Developing a Sustainable Spending Plan (SSP) vs. Using a Systematic Withdrawal Plan (SWP)

We still see quite a bit of literature in the popular press encouraging retirees to use specific Systematic Withdrawal Plans (SWPs) to determine withdrawals from their accumulated savings.  For example, the recent article, “No Pension? You Can ‘Pensionize’ Your Savings” discusses the “Spend Safely in Retirement” strategy developed by Steve Vernon, Joe Tomlinson and Dr. Wade Pfau in collaboration with the Society of Actuaries.  The SWP advocated in their report is the IRS Required Minimum Distribution approach we discussed in our post of December 21, 2017.  In addition, we are aware that many researchers and financial advisors still advocate the use of SWPs, and some even confusingly refer to these “withdrawal plans” as “spending plans.”  Therefore, we will once again

• attempt to draw the distinction between spending plans (and in particular Sustainable Spending Plans (SSPs)) and SWPs, and 
• Indicate why we believe SSPs are superior to SWPs
  

SWPs

SWPs provide a retiree with an algorithm for withdrawing funds from their investment portfolio.  Sometimes this is also referred to as “tapping” one’s savings.   Common examples are the 4% Rule and the IRS RMD approach.  SWPs can be very simple or very complicated (with floor and ceiling adjustments, etc.) but all involve systematic withdrawals from accumulated savings.  It is generally assumed that the amount withdrawn for the particular year under the SWP plus income from other sources (IFOS) for that year will be spent by the retiree (or couple). 

A SWP isn’t coordinated with the amount or timing of income the retiree (or retired couple) may have from other sources (IFOS).  Assuming a retiree’s IFOS is reasonably constant from year to year, it is possible that adding the SWP withdrawal to the IFOS for the year may be consistent with the individual’s spending goals.  However, even assuming that this is the case, the SWP only focuses on recurring spending needs and does not consider non-recurring spending needs the retiree may have, such as unexpected expenses, long-term care costs or specific bequest motives.  As noted in the Society of Actuaries’ recent report, Shocks and the Unexpected: An Important Factor in Retirement, “Successful provision for the unexpected is critical to success in financial management during retirement.”  So, any SWP will be deficient in this regard.

SSPs

A Sustainable Spending Plan develops a spending budget that is consistent with the individual’s (or couple’s) spending goals.  Typically, these goals will include:

• Maximizing current levels of spending without jeopardizing ability to meet future anticipated expense needs 
• Not spending too much and not spending too little 
• Avoiding year to year spending volatility 
• Having spending flexibility 
• Leaving approximately desired amounts to heirs at death
  

The reader will note that none of the above goals necessarily involves how much should be withdrawn from savings (or how systematic such withdrawals should be).  The focus of the SSP is on spending, not withdrawals from savings.  For example, if one member of the couple’s Social Security benefit is expected to commence at a later date than the other member, it may be very reasonable (and consistent with the couple’s spending goals) for the couple’s withdrawals from savings to be larger before the second commencement than after.  In fact, in situations where IFOS doesn’t commence at the same time or expenses are non-recurring in nature, an SSP will work much better than an SWP in meeting typical spending goals.

The Actuarial Approach advocated in this website will help you develop a SSP, not an SWP.  Under the Actuarial Approach:

• All of your assets are considered, not just your accumulated savings 
• All of your spending liabilities are considered, not just your recurring spending 
• Since the amount withdrawn from savings is equal to the sustainable spending amount minus IFOS, it will automatically mitigate potential spending volatility associated with amount and timing differences that may be inherent in IFOS 
• You can maximize current spending without jeopardizing your ability to meet expected future expenses.  For example, you can increase current real dollar spending by

o  treating travel expenses or home mortgage expense as a non-recurring expense, or
o  planning on future expenses that decrease in real dollars

• Spending is flexible and is automatically adjusted, as a result of annual valuations, to be consistent with your goals (even if those goals change), and 
• Periodic scenario testing will enable you to better plan for deviations from assumed future experience
  

Conclusion

Depending on personal situations and goals, SWPs may be OK for some individuals and couples, and may be just fine as a distribution option in a defined contribution plan or IRA, but generally you (or your financial advisor) can do better.  The Actuarial Approach will help you develop a much more robust spending budget (SSP) than can be obtained by simply adding an SWP amount to IFOS.  Will it take a little more work and number crunching?  Yes.  But, we believe it will be worth your while, and that is why we refer to our website as, “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”

Save More for Retirement? Nah, I’ll Just Work Longer

This post is a follow-up to our post of December 11, 2017 titled, When Can I Afford to Retire and When Should I Commence my Social Security Benefits (which was a follow-up to our posts of November 14, 2016 and April 28, 2014 touting the clear financial benefits of working longer).  In that post we included an example and concluded that:

“John’s calculations [using our Actuarial Budget Calculators] will show that if he retires and defers commencement of his Social Security benefit, he can expect his real dollar spending budget to increase by about 1% for each year of deferral (or slightly less if John is not in “excellent” health), whereas it increases by about 8% for each year that he continues to work.  Therefore, while we agree that the deferral of Social Security commencement strategy is probably “better than a poke in the eye with a sharp stick”, your decision of when to stop working is generally going to be a more significant driver of the amount of your spending budget in retirement than your decision of when to commence your Social Security benefit.’

