Milevsky Probability of Portfolio Ruin Calculator

Thanks to Dirk Cotton for the shout-out in his December 5 post, Think Like a Bayesian Pig.   Another excellent post from Mr. Cotton, and the comments that follow his post are also very worthwhile reading. 

At the bottom of his post, Dirk provides a link to a 2005 paper by Moshe A. Milevsky and Chris Robinson, and in the comment section, he provides a link to the Milevsky Probabililty of Portfolio Ruin Calculator.  

I must admit that the work done by Milevsky and Robinson was unfamiliar to me.  So, thanks to Dirk for bringing it to my attention.   While the paper is somewhat technical, the Probability of Ruin Calculator associated with the paper is not all that complicated,  and it turns out to be a very powerful tool in my opinion.  I was so impressed with it that I am including it in the "Other Calculators/Tools" section of this website.  I believe that that the Milevsky tool can provide retirees and financial planners with another valid point of reference (in addition to the approach recommended in this website and other approaches) to be used in developing a spending budget, particularly if the retiree has no other fixed dollar sources of retirement income (like fixed dollar pensions/annuities) or significant bequest motives.   The remainder of this post will discuss the Milevsky/Robinson approach and how I think it can best be used for budgeting in retirement under certain circumstances.

Milevsky/Robinson Approach

As opposed to the deterministic approach for investment returns and expected payout periods baked into the simple spreadsheet provided on this website,  Milevsky and Robinson advocate an approach that successfully reflects the fact that both investment rates of return and the time until death are stochastic in nature (have certain probability distributions).   By making certain assumptions about the probability distributions,  they develop probabilities of sustainable real dollar spending rates for various combinations of life expectancy, expected real rates of return and portfolio risk (measured by the standard deviation of the distribution of returns).

When using Milevsky's Probability of Portfolio Ruin Calculator, the user should note that the expected portfolio rate of return (an arithmetic mean over the remaining lifetime) input is a real (after-inflation) percentage.  Thus, the expected rate of return comparable to the real rate recommended in this website is 2% (which is approximately the real rate implied by a 5% per annum nominal investment return and 3% per annum inflation).   Also note that the spreadsheet anticipates inputting a whole number of years remaining in retirement equal to the retiree's remaining life expectancy.   Inputting expected rate of return, portfolio standard deviation, withdrawal rate (a percentage of accumulated savings at the current age with such product increasing by inflation in subsequent years) and remaining life expectancy at the current age, the spreadsheet produces a probability of ruin (running out of money prior to death) and it's complement (not running out of money prior to death). 

Keeping in mind that since there is approximately a 50% probability of outliving one's life expectancy, any probability of ruin less than 50% means that the retiree is more likely than not to die before running out of money (assuming no future changes in spending occur).  A probability of ruin of 25% means that the retiree is about three times more likely (75%/25%) than not to die before running out of money (assuming no future change in spending occur).   Since many retirees are almost as worried about not spending enough as those who are worried about spending too much, it does not bother me to develop a spending budget based on a 25% probability of ruin.   As I have previously indicated in this website,  developing a spending budget for retirement is a "balancing act."   It is also important to note that the term "ruin" here may be a misnomer and may more appropriately be considered as a probability that real dollar spending may need to be reduced in the very later years of life as a result of living well beyond one's life expectancy.   This possibility may not be a disaster, but may actually be more consistent with studies that show declining spending needs at older ages.  

I compared results of the Milevsky's Probability of Portfolio Ruin Calculator (using assumptions described below) with the results of the simple spreadsheet in this website (Excluding Social Security V 2.0) using the recommended assumptions.   If I input a 2% real expected rate of return in Milevsky's spreadsheet, 5% standard deviation, male life expectancy based on the average of the 2010 Social Security and 2012 Individual Annuity Mortality Tables available on the Society of Actuaries  website (a link to which resides in the "Other Calculators/Tools" section of this website) and solve for the withdrawal rate that produces approximately a 25% probability of "ruin", I come very close to the withdrawal rates produced using the Excluding Social Security V 2.0 spreadsheet and the recommended assumptions at most ages.   There is some significant deviation at the very older ages, as I recommend using life expectancy if age plus life expectancy is greater than 95.  When I reach my late 80's I may switch to the Milevsky approach depending on how concerned I become at that point about outliving my savings.  Females, who have longer life expectancy, may also wish to look at the Milevsky approach when they reach their mid-80s.

Those of you out there who play with this spreadsheet may find it of interest that inputting a 4.4% withdrawal rate and 20-year life expectancy and an 8% withdrawal rate and 9 year life expectancy will produce about a 25% probability of ruin for each of the following combinations of expected real investment return/standard deviations:  2%/5%, 3%/11.5%, 4%/15.5%, 5%/19%, 6%/21.7% and 7%/24.5%.   This result shows that achieving higher real rates of return by taking on more risk may not increase your retirement budget.

How to best use the Milevsky Spreadsheet (In My Opinion)

As alluded to above, while the Milevsky spreadsheet is a powerful tool that provides retirees with another data point in planning for retirement, it does have some weaknesses.  It  does not, for example, coordinate the spending budget with fixed immediate or deferred annuities/pensions and it does not reflect bequest motives.

