What’s in a Name? That Which We Call the Actuarial Approach…

We get questions from readers and “push-back” from retirement experts and others about the name we have chosen for the approach we advocate in this website for helping people make financial decisions.  Some don’t know what “the Actuarial Approach” is and are looking for a definition and some point out that there are many approaches that involve actuarial concepts to varying degrees, and it is presumptuous of us to lay claim to “the” actuarial approach.  This post will discuss:

• what the approach is, 
• common misperceptions about it, and 
• why we call it the Actuarial Approach.
  

What is the Actuarial Approach?

The Actuarial Approach is the use of basic actuarial principles to accomplish one’s personal financial goals.  For many years, actuaries have been helping sponsors of financial systems accomplish financial goals using basic (or fundamental) actuarial principles (or concepts).  The Actuarial Approach advocated in this website applies many of these same principles to personal financial goals.  These fundamental actuarial concepts include:

• Making assumptions about the future 
• Time value of money 
• Concept of probabilities 
• Mortality 
• Use of actuarial present values 
• Use of a generalized individual model that compares assets with liabilities 
• Periodic gain/loss adjustment to reflect experience different from assumptions (annual valuations), and 
• Conservatism
  

These principles (and others that may not be applicable to a personal financial situation) are conveniently summarized in the 1989 monograph by Charles Trowbridge entitled, Fundamental Concepts of Actuarial Science.  We have included a copy of this monograph in our Other Calculators and Tools section, for those who may be interested in actuarial science.

We believe these tried and tested principles are mathematically superior to the strategic withdrawal plans advocated my many retirement experts and academics.

For additional discussion of the Actuarial Approach, you can read our brief description of the Actuarial Approach.

Common Misperceptions About the Actuarial Approach

We find that there are several misperceptions about the Actuarial Approach and, for the most part, they all stem from the same source: individuals believe the Excel workbooks we provide in our website and our recommended assumptions comprise the Actuarial Approach.  It is important to note that we provide the workbooks and recommended assumptions simply to make it easier for users to apply the following basic actuarial formula, which compares one’s assets with one’s spending liabilities:

This one misunderstanding apparently creates a lot of confusion and misperceptions.  For example, we have been told:

• Because the Actuarial Approach uses deterministic assumptions, it is not as robust as approaches that use Monte Carlo modeling and stochastic assumptions 
• Because the assumptions used in the Actuarial Approach are conservative, the results are too conservative 
• Because the Actuarial Approach uses a fixed lifetime planning period rather than probabilities of death, it is not sophisticated enough 
• Because it determines spending budgets on a pre-tax basis, it is not useful, etc.
  

These comments all reflect the same basic misunderstanding about the Actuarial Approach: Just because we make simplifying assumptions (like the ones discussed above) to make the calculations easier in our workbooks, doesn’t mean that these issues necessarily apply to the general Actuarial Approach model.  If you want to make the Actuarial Approach more complicated and theoretically more sophisticated, you can do it and still follow basic actuarial principles.

Why do we call it the Actuarial Approach?

We call it the Actuarial Approach for several reasons:

• The name is sexier and more concise than “the approach that uses basic actuarial principles to accomplish personal financial goals” 
• It is consistent with the approach used by actuaries to help sponsors of financial systems accomplish financial goals 
• We are two pension actuaries who used a similar process for guiding pension plan sponsors 
• It utilizes more of the basic actuarial principles than almost all the other approaches currently in use.
  

Summary

Actuaries use basic actuarial principles to help keep many financial security systems sound and sustainable.  These same principles can be used to help individuals achieve financial goals.  We encourage individuals and their financial advisors to consider using these time-tested and proven basic actuarial principles in their financial planning, at a minimum as a supplement to what they are currently using.  To paraphrase Juliet, “That which we call the Actuarial Approach by any other name just makes good financial sense.”

Hey Millennials, How Much of Your Pay Should You Be Saving?

So, you are a Millennial who is employed but hasn’t started to save yet. The “experts” tell you that you need to start saving like yesterday and you need to save as much as possible. This post will walk you through how to use our Actuarial Budget Calculator for pre-retirees so that you (or your financial advisor) can develop a spending/savings budget that will help you accomplish your financial goals. 

In their recent article in the Journal of Financial Planning, “Planning for a More Expensive Retirement,” PH.D.’s Blanchett, Finke and Pfau develop a life cycle model to determine, among other things, savings rates required in a low investment return economic environment to replace hypothetical individual’s pre-retirement standard of living, assuming retirement occurs at various ages.  These gentlemen conclude,

• “Savings rates would need to rise sharply for households hoping to maintain the same standard of living in retirement if real asset returns are low” 
• “Advisers may need to modify expected returns in planning software to provide clients with more realistic projections on meeting long-term spending goals.”, and 
• Advisers using historical asset return data or outdated mortality assumptions may be providing clients with an unrealistically optimistic estimate of either the age at which they can comfortably retire or the amount of savings needed to maintain their current lifestyle.”
  