In their recent research paper, “The Power of Working Longer,” the authors reach the same conclusion, stating, “Roughly speaking, deferring retirement by one year allows for an 8 percent higher standard of living for a couple and the subsequent survivor.”  And while it is nice to have esteemed academic scholars support the same annuity-based pricing of spending liabilities that we recommend and confirm our calculations, we have some concerns about the authors’ assumptions and methodology, which cause them to conclude that working longer may be a more attractive option for individuals and couples than increasing their savings.  While we agree that working longer is a powerful tool for increasing an individual’s or couple’s spending budget in retirement, we think it is probably a financial planning mistake to believe that you don’t have to save for retirement because you will simply work longer and rely on increased Social Security benefits, especially if you are relatively highly paid. 

Authors’ Assumptions and Calculations for Stylized Household

The authors look at a “stylized household” which consists of a 36-year-old primary earner and his or her same age spouse.  It is not clear from the example whether the spouse has the same earnings or has no earnings.  The following assumptions are made by the authors:

• Whatever wage is being received by the household (either approximately the economy-wide average wage index by the primary earner and nothing for the spouse or two times that amount assuming they are both paid the same amount), it is assumed to remain constant until the assumed retirement age of 66 
• Contributions of 6% of annual wage are made to their respective 401(k) plans and these contributions receive a 50% match (assuming here that the spouse actually has earnings) for a total of 9% of wage annual contributions. 
• The assumed rate of return on accumulated savings in the 401(k) plans is 0%.  This assumption is inconsistent with the assumptions used by the authors to convert accumulated savings to lifetime income and significantly inconsistent with the approximate 6% return assumption used in Social Security law to develop actuarially equivalent adjustment factors for early and deferred retirements. 
• Social Security benefits for the husband and wife at age 66 are assumed to be 42% of their assumed to be constant wage at age 65.  Note that the authors state that this is an average benefit payable at Social Security’s full normal retirement age, but under current law, age 66 would not be the full normal retirement age for these individuals.  No Social Security spousal or survivor benefits are considered. 
• Social Security law is assumed to remain unchanged in the future.  This assumption includes continuation of actuarial increases of 8% per annum for each year of deferred commencement (even though increases in wages and real investment returns are assumed to be nil, and no changes in program benefits in light of significant future expected deficits. 
• Accumulated savings are converted to an annuity at assumed retirement using fairly conservative assumptions and also assuming payment in the form of a joint and survivor annuity with 100% to be paid to the last survivor (even though the effect of survivor benefits in Social Security is to pay in the form of a joint and survivor annuity with 66.67% paid to the surviving spouse.
  

Using these assumptions, the authors conclude that the 9% of pay rate of savings (6% plus the 3% match) for the next thirty years will generate only about 19.4% of total expected retirement income at expected retirement at age 66 with the remainder (80.6%) coming from Social Security. 

Comparison with Our Calculations

Somewhat surprising to us, given the assumptions made by the authors, the authors’ approximate 80%/20% distribution of expected real retirement income between Social Security and accumulated savings for this stylized couple is not terribly different from the distribution obtained by using the Actuarial Budget Calculator (Pre-Retired Couple) for a 36-year-old couple currently both earning $50,000 per year and contributing 9% of pay.  For our calculations, we assumed:

• 3% future pay increases, 
• Economic and longevity assumptions we recommend for determining the Actuarial Budget Benchmark, 
• a 33 1/3% reduction in desired retirement income upon the first death within the couple. 
• Social Security benefits from The Social Security Online Quick Estimator (with adjusted future pays to be consistent with our 3% pay increase assumption) of about 47% of final year’s pay (about $55,092 per annum in future dollars). 
• Consistent with the author’s calculations, we assumed no other non-recurring expenses or other sources of income. 
• We also ignored the present value of expected spousal benefits from Social Security upon the first death within the couple.
  

Using these assumptions, we developed projected total real first year retirement (age 66) spending of $74,957 of which $60,829 was expected to come from Social Security and $14,128 from accumulated savings.  Thus, our calculations produced a 77% Social Security/ 23% accumulated savings lifetime income split for the authors’ stylized couple. 

This total first year of retirement projected spending of $74,957 represented 62.07% of projected real dollar spending for the final year of working (age 65).  Since it is less than the 85% rate that we recommend as a benchmark target, and further, since no reserves are contemplated for long-term care, unexpected expenses, rainy-day reserves, etc., we would encourage this stylized couple to consider alternatives such as increasing savings, continuing to work, taking on part-time employment, investing more aggressively, cutting back current expenses and/or not committing to funding education costs, tapping home equity, finding a rich person who will leave them an inheritance, etc.

Should You Give Up on Increasing Your Savings?

If you haven’t saved enough to date, we don’t think you should give up in your efforts to save for retirement and assume that you will just keep working and rely on Social Security.  Here are some reasons why we believe you should increase your savings if our ABC tells you that you are falling behind:

• One very nice aspect of increasing your savings, from our point of view, is that it lowers your current spending budget and gives you a smaller spending target to replace in retirement.  If you are saving 25% of your pay and you spend 15% of your pay on work-related expenses, your replacement spending target in retirement is only going to be 64% of your pay (.75 X .85).  By comparison, if you don’t save, your replacement target will be 85% of your pay. 
• The years just prior to your desired retirement will, in many cases, be your best opportunity to save.  You may be eligible to make “catch-up” contributions and expenses such as education costs may be reduced, 
• Given Social Security’s financial condition, there is a non-zero probability that Social Security benefits will be reduced in the future.  These reductions may take many forms, including the possibility that Social Security’s actuarial increase factors for delayed commencement will be reduced to be more consistent with today’s low interest rates.  We call this “Social Security Reduction Risk” 
• You (or your spouse) may not be able (or want) to continue to work at a job that will pay you the same level of earnings (or more) as you age.   Poor health, the need to take care of a family member, corporate downsizing initiatives/mergers, etc. may reduce employment opportunities.  We call this “Continued Employment Risk” 
• If you are highly compensated, Social Security represents a smaller percentage of your overall total retirement income, so you need to save more, all things being equal. 
  

