retiring, my friend and co-worker at Towers Watson, Kin Chan, offered to help me set up this website to help me communicate the approach. It is an offer that he now, I'm sure, regrets as I send him new thoughts to post every few days.
This post once again takes on the so-called experts who say that most retirees aren't smart enough or motivated enough to properly manage their spending. For some reason, they believe that individuals who have managed to live within their means prior to retirement (and even save money) will no longer be able to do so during retirement. I believe that with a little bit of effort and the tools provided in this website most retirees can do a reasonably good job of managing their spending in retirement. It is really as simple as following these four steps:
Step 1: Develop a Reasonable Budget--Using one of the spending spreadsheets and the recommended assumptions set forth in this website, determine how much total income you can spend for the upcoming year (from Social Security, pensions, annuities, withdrawals from accumulated assets and income from employment). To determine your "income" from withdrawals, you may need to adjust your current accumulated assets for events expected to occur in the future. For example you may add the present value of amounts you expect to receive, such as gains from downsizing your home, expected inheritances, re-payments of loans owed you, etc. Conversely you may subtract the present value of such items as future loan repayments you owe or amounts you wish to set aside for unusual future expenses (as discussed in the previous post). The June, 2014 article in the articles and spreadsheets section of this website provides a brief description of how to use the Actuarial Approach to determine a spending budget and includes several posts that provides examples of these adjustments.
Step 2: Determine Your Spending Needs/Living Expenses For the Upcoming Year--Most retirees keep track of their expenses, so they have a pretty good idea of normal living expenses. To this amount add an estimate for other expenses you expect to incur. Don't forget to include taxes that you may need to pay.
Step 3: Compare the Results of Step 2 with Results of Step 1 and Make Necessary Adjustments--If the results of Step 2 are higher than the results of Step 1, you may need to reduce some of your expenses for the year or you may need to increase your income. You can increase your income by working more or you can revisit the assumptions used to develop your budget. For example, you may be comfortable developing a budget that is not expected to remain constant in real dollar terms from year to year, so this adjustment may increase your spending budget for the current year (at the expense of reducing it for future years, all things being equal). Alternatively, you may simply decide that it is not important to have your expenses match your budget for the upcoming year.
Step 4: Repeat Steps 1-3 at Least Once Per Year--This is not a "set-and-forget" process. You need to periodically (I recommend doing this once each year at the beginning of each calendar year) revisit the three step process described above to reflect investment gains and losses, changes in assumptions, deviations of actual spending from the budget or other changes. I recommend using the recommended smoothing algorithm in this website for this purpose. Under this smoothing algorithm, you generally increase your budget by the increase in inflation over the previous year unless your budget falls outside a 10% corridor around the "actuarial value" produced by the spreadsheet. Depending on actual results, your budget may increase or decrease from year to year.
That's it! Yes, it takes some work and some discipline but after the first time it will probably take you less time than you take to plan your next trip, fill out your NCAA tournament brackets or make your fantasy league picks.
There may come a time during your retirement where you are looking at an expense that may blow your annual budget. Examples of such expenses include the purchase of a new car or vacation home, helping your children purchase a new home, paying for a wedding, etc. This post will take a look at several different ways you can handle these "lumpy" expenses under the Actuarial Approach.
In summary, there are quite a few reasonable ways to adjust your budget for unanticipated expenses under the Actuarial Approach. In many ways, developing a budget for retirement is more of an art than a science. Irrespective of what your budget is, you are the one who decides how much of your available assets you will spend each year. After all, it is only a budget, and no one is going to force you to live within it. On the other hand, if you believe you will have unanticipated expenses in the future, it may be prudent to reserve for such expenses by reducing the accumulated assets you have available for normal retirement expenses and establishing a separate unanticipated expense fund.
Before discussing the different ways to adjust your budget for unexpected expenses, lets provide some facts for a hypothetical retiree so that we can illustrate the impact of using the different approaches:
Raymond retired at age 65. At that time, he had accumulated assets of $500,000, a fixed dollar pension of $10,000 per year and Social Security of $24,000 per year. He used the Excluding Social Security V 2.0 spreadsheet in this website with the recommended assumptions. Because he wanted to leave some of his assets to his daughter, he developed his initial spending budget by inputting $100,000 in the amount to be left to his heirs.