In Table 3, the authors’ model shows that if returns remain low, the necessary current savings rate for a single 35-year old making $50,000 per annum with no current savings who wants to retire at age 65 with the same standard of living is 18.1%. This savings rate jumped to 23.66% for an individual currently making $200,000. If retirement is deferred to age 70, however, the savings rates are reduced to “just” 12.74% for the $50,000 individual and 19.76% for the $200,000 individual.

The authors’ model is reasonably complicated and not particularly transparent.  With a little bit of work, however, we were able to use our Actuarial Budget Calculator for Pre-Retirees and our recommended assumptions to come reasonably close to their low investment environment savings rates for hypothetical 35-year old’s currently earning $50,000 and $200,000, respectively. We describe the assumptions and method we used below, so that Millennials and other pre-retirees (or their financial advisors) can duplicate our results and use our workbook to develop their own spending/saving budget based on their own situation and assumptions.
 
Assumptions and method:

• No initial accumulated savings (B7) (including no initial 401(k) balance) 
• Desired number of years until retirement (B 11): 30 years for retirement at age 65 and 35 years for retirement at age 70 
• No income from other sources except Social Security and company sponsored 401(k) plan that matches employee contributions $.50 for each dollar up to 6% of the employee’s pay.  
• 401(k) plan matching contributions (B 17): Each hypothetical worker is assumed to contribute at least 6% of pay each year, so the initial match is $1,500 for the $50,000 worker and $6,000 for the $200,000 worker.  Subsequent years matches are assumed to increase at the same rate (B 19) as used for assumed pay increases.  
• Investment return/discount rate (B 21): 4% per annum (2% real return) 
• Inflation (B 23): 2% per annum 
• Lifetime planning period (B 25): 60 years (death at age 95) 
• Pay increases (B 13): For $50,000 worker: 3% per annum; For $200,000 worker: 3.6% per annum 
• Present value of unexpected expenses (E 39): For $50,000 worker:  $25,000; For $200,000 worker: $100,000 
• Present value of Long-term care expenses (E 37): For $50,000 worker: $75,000 or $0; For $200,000 worker: $75,000 
• Desired amount remaining at end of lifetime planning period (E 35): $0 for both workers 
• Annual increases in spending budgets after assumed retirement (E 33):  For $50,000 worker: 2% per annum (maintain real dollar purchasing power); For $200,000 worker: 1% per annum (decreasing real dollar purchasing power). 
• Reduction in expenses on retirement: For $50,000 worker: 15% of gross pay just prior to retirement; For $200,000 worker:  10% of gross pay just prior to retirement.  See below for more discussion of the implications of these assumptions.  
• Except as noted above, no other non-recurring pre-retirement or post-retirement expenses (such as education expenses, home improvements, etc.) 
• Social Security benefit at assumed retirement age (E 15): We used the Social Security Online Quick Calculator for this purpose.  We selected amounts to be shown in future dollars and adjusted future earnings where necessary to approximately match our pay increase assumption. For the $50,000 individual, this meant that we used a -.9% adjustment to the default earnings used by the calculator to produce about a 3% per year increase in future earnings. For the $200,000 worker, we entered 2017 earnings of $127,200 with no adjustment to the default increase assumption. The resulting estimated benefits for the $50,000 worker were $52,344 (annual) assuming retirement (and commencement) at age 65 and $86,448 assuming retirement and commencement at age 70. Benefits for the $200,000 worker were $92,232 at age 65 and $153,804 at age 70.  The runout tab of our workbook shows pay in future dollars for the year prior to desired retirement, so that you can approximately match that amount with the pay amount shown for the year prior to assumed retirement in the Quick Calculator. 
• Social Security start year (E 17): 30 years for retirement at age 65 and 35 years for retirement at age 70 
• Process used to solve for savings rate needed to replace pre-retirement standard of living (B 15): This is where it gets just a little more complicated.  We had to use a trial and error process to solve for the necessary savings rate that would replace the hypothetical workers’ pre-retirement standard of living because increasing the savings rate decreases the target pre-retirement standard of living. The equation we used for this purpose for the $50,000 individual was:
  

[(1 – Savings Rate (SR)) - .15] / (1 – SR) = ratio of first year spending budget to final working year spending budget, in real dollars from our workbook (E 60). The .15 factor was our estimate of the proportion of the $50,000 worker’s pre-retirement gross pay represented by FICA taxes, work-related expenses and other factors that we assumed would not need to be replaced after retirement.  We estimated this percentage to be about 10% for the $200,000 worker. Note that this process is more complicated, but more consistent with the concept of replacing one’s pre-retirement standard of living than simply solving for the savings rate that will produce say a 80% ratio in E 60.
 