Conclusion

Working longer is a great solution to solving the problem of not having enough income in retirement, if you can make it work.  As the old saying goes, “Nice work if you can get it” (pun intended).  Therefore, unless you:

• really love your job, 
• you are quite happy with the idea of working until age 70 or longer, 
• you believe your boss thinks you are absolutely irreplaceable and/or there is almost no chance you (or your spouse) will lose your jobs (e.g., you are a tenured college professor),
  

we strongly encourage you to use our calculators annually to help you develop a financial plan that considers and, if possible, reduces your Continued Employment and Social Security Reduction risks.    Sorry folks, but for many individuals, this will require increased savings.

Investing and Spending in Retirement is Risky Business

In our February 4, 2018 post, we cautioned our readers to be skeptical of investment or spending strategies that appeared to support higher levels of current spending than those developed under the Actuarial Budget Benchmark (ABB) with little or no perceived increase in risk that future spending would need to be reduced.  Subsequent to writing that post, we came across an excellent article on this subject that we would like to bring to your attention in this post.  The article is “What Investment Risk Is, Illustrated” by Barton Waring and Laurence B. Siegel .  Like most scholarly articles, this one involves making somewhat of an investment in time and effort to wade through, but we believe the effort and expenditure of time is worth it. 

Not surprisingly, what we really liked about this article was that the author’s conclusions are very consistent with the Actuarial Approach and the Actuarial Budget Benchmark advocated in this website.  And while there are minor differences in our recommended approaches, we both advocate:

• Low investment-risk pricing of future spending liabilities, and
• Developing a spending plan by periodically solving for the present value of future spending that equals the market value of assets

The authors conclude that, “Maintaining the value identity allows rules like the ARVA to maximize sensible spending at every point in time, but it means that the spend itself will have volatility.”  The “value identity” to which the authors refer is the requirement that “the present value of planned future spending must equal the present (current market) value of the assets.”  The value identity concept is equivalent to our Actuarial Balance Equation, and ARVA is the “annually recalculated virtual annuity” which is similar in concept to our Actuarial Budget Benchmark (ABB) (and initially discussed in our post of March 22, 2015).

Like us, the authors take on the 4% Rule and conclude, “the faults of the 4% rule as a spending rule always add risk relative to a multi-period CAPM [Capital Asset Pricing Model] inspired ARVA rule.” They write, “Why does the 4% rule perform so poorly? The present value of the planned future 4% spending plan at no time bears any relation to the value of the portfolio, grossly violating the equality of the present value of future spending and the asset value — implying both a greater (unintended!) bequest plan than would have been desired if had been known, as well as a tolerance for a significant possibility of spending ruin.”

The most important take-away from the author’s article, in our opinion, is that if you invest in risky assets in the hope you will achieve higher returns, you will be assuming additional risk.  And this is true whether you use the 4% Rule, the ARVA or the Actuarial Budget Benchmark to determine your spending.  In the author’s words, “Here’s the bottom line: If you take more strategic asset allocation policy risk, you might do much better either in single-period asset-only space, or in multi-period spending space. And on average, you can fairly expect to do better. But the thing is, that you might do a lot worse! You pays your money and you takes your chances. If you don’t like the risk of doing worse, reduce the risk by adopting a more conservative strategic asset allocation policy.”

Since most of us do invest in risky assets in the hope we will achieve higher returns, we encourage you to model the impact on your actuarially determined spending budget of significant deviations in investment returns by using our 5-year projection tab.   As discussed in our post of February 4, we also encourage you to consider establishing a Rainy-Day Fund to mitigate potential spending budget fluctuations. 

We Kick the Tires on Fidelity’s “Retirement Score”

We have been playing around with Fidelity’s free retirement planner, “The Fidelity Retirement Score.”  According to Fidelity, the planner will enable you to “Know where you stand for retirement in just 60 seconds. Answer 6 simple questions to get your score and additional steps to consider as you save for retirement.”  In this post, we comment on the pros and cons of Fidelity’s calculator and compare it with the Actuarial Approach using the Actuarial Budget Calculators (ABCs) for pre-retired single individuals and couples available on our website.  

Executive Summary

The Fidelity Retirement Score is not bad, and it may do a reasonably good job of telling you where you stand in your planning for retirement, particularly if you are not highly paid and you don’t have sources of retirement income other than your savings and Social Security.   We think the Fidelity calculator probably under-estimates required savings rates for more highly compensated individuals.  The analysis that we performed and discuss below, may not be all that interesting to you unless you are a real numbers geek like we are.  If you aren’t, feel free to skip the discussion below of how we kicked the tires on Fidelity’s calculator and our analysis of it. 

The Fidelity Retirement Score—What we Like About It

• Fidelity’s calculator is sexy, quick, easy and, for many people, probably does a reasonably good job of measuring their retirement savings progress.
• Once you have entered your data, you can see how changes in the data you entered affect your score on the scoreboard screen without having to go back through the original data entering screens.  You can also change your lifetime planning period from the default option of to age 93 on the scoreboard screen, which is helpful.
• The calculator estimates your Social Security benefit based on the pay you enter and does not require you to calculate your own estimated benefit.  Nor does it require you to estimate your lifetime planning period (but you can change the default option if you want).
• The calculator projects what you could spend at retirement (including Fidelity’s estimate of your Social Security) and compares that with what Fidelity thinks you’ll need based on what you input for your desired standard of living in retirement.  These amounts are shown in today’s dollars.
• The calculator uses a fairly conservative estimate of future investment earnings (at least compared with many other calculators) and doesn’t increase your projected income at retirement if you increase your investment risk (from the balanced option) by choosing investment portfolios with higher proportions of stock. See our last post, “Should Increasing Your Investment Risk Increase Your Current Spending Budget” for discussion of why we believe this is a good attribute.
• The Fidelity calculator is reasonably consistent with their advice to accumulate ten times your annual pay if you want to retire at age 67.  We have found that this is not a bad rule of thumb, particularly for individuals with no sources of retirement income other than Social Security and  savings. 