His resulting first year budget is $51,733 ($24,000 from Social Security, $10,000 from his pension and $17,733 from withdrawals). In the first year of retirement, his accumulated assets earn 10%. In the second year of his retirement, his accumulated assets earn 3%. Let's assume that CPI increases were 2% in each of his first two years of retirement and further assume that Raymond spends exactly his total budget each year. To determine his budget in subsequent years, Raymond applies the smoothing approach recommended in this website to the sum of his pension and withdrawals and then adds his Social Security benefit for that year.
Since the budget amount (prior to adding Social Security) increased by inflation in each of his first two years of retirement remains inside the 10% corridor around the actuarial value, Raymond determines his budget for his second year of retirement by increasing the first year pension and withdrawals of $27,733 by 2%. This equals $28,288 so he withdraws $18,288 from his accumulated savings and his total budget for his second year is $52,768 ($24,480 from Social Security, $10,000 from the pension and $18,288 from withdrawals).
Late in his second year, Ray determines a preliminary budget for his third year. He increases the pension and withdrawal from the previous year of $28,288 by 2% to get a sum of $28,854 for a total budget of $53,824 ($24,970 from Social Security, $10,000 from the pension and $18,854 from withdrawals. At the beginning of his third year of retirement, he has $527,572 in accumulated assets. By comparison, the actuarial budget for his third year (based on the spreadsheet without smoothing) would be $55,094 ($24,970 from Social Security, $10,000 from the pension and $20,124 from withdrawals).
But, let's assume that at the beginning of his third year of retirement, Ray discovers that he has an upcoming expense of $40,000 at some time in the near future. How should he adjust his third year budget in light of this new expense?
Approach #1--Restart the Actuarial Approach
Under Approach #1, Ray redetermines his budget for year 3 reducing his assets at the beginning of year 3 by $40,000 (even though all of this expense may not occur in year 3). So, instead of inputting $527,572 in assets to determine the actuarial budget, he enters $487,572 and a 28 year remaining period. The resulting total budget is $53,265 ($24,970 from Social Security, $10,000 from the pension and $18,295 from withdrawals).
Approach #2--Treat the Unexpected Expense as Any Other Gain/Loss (Including Deviations of Withdrawals from Budget)
Under Approach #2, Ray inputs $487,572 into the spreadsheet as his accumulated assets (the same as in Approach #1). Using the smoothing method, he compares the result of the spreadsheet calculation ($28,295 = $10,000 from the pension and $18,295) with the previous years total increased by 2% inflation ($28,854). Since the amount from the previous year increased by inflation falls within a 10% corridor around the actuarial value, Ray adds $28,854 to his Social Security benefit of $24,970 to get the same budget for his third year that he had prior to recognition of the unexpected expense.
Approach #3--Recognize the Expense in Budget Over a limited Period
Ray doesn't feel comfortable with the negligible or no decreases in budget resulting under the first two approaches and feels that spending an extra $40,000 in accumulated saving should be recognized in his spending budget over a shorter time-frame. Therefore, under Approach #3, Ray decides that he will reduce his spending budget for each of the next four years by $10,000 per year. To accomplish this, Ray will add $40,000 to his reduced assets of $487,572 in year three and will determine the same budget (without recognition of the extra expense) of $53,824. From this amount, he will subtract $10,000 to get a third year expense budget of $43,824.
To determine the budget in year 4, Ray will follow the regular actuarial process, but instead of adding $40,000 to his beginning of year assets, he will only add $30,000. He will then subtract $10,000 from the resulting budget. He will continue this process for two more years until there are no more adjustments to the inputted assets and no more $10,000 subtractions from the budget. Depending on whether Ray actually pays attention to his spending budget, this approach is more conservative than the first two, but results in approximately a $10,000 increase in his annual budget when the expense is fully recognized.
Approach #4--Reduce Amount Desired to be Left to Heirs
Yet another approach is to use either Approach #1 or Approach #2 and reduce the amount previously input for the bequest motive. This approach may be perceived to me more reasonable if in fact the unanticipated expense is in reality a pre-payment of one's bequest motive (such as a gift to assist a child purchase a home).
This post welcomes yet another challenger to my claim that the Actuarial Approach is a better withdrawal strategy for you to use to develop a reasonable annual spending budget in retirement. The challenger in this post is called the "Bucket System" and an example of its use is set forth in this Bankrate article.