Results

The table below shows our workbook results for the two hypothetical 35-year olds based on the assumptions and method above vs. the authors’ results.

(click to enlarge)

While our results are comparable, we tend to show a bigger decline in the required savings rate associated with working until age 70, rather than retiring at age 65 than the authors. This may be due to our constantly increasing pay assumptions. 

So how much of your pay should you be saving?
 
Our Actuarial Budget Calculator gives you a tool to develop a spending/savings budget based on your situation, your assumptions and your financial goals. You may feel that savings rates developed using our workbook and our recommended assumptions are too high because you will earn a higher real rate of return than 2%, you will never retire, you will work part-time after retirement or you will have other sources of income. On the other hand, it is certainly possible that:

• your estimated Social Security benefit under current law may be reduced in the future (see our post of December 15, 2016),   
• your employment may cease prior to your desired retirement date, 
• you may desire a higher standard of living after retirement than before, or 
• you may have other expenses such as college education costs or home improvements for which you also need to save.  
  

You will also need to decide whether saving for purchase of a home requires additional saving or whether the value of your home can ultimately be used to meet some of your expenses in retirement. 

Even though our workbook simplifies the calculation process to some degree, this planning and budgeting stuff may seem too complicated to you, too much work or just too painful to consider at this time. We understand that you may not be currently focused on saving for your retirement. It is not too early, however, to develop a financial plan for the future, and we encourage you to consult with a financial advisor or use our ABC for pre-retirees for this purpose. We know that this is a tough task, but we assure you that it can be done.  We just read about a 31-year old who saved over one million dollars in just 5 years.  His motivation for starting to save? He used a retirement calculator that told him he needed $1.25 million to retire. 

You Can Spend It Now or You (or Your Heirs) Can Spend It Later – Part II

When to Spend Your Assets – It’s a Balancing Act

This post is a follow-up to our post of October 24, 2014, which pointed out that determining the right amount to spend each year is a balancing act.  If you spend too much early in your retirement, you may fall short later when you get older.  If you spend too little early in your retirement, you may have more assets than energy when you get older.  If you could only predict exactly:

• when you will die, 
• how your investments will perform, and 
• how your expenses in retirement will change each year,
  

you could determine exactly how to spread your spending over your remaining lifetime period to best meet your financial objectives.
 
Example
 
An example of this balancing act is illustrated in the graph below, which we originally included in our post of December 3, 2014.  This graph shows initial and projected budget amounts (in inflation-adjusted dollars and excluding Social Security benefits) for a 65-year old retiree with $600,000 in accumulated assets.  The budgets were determined using the Actuarial Approach (and recommended smoothing) using two different assumptions for the retirement payout period, what we call the lifetime planning period.  If you know that you will earn 5% per annum, inflation will be 3% per annum and you will live to age 95, you can structure your spending to remain constant each year in real dollars (the straight green line).  On the other hand, if the only thing you don’t know is how long you will live, and you assume that you will live only as long as your life expectancy, your initial spending (red line) will be higher than the green line spending. In the future, however, you will experience actuarial losses each year you survive, and your spending budget will decrease and ultimately decline below the green line as you get older.  We used this graph in 2014 to support our recommendation that retirees, who aren’t aware of a specific health issue that would definitely shorten their expected lifetime, should assume that they live until age 95 or their life expectancy, if greater to avoid these actuarial losses until approximately age 90.

(click to enlarge)

We Must Make Assumptions

Unfortunately, we won’t know the answers to how long we will live, how much our assets will earn or how our expenses will increase each year until we die.  And by then, it will be too late for this information to help us much.  So, we must make assumptions about the future and hope that they are about right.  Equally important, as discussed in our previous post, retirees (and their financial advisors) need to periodically value their assets and spending liabilities to see how actual experience about the future compares with the assumptions previously made about the future.  Actual experience more favorable than assumed (gains) will increase future actuarial spending budgets (determined before application of any smoothing) and actual experience less favorable than assumed (losses) will decrease future actuarially calculated spending budgets.

Experience Gains
 
As a practical matter, most retirees prefer to err on the “too conservative” side, so that if experience deviates from assumptions, their future actuarial spending budgets are more likely to increase rather than decrease.  For this reason, we recommend using relatively conservative assumptions about the future.  Note, however, that there is nothing in the Actuarial Approach that implies that retirees must actually increase their future spending if future experience does turn out to be more favorable than assumed.  Retirees can always save these “experience gains” in a rainy-day fund.

“Safe” Spending Approaches May Not Be All That Safe

In our experience, spending budgets developed using the Actuarial Approach and our recommended assumptions are generally consistent with initial spending budgets developed using well-designed Monte Carlo models, as many financial advisors are also reasonably conservative and don’t relish the thought of telling their clients that they will need to reduce their spending in the future.  Thus, these financial advisors tend to recommend conservative spending strategies.  Because their spending recommendations are generally communicated with relatively high probabilities of success for the entire lifetime planning period, there is often less discussion about the need for periodic valuations and future adjustments.