How We Analyzed Fidelity’s Calculator

As retired actuaries, we still like to crunch numbers.  So, we crunched some numbers for individuals earning $50,000 per year and $200,000 per year using both Fidelity’s calculator and our Actuarial Budget Calculator (ABC) for Single Pre-Retirees.  For the Fidelity calculations, we entered

• retirement at age 67, 
• “Spend the Same” standard of living and 
• “Balanced” investment style,
• Lifetime planning period ending at age 94 (vs. their default option of 93)  

For the ABC calculations, we entered our recommended assumptions (4% annual investment return, 2% annual inflation and 2% desired increases in spending after assumed retirement).   Consistent with these assumptions, we also assumed 3% annual increases in compensation.  In order to make the ABC calculations somewhat comparable to the Fidelity calculations we also assumed:

• A lifetime planning period ending at age 94 (our recommended assumption for a 65-year old male),
• Social Security commencement at age 67
• No unexpected expenses, no desired estate remaining at death, no long-term care costs, no other non-recurring pre-retirement or post-retirement expenses, no other pre-retirement or post-retirement sources of income (such as annuities, matching employer contributions, income from part-time employment, proceeds from asset sales, pensions, rental income, etc.)
• No income from spouses and no decrease in desired spending in the event of the first spouse death

For both sets of calculations, we assumed the individuals had accumulated Fidelity’s age-related recommended benchmark amounts of savings for successful retirement at age 67:

• Age          Target Accumulated Savings as a multiple of pay
• 35  2X
• 40  3X
• 45  4X
• 50  6X
• 55  7X
• 60  8X
• 66  10X

We also entered 12% of pay annual savings rates for both sets of calculations.  For the Actuarial Approach Social Security benefit amounts, we went to the Social Security Online Quick Calculator and calculated projected benefits commencing at age 67 in future (inflated) dollars using a relative growth factor in future projected earnings of -1% to be consistent with our 3% annual pay increase assumption.  We then calculated real dollar (today’s dollar) equivalent of this benefit using our 2% discount rate assumption. 

We assumed the amount that Fidelity indicates as the amount you’ll need monthly in retirement will remain constant in real dollars throughout your period of retirement.  It is not clear to us, however, how Fidelity incorporates their famous cost of healthcare in retirement estimate ($275,000 for a couple both age 65 retiring in 2017) into this amount you’ll need. 

The table below shows the results of the calculations.  Amounts are shown in today’s dollars.

(click to enlarge)

Our Analysis and Some of the Things We Don’t Like About the Fidelity Calculator

The first thing we noticed was even though the Fidelity calculator indicates that the spending target option they determine is “spend the same,” their idea of what this means is if your pay is relatively low, Fidelity believes your “spend the same” amount will be about 80% of your pay and if your pay is relatively high, your “spend the same amount” will be about 60% of your pay.  By comparison, our ABC estimates your spending before retirement by subtracting what you are saving from your estimated pay.  Thus, under our calculator, the more of your pay you save, the less of it you spend, all things being equal.  However, since your work-related expenses and your taxes will probably less in retirement, our recommended income replacement target is about 85% of your “spend the same” amount.  

The significant difference in how “spend the same” is defined in the two calculators results in significantly different spending targets and savings rates necessary to achieve retirement spending goals.  While the Fidelity calculator appears to imply that an individual earning $50,000 should be saving more than 12%, the individual earning $200,000 appears to be in good shape.   By comparison, our calculator implies that the $50,000 worker is probably ok saving 12% of pay (after adding in recommended levels of expected non-recurring expenses like long-term care costs), but the higher paid worker probably needs to save closer to 20% of pay to “spend the same” in retirement.  Highly compensated individuals using Fidelity’s calculator might find that their “on target” score over 100 may not be as “on target” as they thought. 

While Fidelity assumes that real wages will increase in the future for individuals, their calculator does not assume real Social Security benefits will increase for these individuals.   Ours does.  And while Fidelity’s calculator indicates, “your score is calculated assuming an underperforming market, so it represents a conservative estimate of how much income you could have during your retirement,” the balanced investment style appears to be expected to earn about 5% per annum and therefore would be expected to have more investment risk than the annuity-based pricing investment return assumption of 4% that we recommend.  This extra investment risk is downplayed in the Fidelity calculator.  The difference in expected returns (extra risk) is quantified by comparing the columns labeled “Projected Retirement Income @67 from Accumulated Savings.”

As discussed above, to facilitate comparison of the calculators we had to assume that the hypothetical individuals we looked at only had savings and Social Security benefits and further, they would commence Social Security at the assumed retirement age.  In this respect, the Fidelity calculator has very limited flexibility to consider other sources of retirement income or other commencement dates and does not even attempt to consider couples planning. 