Under the Bucket System, Jason Flurry proposes to establish three separate investment buckets (with increasing levels of investment risk) and a strategy for draining those buckets over time to provide retirement income to a hypothetical 55-year old couple with $2 million in accumulated assets. His proposal would be expected to provide the couple with income of $60,000 per year for the first ten years of retirement. In order to facilitate a comparison of the approaches, I am going to assume the following additional facts:
- the couple has earned combined Social Security benefits of $4,000 per month payable at age 65 (before any increases in inflation),
- investment return per annum for the Bucket System equal to the percentages specified in the example (0% for Bucket 1, 4% for Bucket 2 and 6% for Bucket 3
- 5% per annum investment return for the Actuarial Approach
- 3% per annum inflation
- no other sources of retirement income, no desire to leave significant amounts to heirs, expected payout period under the Actuarial Approach of 40 years at initial retirement, and
- the couple expects to commence their Social Security benefits at age 65. They expect the total annual amount of their Social Security benefits at that time (with 10 years of inflation at 3% per annum) will be $64,508 ($4,000 X 12 X 1.3439).
Under the Actuarial Approach, the couple uses the Social Security Bridge spreadsheet from this website, enters $2,000,000 in assets, expected Social Security of $64,508, number of years until commencement of Social Security: 10, zero to be left to heirs and the other recommended assumptions for the spreadsheet. The resulting withdrawal for the first year is $103,340. And, if the assumptions are exactly realized each year (and the couple spends exactly the total budget amount each year), each future year's total budget (Social Security plus withdrawals) until the couple reaches approximately age 91 is expected to remain at $103,340 per year in real (inflation-adjusted) dollars.
By comparison, if all assumptions are realized under the "Bucket System" set forth in the article (and the couple spends the total budget amount each year--withdrawal plus Social Security), the total budget (in real dollar terms) is expected to increase significantly when the couple starts commencement of Social Security and again after 15 years when income from the third bucket kicks in. The figure below shows a comparison of the expected total budget amounts under the two approaches from the couple's age 55 until they reach age 90. I calculate that there will be in excess of $3.2 million in assets (including about 871,000 in Bucket 2) remaining at age 91 under the Bucket System vs. $749,489 at age 91 under the Actuarial Approach. Note that this amount ($749,489) is shown in the run-out tab of the Social Security Bridge spreadsheet. If you can't see the run-out tab, you need to maximize the spreadsheet window.
Of course, actual future experience will not exactly follow assumed experience. That is why it is important for a systematic withdrawal approach to automatically adjust for actual experience. Under the Actuarial Approach this is easily accomplished: As long as the previous year's budget amount increased by the increase in inflation for the previous year falls inside of a 10% corridor around the actuarial value, you stay with the previous year's value increased by actual inflation. Automatic adjustment occurs under the Bucket System after the 15 year when the couple uses the IRS Required Minimum Distribution (RMD) rules to determine distributions. As mentioned in previous posts, budget amounts can vary significantly from year to year under RMD approach as there is no smoothing of the actual experience.
The three major problems with the Bucket System (based on the facts of this example) from my perspective are: 1) it does not coordinate well with expected commencement of Social Security benefits, 2) it does not anticipate future inflation and 3) it uses the RMD rules to determine distributions from Bucket 3. As a result of the first two problems, the matching of retirement income to the energy level of the hypothetical couple may not be optimal. During the first ten years of their retirement, when they may wish to enjoy a more active life style including travel and adventure, their retirement income is significantly restricted relative to expected income in later years. In addition, RMD is more likely to leave more money to heirs than desired.
Note that the Actuarial Approach produces an expected budget pattern under these assumptions that is constant in real dollar terms. Some argue that retirees don't need constant real dollar income in retirement, but can accept some degree of decrease as they age, perhaps followed by an increased need much later in life. This "smile" pattern can also be accomplished under the Actuarial Approach by inputting a lower percentage for desired increase in payments than the percentage anticipated for inflation and by inputting the expected increase in cost (for assisted living, etc.) as amounts desired to be left to heirs. I believe it is better to factor these needs directly into the calculation than it is to use a method (such as RMD) that can simply result in unintended and undesirable deferral of spending. Of course, different spending patterns can also be achieved by consciously spending more or less than the spending budget produced under whatever approach is used.
(click to enlarge)