We believe it is important for retirees to understand, however, that if they invest a significant portion of their assets in equities and other risky investments, very few spending strategies will be truly “safe” in terms of guaranteeing against future spending decreases.  As we noted in an article included as the second post in our website in 2010:

“[Nobel Laureate William] Sharpe says what's really wrong with the 4% plan is its insistence on fixed spending coupled with investing in a portfolio with variable returns.”

Therefore, most retirees need to be prepared for possible decreases in their spending budgets, in the event their investments earn less than the assumption(s) used to develop their initial spending budget or other experience is less favorable than assumed.  

If you (or your financial advisor) believe our recommended assumptions are too conservative, you don’t have to use them.  By using more optimistic assumptions about the future, however, you must realize that you are increasing the possibility of future spending budget decreases, relative to your desired spending goals, all other things being equal.
 
Impact of Using More Optimistic Assumptions
 
The chart below shows the impact on an initial spending budget of using our current recommended assumptions and alternative assumptions for a hypothetical 65-year old male retiree with $800,000 in accumulated savings and a Social Security benefit of $22,000 per year.  Our hypothetical retiree assumes his home equity will cover his long-term care expenses, has budgeted $50,000 for unexpected expenses, and has no bequest motive.  You can check these calculations by using our ABC for Retirees workbook.

(click to enlarge)

The first column, labeled Base Assumptions, uses our current recommended assumptions of:

• 4% Expected rate of return / discount rate (2% real rate of return), 
• 2% Expected rate of inflation, 
• Lifetime planning period (LPP) of (95 - current age = 30), and 
• Constant real dollar future spending (Desired increase in future budget amounts of 2%)  
  

Subsequent columns show the effect on the base assumption initial budget of selecting different rates of future spending increases, different real rates of investment return, and different lifetime planning periods.  Note that the dollar and percentage increases may differ for different retiree situations.  Also, note that the dollar and percentage increases may not be additive if two or more different assumption changes are combined.  

Developing different spending budgets under different assumptions provides retirees with additional “data points” to help them make better spending decisions.  For example, our hypothetical retiree may decide that he is comfortable using something closer to his life expectancy (22 years) to determine his spending budget, rather than assuming a 30-year lifetime planning period.  This could be based on a combination of rationales, for example:  

• he doesn’t need to have constant real dollar spending in retirement, 
• his parents did not live very long or 
• he will earn more than a 2% real rate of return on his assets, and those investment gains will counterbalance the potential actuarial losses if he lives too long.  
  

Conclusion

If you use the Actuarial Approach, changes to your spending budget can either occur by

• evolution (gradually as actual experience emerges) or 
• revolution (in the year you change assumptions).  
  

You can either use the recommended assumptions and increase your future spending budgets as experience gains emerge (assuming they do), or you can use more optimistic assumptions to develop a higher initial spending budget with an increased risk that you will have to reduce your spending budget in the future.  The choice is yours.  The assets that you don’t spend now will be available for you (or your heirs) to spend later.  The ABC for Retirees can provide you with data points to help you with this difficult spending balancing act.

The Actuarial Approach—Much More Than Just a Measure of Where You Stand Financially

In his post of March 10, Bob French touts the benefits of comparing one’s assets to one’s liabilities to determine where an individual or couple stands financially.  Bob calls this calculation “the funded ratio.”  This is the second recent discussion advocating what is essentially the Actuarial Approach to develop a funded ratio.  See our post of March 5, “Actuarial Approach with a Different Name” for discussion of the “personal funded ratio” proposed by Messrs. Hill and Pittman.

The concept of comparing one’s assets to one’s liabilities is the foundation of the Actuarial Approach advocated in this website.  Readers of this website are quite familiar with the following equation, which we employ frequently:

where items on the left-hand side of the equation equal the individual’s assets and the items on the right-hand side equal the individual’s spending liabilities.

The funded ratio proposed by Messrs. French, Hill and Pittman divide assets by aspirational liabilities (the individual’s spending goals) to help the individual determine where he or she stands in meeting retirement goals and how much the individual’s assets would need to be to meet these goals.  And while this aspirational funded status measurement is easily accomplished under the Actuarial Approach with the assistance of our Actuarial Budget Calculator (ABC) workbooks (by backing into how much assets are required to produce the aspirational spending budget), individuals can also use this basic actuarial equation to develop an actuarially calculated spending budget for the current year, by manipulating the above equation, to get:

The denominator of the item on the right-hand side of this equation is the present value of future years of retirement, with desired increases in future recurring spending budgets of x% per year (similar to the cost of retirement developed in the Blackrock CORI index, as discussed in our post of January 29, 2017).

So, if you like how the Actuarial Approach helps you determine how much assets you will need to fund your aspirational spending liabilities, you will really like how it helps you develop a spending budget, based on the assets you actually have.