Conclusion

We encourage you to use a calculator to plan for your retirement and to develop a spending/savings budget to help you achieve your retirement goals.   And, when you are planning, it is also very important to remember that whatever calculator you use is only going to provide you with a planning “data point” for you to consider along with many other factors.  For many single individuals, Fidelity’s calculator may provide a reasonably good starting data point.  By comparison, our ABC’s for pre-retired single and couples may not be as sexy as Fidelity’s Retirement Score calculator (or others available on the Internet), and you may not be able to “know where you stand for retirement in 60 seconds.”  However, we believe our calculators are more accurate and flexible in terms of considering all your potential assets and spending liabilities.   We also give you the capability of reflecting the commencement of benefits (such as Social Security) at ages other than your desired retirement age,  having increasing or decreasing patterns of real-dollar spending, and our spreadsheets can be used by individuals and couples outside the U.S.  This is why we advertise our website as “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”

As we have discussed in prior posts, it is also important for you to consider the potential for deviations from expected experience as part of your planning.   For example, your employment may not continue until your desired retirement age, so you will probably want to be even more conservative in your retirement planning than indicated by any retirement calculator, at least until more-favorable-than-assumed experience emerges. 

Should Increasing Your Investment Risk Increase Your Current Spending Budget?

From time to time, we receive comments from readers who wonder why the recommended assumed investment return/discount rate (currently 4% per annum, or 2% in excess of our recommended annual assumed inflation rate) used to determine one’s Actuarial Budget Benchmark (ABB) is so low.  Given historical returns and the run-up in the equities markets over the past nine years, some feel that equities (or other risky assets) represent a source of consistently higher rates of return that can be expected, over sufficiently long measurement periods, to continue to outperform lower risk investments in the future.  These individuals argue that these expectations justify using higher real assumed rates of return in their budget calculations that can support higher current spending budgets than produced by the ABB, all things being equal.  Other readers wonder why we don’t link our assumed investment return/discount rate to the individual’s assumed investment mix, like most financial advisors and spending calculators do.

In this post, we will:

• Explain why we recommend assuming a low-investment risk rate of return, irrespective of an individual’s current investment mix, at least for determining one’s ABB 
• Discuss our concerns with budgeting approaches that imply that you can increase your current spending budget by increasing your investment risk, and 
• Describe how we use the ABB to develop our own personal spending budgets.
  

Before proceeding, however, we want to remind you once again that

1. we don’t advocate any particular investment strategy, 
2. we don’t insist that you spend a certain amount in any given year, and 
3. we encourage you to calculate your ABB in addition to whatever other approach you may be using to develop your spending budget, as another “data point” that you may find useful.
   

Why We Recommend a “Low-Investment Risk” Rate of Return Assumption for Developing Your ABB

To make the ABB a “mark-to-market” calculation, the market value of an individual’s (or couple’s) spending liability is determined using financial economics principles, by using the price of a portfolio of financial assets whose expected distributions match the individual’s anticipated spending in amount, timing and probability of payment.

We recommend using inflation-indexed life annuities as the financial assets for this purpose, and we solve for discount rates and longevity planning periods that produce about the same pricing (inflation-indexed annuity-based pricing assumptions) as for these low-investment risk investments.

While equities and other risky investments may be expected to generate higher returns than low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more risk and are generally not considered to be financial assets “whose expected distributions match the anticipated spending in amount, timing and probability of payment.”
 
It should be noted that the Actuarial Approach is a self-correcting approach.  If future experience is more favorable than assumed in the budget calculations, future spending budgets determined under the Actuarial Approach will increase relative to current spending budgets.  If future experience is less favorable than assumed, future spending budgets will decrease relative to current spending budgets.  Therefore, in this post, we are talking about when such favorable (or unfavorable) future experience is “recognized” for budget calculation purposes.  If you invest in risky assets and expect higher returns as a result, should you recognize those higher expected future returns in your current budget calculation or should you wait and recognize gains in a subsequent year’s budget calculations after they have actually occurred?  See our post of March 20, 2017 “You Can Spend It Now or You (or Your Heirs) Can Spend It Later Part II” for more discussion of this spending balancing act.

Our Concerns with Budgeting Approaches That Imply You Can Increase Your Current Spending Budget by Increasing Your Investment Risk

We are concerned about budgeting strategies (such as those that may be developed using Monte Carlo modeling, safe withdrawal approaches or even our Actuarial Approach with higher than recommended assumed real rates of return) that appear to offer higher levels of current spending at little or no perceived additional risk (of having to reduce your expected spending budget in the future).  For this reason, we recommend that you annually compare your spending budget with the ABB to quantify how much risk you are assuming with your current budget strategy.

We acknowledge that by investing in risky assets, your future investment returns may exceed those expected on low-risk investments, but we are concerned about approaches that recognize expected favorable experience in the spending budget calculation before such favorable experience has actually occurred.  We don’t believe there is a “free-lunch” to be gained by investing in equities or other risky assets.  If there were, insurance companies would want to invest more in equities rather than bonds to cover their liabilities, and it would be a “no-brainer” to leverage your investments (for example, by taking out a mortgage loan at 4% and investing the proceeds in equities expecting a 6% return). 

We are also concerned that some individuals who wish to increase their current spending levels may be persuaded to increase their equity investments beyond their tolerance for risk in order to chase higher expected returns.

How We Develop our Annual Spending Budgets

We don’t know what your future holds and we don’t know your spending goals.  As a result, we can’t tell you what the “correct” amount of your spending should be this year.  We can (and do) provide you with tools to help you perform your own calculations (with or without help from your financial advisor).  We do know that some of you use our Actuarial Budget Calculators with more optimistic investment return assumptions than the annuity-based pricing assumptions we recommend because you believe your investments will earn higher rates of return in the future and you aren’t overly concerned about the extra risk you are assuming.  And, who knows?  Your approach and assumptions may work out better for you than our recommended assumptions.

For what it is worth, we can tell you how we go about our annual budget setting process.  We invest a portion of our retirement savings in equities, and we expect to earn relatively higher rates of return on these risky assets than on our low-risk investments.  We use what we call the “ABB with Rainy-Day Fund” approach.  Under this approach, we calculate our budgets based on our recommended annuity-based pricing assumptions and in the years following years where we experience actuarial gains from more favorable than assumed experience, we park some or all of these gains in a Rainy-Day Fund, which in our spreadsheets is also called “other non-recurring expenses.”  Until we decide to use these Rainy-Day Funds, they do not enter into the calculation of our “annual (recurring) spending budget.”  If (when) we experience a poor investment year, we can dip into this Rainy-Day Fund to mitigate the resulting decrease.  Or, if the Rainy-Day fund becomes too large (which is a pleasant problem to ponder), we can use a portion of it to increase our future spending budgets.

Under this “ABB with Rainy-Day Fund” approach, we don’t recognize more favorable-than-assumed experience in our budget calculations until it actually occurs (or in some instances, not until after it actually occurs).  We feel this is a more prudent approach than one that recognizes higher return expectations before they occur, as would be the case, for example, in the common Monte Carlo model that assumes future higher rates of return when developing (or testing) a spending plan based on a given investment strategy.

Conclusion

We encourage you to be skeptical about spending budget approaches that appear to promise higher levels of spending if you increase your investment in risky assets, or that imply there is little extra risk associated with investment in riskier assets.  Unfortunately, developing a reasonable spending strategy in retirement is a fairly complicated and risky business.  To manage your risks, you might want to consider using the same “ABB with Rainy-Day Fund approach” that we use.  If you don’t use this approach, we encourage you to annually compare the results of the spending strategy you do use with the ABB to quantify your risks and, as discussed in our post of November, 26, 2017, we also encourage you to model potential deviations from assumed experience for the purpose of potentially mitigating your risks.

Life Expectancy vs. Lifetime Planning Period—Part II

This post is a follow-up to our post of December 6, 2017 regarding lifetime planning period (LPP) assumptions used in financial planning.  As discussed in the December 6 post, for purposes of calculating your Actuarial Budget Benchmark (ABB), we recommend that you use the LPP (or LPPs for couples) based on the 25% chance of survival for a non-smoking male or female (as appropriate) with “excellent health” from the “Planning Horizon” section of the Actuaries Longevity Illustrator.

In this post we will address:

• the binary nature of the mortality/longevity assumption for individuals 
• how the LPP assumption is expected to change as one ages, 
• the spending budget implications of continuing to survive, and 
• general implications of planning to live longer than your life expectancy
  

We will also “walk back” a statement we made in the December 6 post that using the 25% chance of survival LPP would enable you to avoid actuarial losses from living too long until you reach your late 80s. 

Binary Nature of Mortality

Some retirement planners and retirement experts advocate the use of probabilities of mortality at each age for personal retirement planning, with the implication that the use of such probabilities makes the resulting spending budget more accurate than approaches that do not use such probabilities.  We are not swayed by this logic, as “pieces” of us do not die each year.  We are either alive for an entire year or we die during that year.   If we die during a particular year, we are generally not alive for any subsequent year.  The law of large numbers that may work well for pension plans with lots of participants doesn’t necessarily apply to individuals or couples.  Therefore, we have no problem developing a spending budget that assumes a specific LPP and a definite age of death at the end of that LPP.

How the LPP is Expected to Change as One Ages

There is a common misperception that your LPP decreases by one year each year that you remain alive.  It would make financial planning easier if this were true, but it isn’t.  The longer we live, the later becomes our anticipated age at death, because we have already reached a certain age.  This is best illustrated by an example.  Based on the mortality assumptions used in the Actuaries Longevity Illustrator, the life expectancy (50% chance of survival) at age 65 for a non-smoker female in excellent health is 25 years, or an expected age of death of 90.  By comparison, the life expectancy (50% chance of survival) at age 85 for a non-smoker female in excellent health is 8 years, or an expected age of death of 93, or 3 years longer.

The graph below shows the expected age at death for non-smoker females aged 65-99 in excellent health under three different lifetime planning alternatives from the Actuaries Longevity Illustrator:

• 50% chance of survival (or more commonly known as “life expectancy”), 
• 25% chance of survival, and 
• 10% chance of survival
  

Instead of showing three horizontal lines, as would be expected if your LPP decreased by one year each year you remain alive, all three chance-of-survival lines show increasing expected ages at death as the females age, with larger total increases required for the higher percentage chances of survival.

(click to enlarge)

It should be noted that the Actuaries Longevity Illustrator calculates the expected ages at death for someone currently age 65 assuming that this individual was born in 1953, while the expected age at death for someone currently age 85 assumes that such individual was born in 1933, so we are not looking at expected ages at death for the same woman born in 1953 in this graph.  To the extent that current mortality tables anticipate mortality improvement based on year of birth, the expected age at death for a female born in 1953 when she reaches age 85 may be later than implied in this graph.

Budget Implications of Continuing to Survive

Generally, the longer the assumed LPP, the smaller the initial actuarially determined spending budget in retirement.   So, using the 50% chance of survival LPP will give you a larger initial actuarial spending budget than using the 25% chance of survival LPP, all things being equal.  The potential downside, however, of using the 50% chance of survival rather than the 25% chance of survival LPP is that you are also increasing your chances of experiencing future spending budget declines as you age (as conceptually illustrated in the graph in our post of December 6).  