The Consequences of Overestimating Retirement Expenses

This week, Advisor Perspectives published our article, The Consequences of Overestimating Retirement Expenses.  The article discusses some of the weaknesses of using traditional planning approaches that target constant real dollar spending for a retiree’s entire planning period.  It also discusses how these weaknesses can be addressed using the Actuarial Approach advocated in this website.  We provide an example for a hypothetical couple that uses our Actuarial Budget Calculator (Retirees) workbook. 

Actuarial Approach with a Different Name

In their article, “Rethinking Retirement Liability,” authors Russ Hill and Sam Pittman introduce us to a financial planning technique that they call the “personal funded ratio.”  From what we can tell from the article, this technique is nearly identical to the Actuarial Approach we advocate in this website, where a retiree’s total assets are compared with her total liabilities (the authors prefer the terms “resources” and “claims”). 

It’s nice to read from these gentlemen what we have been saying in this website for a long time: 

“We believe the personal funded ratio [Actuarial Approach], a technique adapted from the world of defined benefit pension plans, can serve as a valuable addition to the financial advisor’s tool kit and provide a useful gauge for clients to understand how they can pursue their lifestyles both before and during retirement.”

The Actuarial Approach and the Importance of Ongoing Financial Planning

Many financial advisors utilize Monte Carlo analysis (MCA) to help their clients develop financial plans in retirement.  We have written in the past about the potential problems of using MCA, and frankly we are not big fans of relying on it exclusively.  The Actuarial Approach that we advocate utilizes transparent deterministic assumptions and anticipates ongoing (generally annual) valuations of a retiree’s assets and liabilities to help keep a retiree’s spending on track throughout retirement.  Because it does not use MCA and appears to be more volatile than the approach they use, the Actuarial Approach is looked upon by many academics and financial advisors as somehow inferior. This post will once again:

• attempt to defend the approach we advocate as just as good, if not better than MCA, and 
• encourage individuals and their financial advisors to consider using the Actuarial Approach for financial planning, at a minimum as another data point to be considered in the spending decision process.
  

The inspiration for this post was a recent Michael Kitces’ blog post written by Derek Tharp, which set forth steps financial advisors can take to avoid having their clients misinterpret their MCAs.  We agree with Mr. Tharp that there are several potential problems with MCAs and some of these problems can be mitigated if financial advisors:

• stress that “Clients should understand planning is not a one-time occurrence”, 
• “Emphasize the importance of ongoing planning”, and 
• “Present information in more than one way.”
  

Background

We believe financial planning is a process that benefits from periodic attention.  As pension actuaries in our former lives, we performed annual actuarial valuations to determine annual contribution ranges for our plan sponsor clients.  Like the process anticipated by the Actuarial Approach, the pension contribution determination process involved periodic measurements of assets and liabilities, along with deterministic assumptions about the future.  We and our clients both knew that the assumptions we made about the future in a pension actuarial valuation would not be exactly realized in subsequent years, and the plan’s future annual contribution ranges would change somewhat from year to year as actual experience emerged.

This pension actuarial process was not then and is not now a “set and forget” process.  We did not, as a general rule, do a MCA with 10,000 simulations of the future, tell our clients that keeping this year’s contribution level and the current asset mix fixed in future years had a 92.3% probability of successfully funding the plan for the indefinite future, and leave it at that.  It was understood that there would be ongoing valuations and changes to keep the plan’s funding on track.  The client also understood that there was considerable contribution flexibility built into the process, as the impact of future experience deviations and changes in assumptions on future contribution ranges could be smoothed to some degree.  It is with this same “deterministic assumption and annual valuation process” background that we approach personal financial planning.

Monte Carlo Analysis

Monte Carlo analysis (or Monte Carlo modeling) attempts to forecast the future based on historical experience.  This is somewhat analogous to trying to drive a car while looking out the back window.  There is an excellent likelihood that future experience won’t be anything like prior experience, and the projection will be inaccurate.  Running 10,000 simulations does not improve one’s ability to forecast the future.  Under MCAs used by many financial advisors, historical real rates of return and probability distributions of returns for various asset classes are assumed to continue.  For the client, MCA is a non-transparent process that requires a fair amount of faith.

To make these projections somewhat more realistic, some financial advisors adjust historical returns to reflect current economic conditions.  Since the primary output of a MCA is a probability of success for a given level of real dollar spending, there is an implication, if the probability of success is high enough, that the resulting spending level is essentially guaranteed and need never be changed. To achieve this result, the analysis assumes not only that historical returns will repeat themselves, but that the client will spend exactly the specified real dollar spending budget each and every year in the future.  Mr. Tharp is correct that clients may be easily mislead by MCAs.  What the clients do know is that MCAs involve lots of sophisticated calculations, so they figure they must be right.