Each one of the increases from the initial expected age at death shown in the three lines in the above graph represents a year when the LPP is not expected to decrease by one year from the previous year. Because the actuarially determined spending budget is calculated assuming that your LPP will decrease by one year each year, each one of these increases is expected to produce an “actuarial loss” in the year of increase.  As with any other actuarial loss recurring from experience that deviates from an assumption, this actuarial loss will decrease that year’s spending budget, all things being equal.

While we continue to recommend using the 25% chance of survival to determine your Actuarial Budget Benchmark (as the combination of the recommended discount rate and this chance of survival is roughly equal to current annuity pricing and the difference between the ABB based on the 25% chance of survival and a lower budget based on a 50% chance of survival strikes us as a reasonable cost of self-insuring one’s retirement), we do want you to be aware of the potential for actuarial losses from this source (and possible spending budget reductions) starting in your early 80s (a little bit later for males) and increasing significantly in your 90s.  Of course, if you survive into your 90s, you may be able to dip into unused funds set aside for bequest motives, long-term care costs, unexpected expenses, home sales, rainy-day funds from favorable investment returns (i.e., actuarial gains from investments), to offset these actuarial losses.  And your recurring spending needs may also be somewhat diminished at these later ages.

Alternatively, you can defer your chances for experiencing these actuarial losses from longevity until your 90s by developing your spending budget based on a 10% chance of survival.  Doing so, will produce a lower initial spending budget than using the 25% chance of survival LPP.   Or, you can scenario test your budget by inputting the higher LPPs associated with the 10% chance of survival and use the result as another “data point” in your budget setting process.

In our post of December 6 of last year, we indicated that if you used the 25% chance of survival LPP, we did not anticipate actuarial losses from longevity until you reached your late 80s.  This was based on the male mortality table we used in 2014, but is not the case with the tables currently used by the Society of Actuaries and American Academy of Actuaries in the Actuaries Longevity Illustrator, as evidenced in the graph above.

General Implications of Planning to Live Longer than Your Life Expectancy

1. If your spending follows the Actuarial Approach, you are likely to leave money on the table when you die.  Since under this approach you are annually adjusting your LPP based on your age (and not just reducing it by one year each year to live), you are likely to die with some assets left unspent.  The amount of unspent assets should be a little higher with the 25% chance LPP than the 50% chance LPP.  For this reason, you may wish to reduce the amount you plan to leave to your heirs. 
2. As noted above, by selecting an LPP (or LPPs) longer than your life expectancy, you are generally lowering your current spending budget and reducing the risk of subsequent declines in future spending budgets relative to a budget developed based on your life expectancy.  You will also notice that planning to live longer than your life expectancy will make certain investment strategies appear relatively more favorable.  For example, investments in annuities (either immediate or deferred) or Social Security commencement deferral strategies may appear to be more financially advantageous than if you based your LPP on your life expectancy.  We don’t necessarily have a problem with this result, as we believe that assuming a longer-than-life-expectancy LPP is just part of the cost of self-insuring one’s spending liabilities.

Maintaining Your Principal—Another Spending Budget “Data Point”

Recently published research from BlackRock confirmed earlier research from the Society of Actuaries that retirees tend, on average, to spend just about their income each year, where income is defined as income streams from sources such as Social Security and employer provided pensions plus interest, dividends and capital appreciation on their investment portfolios.   According to the research, “The vast majority haven't been spending their retirement savings—leaving nest eggs mostly untouched and living on ready sources of income instead.”  This post will discuss this “maintain your principal” (MYP) strategy as another “data point” to be used in determining your spending budget setting strategy.

The MYP strategy has been around ever since people started to retire and wondered how they should deploy their accumulated savings.  The strategy can work reasonably well if you don’t need to rely too heavily on portfolio income for essential expenses and/or if interest and dividend payments generated by your portfolio are reasonably adequate and stable.  In the recent low-interest rate environment, it has been difficult for some retirees to make this strategy work well.  The Blackrock research appears to find, however, that many retirees have adjusted their spending to implement this strategy, even during the recent low-interest rate environment.

We at How Much Can I Afford to Spend don’t tell you how much you should spend each year.  That is your decision to make.  We do give you tools to use to provide you with additional “data points” that can supplement other data points available to you to help you make your spending decisions.  Further, even if you use our recommended Actuarial Budget Benchmark (ABB) to develop your annual spending budget, there is no requirement to actually spend that amount each year.   For example, you may feel more comfortable spending less than your ABB.

We are strong advocates of retirement planning that meets your specific financial goals.  If one of your primary goals is to maintain or grow your accumulated savings, then the MYP strategy may be more appealing to you than a spending strategy that reduces your accumulated savings over time to fund your goals for higher levels of spending.

As we have said many times in this website, we encourage you to annually calculate your ABB and compare it with whatever you are currently doing to develop your spending budget.  If the MYP strategy isn’t consistent with your long-term spending goals, you owe it to yourself to examine alternative strategies that may be.

It’s Time to Perform Your Annual Actuarial Valuation

As part of our ongoing effort to encourage you to think more like an actuary when it comes to your personal finances, this post will recommend that you to perform an Actuarial Valuation based on your personal data as of January 1, 2018, and prepare an “Actuarial Report” to document your thought process and your planning decisions.  The purposes of this exercise are to:

• Review how well you did in 2017 
• Develop 2018 spending budget “data points” 
• Finalize your 2018 calendar year spending budget (or spending/savings budget for pre-retirees) 
• Document the assumptions, data and adjustments used to determine your final 2018 spending budget, and 
• Collect and save information that may be useful for your future actuarial valuations
  

The first step in the actuarial valuation process is to gather all your relevant personal financial data as of January 1, 2018.