Monte Carlo Analysis vs. the Actuarial Approach

By comparison, the Actuarial Approach (utilizing recommended assumptions) assumes future deterministic investment returns based on current insurance company annuity pricing.  These investment return assumptions are independent of the client’s actual investment strategy.  If the client’s actual future investment returns deviate from this assumed rate, the assumed rate is changed or if actual spending deviates from the spending budget, the client’s future actuarially determined spending budget will increase or decrease accordingly.  This does not imply, however, that the client’s spending must fluctuate from year to year, as the client’s annual spending budget (or actual spending) can be smoothed to some degree.

It has been our experience that an initial spending budget for a retiree who desires a relatively high probably of success under a well-conceived MCA approach that properly recognizes all sources of income and all significant expenses, is generally comparable to the spending budget developed under the Actuarial Approach with recommended assumptions.  In fact, the Actuarial Approach may produce higher initial spending budgets than the MCA approach under these circumstances.  It has also been our experience that initial spending budgets developed using adjusted historical experience and high probabilities of success don’t vary greatly based on the client’s asset mix, as the higher expected returns expected from mixes containing more equities are mostly counterbalanced by the larger amount of risk in such investment portfolios.

While initial spending budgets developed by the two approaches may be comparable under certain circumstances, the Actuarial Approach offers several features that are not generally available under a traditional MCA:

• It allows one to easily model investment risk and spending risk.  Our workbooks contain a 5-year projection tab that gives the client the opportunity to model the effect on future actuarial spending budgets of deviations in future investment returns and spending.  This type of information can be helpful in developing investment strategy and general financial planning. 
• It allows one to model different future spending patterns.  Unlike MCAs which typically assume constant real dollar future spending, our workbooks permit the user to assume declining real dollar future spending more consistent with observed spending in retirement.  The budget by expense-type tab in the ABC for Retirees also permits the user to make different increase assumptions for different types of future expected expenses.
  

Monte Carlo Analysis and the Actuarial Approach Can Work Together

If the MCA properly considers all the client’s assets and future expenses/liabilities, uses reasonable assumptions about the future, and the client is comfortable with a given probability of success and constant real dollar spending in retirement, the MCA approach may produce a reasonable spending budget for the client.  As Mr. Tharp says in his article, however, it is important for clients to recognize that developing a spending budget is not a one-time event and should be revisited periodically.  In addition to reflecting actual investment performance and actual spending, the client’s spending budget may also change over time as the client’s spending goals change.  We believe the data points obtained by applying the Actuarial Approach on an annual basis can:

1. Be an independent check on the reasonableness of a Monte Carlo analysis, 
2. Be an important supplement to the data points developed by a MCA in keeping client spending on track and consistent with the client’s financial objectives, and 
3. Present information in a different way to increase client understanding.
   

Therefore, we encourage retirees and their financial advisors to periodically compare the spending budgets they develop with their MCAs (or other approaches) with spending budgets under the Actuarial Approach.

We like the way Mr. Tharp thinks, and we look forward to future articles by him.  In a future blog post, we will discuss how Mr. Tharp’s post of February 22 regarding development of spending budgets that are expected to decline in real-dollars as retirees age is yet another advertisement for using the Actuarial Approach. 

Five Ways to Increase Your Near-Term Spending, Part II

This post is a follow-up to our post of November 30, 2015 in which we talked about ways to increase your near-term spending in retirement.   In that post we discussed:

1. Finding part-time work or other sources of income 
2. Deferring commencement of Social Security or purchasing annuities 
3. Using more aggressive assumptions in your calculations 
4. Using more aggressive assumptions for non-essential expenses, and 
5. Simply increasing your budget (or your spending) by x%

We also cautioned our readers that, all things being equal, increasing near-term spending increases the risk of declining real (today’s) dollar spending later in retirement.  In this post, we will focus on a subset of the third approach discussed above; lowering the assumed annual target rate of increase for future spending budgets to increase current spending budgets (or reduce the assets needed to fund a given level of spending). 

Within the past few years, several researchers and retirement experts have observed that retiree spending appears to decline in real dollar terms as individuals age.  We discussed this research and how retirees could use our spreadsheets to anticipate declining real dollar spending in developing their spending budgets in our posts of March 31, 2016, August 20, 2016 and November 4, 2016.  More recently, a retirement expert from the UK, Abraham Okusanya, argued in this article that spending in retirement does not follow a “U-shaped pattern” as previously thought, but rather declines in real dollar terms throughout the entire retirement period.

Considering the growing volume of research showing declining real dollar spending in retirement, several retirement experts have suggested that individuals should consider developing their spending budgets so that they also decline in real terms throughout retirement. For example, Mr. Okusanya implies that, based on spending research in the U.S., it would be ideal to target inflation minus 1% (or more) for purposes of developing future spending budgets in the U.S. 

The retirement experts have concluded that this lower target for future spending means that either near-term spending can be increased or the amount a person needs to save for retirement can be reduced, compared with assuming a constant real dollar future spending target.  The experts are less clear, however, as to exactly how much spending may be increased (or savings decreased) by assuming the lower future spending target.

As with all spending matters, we at How Much Can I Afford to Spend leave decisions of how much you spend in a year up to you and your financial advisor.  We simply provide you with tools that give you data points designed to help you make your spending decisions.  However, unlike the retirement experts, we can easily quantify for you how much your current spending budget will be increased (or your necessary savings decreased) if you assume that your future spending budgets will increase by inflation minus 1% in retirement, rather than by inflation. We determine the relevant percentages by first taking the basic actuarial equation that is the foundation for this website:

and manipulating it to obtain: 

To quantify how much This year’s spending budget will increase by targeting future spending budget increases of inflation minus 1%, rather than inflationary increases, we need to divide PV future years increasing by the assumed rate of inflation by PV future years increasing by inflation minus 1%.  The PV future year values are available in the Present Value Calcs tab of our workbooks. 

Similarly, the reciprocal of this ratio will give us the % decrease of needed savings to produce a desired level of spending.

The table above shows the results under our current recommended assumptions at various ages. So, developing a spending budget at age 65 under these assumptions and further assuming future spending budgets increase by 1% per year, rather than the recommended inflation assumption of 2% per year, would increase the actuarially calculated spending budget by 13.3% (or decrease the adjusted assets needed to provide the desired level of spending assuming retirement at age 65 by 11.8%), all things being equal.

Note that if you are, or your financial advisor is, determining your spending budget by adding the results from a Systematic Withdrawal Plan (SWP) to your income from other sources (including Social Security), it may be somewhat more difficult than as described above to develop a spending budget designed to increase at a rate other than inflation.  As discussed in prior posts, SWPs are not really designed to work well unless Social Security is the only other source of income in retirement and the retiree’s spending objective is to have constant real dollar spending in retirement.

While research may support decreasing real dollar spending in retirement, we encourage our readers to develop their future spending increase assumption (or assumptions) by separately examining expected future increases for the three types of future expenses in our Budget by Expense Type tab in our Actuarial Budget Calculator (ABC) workbooks:

• Essential non-health expenses 
• Essential health expenses 
• Non-essential expenses

Since it is not unreasonable to assume that future essential non-health expenses will increase with inflation and essential health expenses may increase at a faster rate than inflation, you may not be comfortable assuming total future recurring spending budgets will increase at a rate of inflation minus 1% (or more) unless your non-essential expenses are assumed to be a relatively large component of your initial spending budget.

Avoiding Financial Regret about Retiring Too Early

In their recent Wall Street Journal article, “Before Retiring, Take This Simple Test,” Dr. Shlomo Benartzi and Dr. Martin Weber encourage individuals considering retirement to take a “two-question quiz that can help predict whether [they will] regret the timing of [their] retirement.”  Dr. Benartzi is a behavioral economist professor at UCLA, and Dr. Weber is a professor at the University of Mannheim in Germany, with special interests in behavioral finance and its psychological foundation.  It is an interesting article that advocates the use of behavioral economics tools like the two-question quiz to “help us find ways to stop people from retiring too early" and regretting their decision.

The two questions in the quiz are almost the same, but the slight difference in timing of the two questions allows for measuring the consistency of time preference.  That is, answering the two questions inconsistently exhibits preference for immediate rewards, as opposed to postponement of rewards.

The recommendation comes from a study of over 3,000 Germans who answered the quiz.  Per the authors, the respondents with inconsistent answers to the quiz:

• “exhibit a tendency known as present bias, or hyperbolic discounting”, 
• “tend to retire…earlier (about 2.2 years on average) than those with consistent preferences”, and 
• “over time, these people are also far more likely to say they regretted the timing of their retirement.”
  

The authors also concluded that retiring about 2.2 years on average earlier than those with consistent preferences resulted in “roughly a 13% reduction in their monthly benefits.”  Perhaps the German retirement system is different from that in the U.S., but as we will show in the example below, each year of continued employment and deferral of retirement from age 62 to age 70 results in closer to a 10% increase in an individual’s real dollar spending budget, rather than the 6% figure (13% divided by 2.2) cited by the authors.

As retired actuaries and not behavioral economists, we at How Much Can I Afford to Spend in Retirement believe that substituting facts for appearances and demonstrations for impressions are still good ways to influence individual behavior.  And while we share the goals of behavior economists to help people make better decisions, we believe that any “framing” of the retirement age decision should be based on reasonable calculations.

Example

Let’s assume we have a single female, Beth, currently age 62, making $100,000 per year.  She has $500,000 in accumulated savings, in addition to her home equity.  She is currently eligible to receive an immediate annual Social Security benefit of $20,124, but she has no other sources of retirement income.  Her employer sponsors a 401(k) plan that matches contributions up to 6% of pay with a 50% match.  Beth contributes enough each year to receive the maximum employer match and her annual savings (including her 401(k) contributions) are 15% of pay. 