Measuring How You Did in 2017
 
We hope that you saved your data as of January 1, 2017 and documentation of your 2017 spending budget calculations.  With this data you should be able to determine how you did in 2017, by approximating the items in the following equation:

2018 Accumulated Savings

=

2017 Accumulated Savings

+

2017 Investment Income

+

2017 Income from Other Sources

–

2017 Amount Spent

Solving for these amounts and comparing them with amounts expected, based on your 2017 calculations, will enable you to determine your total actuarial gain/(loss), by subtracting Expected 2018 Accumulated Savings from Actual 2018 Accumulated Savings.  If your actual 2018 BOY Accumulated Savings exceeds your Expected 2018 Accumulated Savings, you experienced an “actuarial gain.”
 
Similarly, you can determine your gain/(loss) by source by comparing actual amounts experienced in 2017 with expected values (based on the 2017 actuarial valuation) for the following items:

• investment income 
• income from other sources 
• spending
  

Since it looks like equities will have earned about 20% during 2017 (based on the S&P 500 index at the time of writing), those of you who invested a significant portion of your Accumulated Savings in equities probably experienced actuarial gains on investment income during 2017.  All things being equal, these investment gains will translate into a larger Actuarial Budget Benchmark (ABB) for 2018.  We will discuss below, however, whether you might want to save some of these gains in a Rainy-Day Fund rather to use them to increase your 2018 spending budget.
 
Developing 2018 Spending Budget “Data Points”
 
As discussed in our post of April 20, 2017, the process of deciding on your 2018 spending budget involves considering a number of “data points.”  The data points may include, but are certainly not limited to, the following:

• Your 2017 Spending Budget or actual 2017 spending increased with inflation or some other percentage increase 
• Your 2018 Spending Budget recommended by your financial advisor or someone else, 
• Your 2018 Actuarial Budget Benchmark (ABB) 
• Your desire to avoid significant fluctuations in spending 
• Your desire to be conservative 
• Your scenario testing (discussed in our post of November 26, 2017) 
• Recurring and non-recurring spending plans for 2018, etc.
  

For the first item above, we recommend using the same increase announced for Social Security cost of living increases for 2018: 2%.  If you develop your spending budget based on desired future increases of inflation minus 1%, however, your preliminary 2018 Spending Budget “data point” would be your 2017 spending budget increased by 1% (2% ‒ 1%).

As previously discussed in many of our previous posts (most recently in our post of November 6, 2017), we encourage you to develop your ABB as another data point in your budget setting process.  The ABB is a budget developed using basic financial economic principles by comparing the market value of your assets with the approximate market value of your spending liabilities (i.e., the theoretical cost of purchasing currently available insurance annuity contracts to cover your future spending).  The purpose of the ABB is to gauge how conservative or aggressive your current spending strategy is.  Armed with this benchmark, you can choose the level of spending with which you are comfortable and, just as important, you can monitor how aggressive your spending is each year by annually comparing it with your annually revised ABB. Recommended assumptions to develop your ABB as of January 1, 2018 are summarized in the overview tab of our Actuarial Budget Calculator (ABC) workbooks and, with the possible exception of using different Lifetime Planning Periods (LPPs) for couples, are unchanged from last year.  

As noted above, if you invested significantly in equities in 2017, it is likely that you enjoyed some investment gains.  In order to avoid significant fluctuations in spending and to be more conservative, you may wish to put some or all of your unexpected 2017 investment gains in a Rainy-Day Fund.  One way you can do this is to increase the amount entered in our Actuarial Budget Calculators (ABCs) for the present value of unexpected expenses and non-recurring expenses.  We have no idea when the equity market will see its next “correction,” but it does seem prudent to us to plan on one.  You may wish to use our 5-year forecast tabs (in the ABCs for single retirees and pre-retirees) to see how a significant correction in 2018 could affect your 2019 ABB.

Finalizing Your 2018 Spending Budget
 
Based on the data points discussed above (and possibly others), you can finalize your 2018 Spending Budget.  And while we use the terms “final” and “finalize,” you can always revise your final 2018 spending budget during the year if economic conditions or your personal situation changes.
 
Documenting Your 2018 Actuarial Valuation
 
Actuaries generally document their work in what is called an “Actuarial Report.”  We encourage you to document your work in sufficient detail that you can figure out next year what you did to develop your final 2017 Spending Budget.  This process can be as simple as printing out the “Input and Results” tab of the ABC workbook you used and writing notes on it.  Or you may save the workbook with your notes in a file on your computer.
 
Maintaining an Historical Record
 
In addition to documenting your work in developing your 2018 Spending Budget, we encourage you to maintain an historical record of your spending budget calculations.  This historical information will provide you with additional “data points” that you can use to refine future spending budget determinations.  We have provided a sample spreadsheet for this purpose that will reside in our “spreadsheets” section.  We aren’t trying to make you do a bunch of unnecessary busywork, so feel free ignore items in this spreadsheet you don’t feel like maintaining.  This is just a spreadsheet that we use ourselves to maintain historical information.  We have started the spreadsheet with 2017 information, but if you have information for earlier years, feel free to add that earlier information to your personal spreadsheet. 

(click to enlarge)

Conclusion

Instead of watching some of those college football games this year, we recommend that you take some time to think about your personal financial situation and do some planning.  We recommend that you perform an actuarial valuation of your assets and spending liabilities, and document your thought process in an Actuarial Report that you can revisit next year during college bowl season.  We also recommend that you maintain this information each year so that you can use the historical information to make better assumptions and spending decisions.
 
Happy New Year and Happy Budgeting from Ken and Bobbie.