Beth wants to know about how much her real annual spending income would be if she retired today at age 62 or if she kept working and retired at age 65, 68 or age 70.  For immediate retirement, she uses our Actuarial Budget Calculator (ABC) for retirees workbook.  For the other ages at retirement, she uses our ABC for pre-retirees.  She makes the following assumptions and other data entries:

• Our recommended assumptions for discount rate (4%), inflation (2%) and lifetime planning period (death at age 95) 
• Her pay will increase in the future with inflation (2%) 
• No amounts desired to be left to heirs 
• Present value of unexpected expenses: $50,000 
• Desired increases in future spending budgets equal to inflation (2%) 
• Continued pre-retirement savings rate: 15% 
• The present value of her long-term care costs will be covered by her home equity
  

She uses the Social Security Quick Calculator to estimate what her Social Security benefit in today’s dollars will be (shown in the table below) if she continues her employment.  She enters the following amounts into the ABC pre-retirement workbook for future dollar amounts (today’s dollars increased by 2% per year inflation):

The Table below shows the results of Beth’s calculations:

The table shows that, given Beth’s information and assumptions, her spending income will increase about 10% for each year she continues to work and save 15% of her pay.  She can either choose to look at how much her income will increase each year by working or, as suggested by the behavioral economists, she can look at her relative loss by not working.  However she looks at it, she will benefit from using our workbooks to help her make her decision about when to retire. It is important to note that results will vary for different individuals and you should always model your own situation. 

Why the Actuarial Approach Works Even Better

In his January 19 article, “Why this works better than the 4% rule for retirees,” Tom Anderson touts the benefits of using BlackRock’s cost of retirement income (CoRI) index over the 4% Rule for determining how much you will need to retire.  In this post, we point out that if you like the cost-determination concept of BlackRock’s CoRI index for calculating how much you will need to retire, you will like it even better when you use essentially the same cost-determination-concept and the Actuarial Approach to help you calculate how much:

• you will need to retire, 
• you will need to save during your pre-retirement period, and 
• you can afford to spend during your post-retirement period. 

For readers unfamiliar with the CoRI index you can find it here.

BlackRock’s CoRI index and the Actuarial Approach Utilize Essentially the Same Cost-Determination Basis and Spreading Approach

If you use the Actuarial Approach with recommended assumptions and desired increases in future spending budgets equal to the assumed rate of future inflation (i.e., constant real-dollar spending budgets in retirement), you are using approximately the same cost basis (current insurance company annuity pricing) as is anticipated with the CoRI index to spread your adjusted assets (PV of assets minus the PV of future non-recurring expenses) over your expected lifetime planning period after retirement.

This can be illustrated by taking the basic actuarial equation that forms the foundation of this blogsite, and manipulating the terms as we did in our blog post of January 12 of this year, to develop the following equation:

The CoRI index is essentially the same calculation as the PV of future years in retirement, increasing each year by the assumed rate of inflation based on BlackRock’s analysis of current annuity purchase rates.  Here at How Much Can You Afford to Spend in Retirement, we don’t analyze annuity purchase rates every day (like they do at BlackRock) to develop our recommended assumptions, but we do look at them periodically for reasonableness.

The details of the calculations in our Actuarial Budget Calculator (ABC) workbooks are in the PV Calcs tab, where “Present Value of Future Years with Desired Increases” is shown.  This is the present value of future years of retirement used in the equation above, and should be very close to the CoRI index, when you input the recommended assumptions and desired increases equal to inflation into the ABC.  The good folks at BlackRock use somewhat different assumptions for the remaining lifetime planning period after age 65 and use different assumptions for future inflation and the discount rate consistent with life insurance annuity purchase rates, but for spending budgeting purposes, we believe the differences should be fairly insignificant.  The values shown in the ABC workbooks should be somewhat higher since we generally recommend assuming a longer period of retirement.  Since we encourage you to revisit your budget setting process at the beginning of each calendar year, we don’t believe it is necessary to adjust our recommended assumptions unless we become aware of significant changes in life insurance company annuity pricing.

We have no problem if you would rather use BlackRock’s CoRI index in your spending budget calculations if you believe they more accurately represent current insurance company annuity purchase rates.  If you do, however, you will need to solve for the discount rate(s), inflation rate(s) and lifetime planning periods after retirement assumed by BlackRock to develop their CoRI index, so that you can also calculate the present value of your future non-recurring expenses and the present value of IFOS in your budget setting calculations using the equation above.

If you are a big CoRI fan and you think it is time for us to update our recommended assumptions to reflect current insurance company annuity pricing, please let us know and we will review the relevant data and make appropriate changes.