In his post, Dirk Cotton says that the Probability of Ruin Calculator is also an actuarial approach.  I'm going to mildly object to this claim.  I would say that it may be used as part of an actuarial approach, but by itself, it is more like an alternative Safe Withdrawal Rate generator, particularly if it is only used once at the retiree's initial retirement age.   I understand that Dirk is not actually suggesting this, but to be clear, to be considered an actuarial approach, it should involve an annual re-measurement (although not necessarily annual redetermination of the actual budget amount).  This is how I would use the Milevsky approach if I did not have other fixed dollar retirement income sources and bequest motives (and I wanted another data point to consider):  Step 1:  Calculate the withdrawal rate at initial retirement consistent with a 25% probability of ruin, a 2% expected investment return, a 5% standard deviation and a reasonable life expectancy for me (not necessarily based on the mortality of individuals who purchase life annuities).  Step 2:  Multiply the withdrawal rate determined in  Step 1 by my accumulated savings at initial retirement.  This is my spending budget for year 1.  Step 3:  In year two, increase the dollar amount determined in the previous year by the increase in inflation over the previous year.  Revisit the spreadsheet using an updated life expectancy (but generally the same other assumptions and probability of ruin used in the first year) and multiply the resulting withdrawal rate by an update of actual accumulated savings (i.e., current year's assets).  If the  spending budget for the previous year is within 10% of the product of the updated withdrawal percentage and updated assets,  just stay with the spending budget for the previous year increased with inflation.  If not, use the corridor value.  Step 4:  Repeat Step  3 each year.    Note that this basically the same approach (involving the same smoothing algorithm) recommended for the Actuarial Approach in this website.

Demystifying the Spending Spreadsheets on This Website

From time to time, we get questions about our spending spreadsheets.  In an effort to provide retirees who visit this site with a higher level of comfort with the spreadsheets, this post will attempt to explain them in more detail.

We provide two simple Excel spreadsheets in this website for the purpose of helping you develop your annual spending budget in retirement as part of what we call “The Actuarial Approach.”  The spreadsheets are located in the “Articles/Spreadsheet” section.  The first one (Excluding Social Security V 2.0) generally applies if you are currently receiving Social Security benefits and develops a total spending amount (from accumulated savings and any immediate or deferred annuity or pension income for which you may be eligible).  To obtain your total spending budget for the year, you take the result from this spreadsheet (or a smoothed result based on our recommended smoothing algorithm or some other smoothing algorithm) and add income you expect to receive from other sources in the next year such as your Social Security benefit, other inflation-indexed annuity/pension benefits, expected earnings from employment, etc.

The second spreadsheet (Social Security Bridge) applies if you are not currently receiving Social Security benefits but would like to coordinate your current retirement spending with Social Security benefits you expect to receive in the future. 

The Total Spendable Amount shown in the Results section of the Input tab is the answer to the mathematic problem, "What total spendable amount (from accumulated savings and annuities) may be spent in the current year, to be increased each subsequent year by a constant percentage so that accumulated assets will exactly equal the amount desired to be left to heirs at the end of the expected payout period?"

Please be patient when downloading the Excel spreadsheets.  Sometimes it can take a while. If you are requested to provide a password, simply click "cancel" and the spreadsheet should appear.

If you are having trouble seeing all the cells in the spreadsheet once it has downloaded (or you want to see a year-by-year runout of your accumulated savings based on the input items), be sure to maximize the spreadsheet window (by clicking on the “maximize” box in the top right-hand corner of the spreadsheet).

The Excluding Social Security V 2.0 has three tabs in the spreadsheet.  The Social Security Bridge spreadsheet only has two tabs.   As noted above, if you can’t see the tabs at the bottom of the spreadsheets, you need to maximize the spreadsheet window.   After you do this, you should see the tabs labeled, “Input”, “Runout” and “Inflation-adjusted Runout.”  The Social Security Bridge spreadsheet does not have an inflation-adjusted runout tab.

The input sheet allows you to enter your data and assumptions used in the calculations.  Once you enter these items, results are shown in the bottom portion of the spreadsheet.

The Runout tab shows results in nominal (non-inflation-indexed) dollars.  The first year of the Runout spreadsheet shows the beginning of year balance of accumulated savings that you entered, the amount to be withdrawn (payment) from accumulated savings for that year, expected investment return (interest) on the beginning of year balance, any immediate life annuity income for the year, the total spendable amount (from accumulated savings and pension/annuity) for the year and the accumulated savings withdrawal as a percentage of the beginning of year balance.  Similar amounts are shown for each subsequent year based on the expected payout period you entered in the input sheet.  The run-out is based on the assumptions discussed at the top of the spreadsheet.   If you want, you can check to see that the end of year accumulated savings is equal to the beginning of year accumulated savings minus the amount withdrawn during the year plus the expected investment return for the year.  Note that the Runout spreadsheet is somewhat self-checking.  At the end of the expected payout period you entered, the end of year balance for that year should exactly match the amount you entered in the input spreadsheet for the “desired amount of savings to be left at death.” 

The inflation-adjusted Runout sheet (in Excluding Social Security V 2.0 only) adjusts the expected year by year results shown in the Runout sheet for inflation based on the assumption for inflation that you input as the last input item on the input sheet.  If you input the same rate for “annual desired increase in payments” and “expected annual rate of inflation”, the total inflation-adjusted spendable amount shown in Column L should remain the same throughout the expected payment period. 

Below are screen shots from the Excluding Social Security V 2.0 spreadsheet showing the input, and its two Runout sheets.  The data and assumptions used are shown in the Input sheet. 

As discussed above, the Runout sheet for this example shows an end of year accumulated savings balance of $10,000 at the end of the 30th year (the amount inputted for desired savings remaining at death), and the Inflation-Adjusted Runout sheet shows a total inflation adjusted spending amount that remains constant throughout the 30-year expected payment period of $40,259 per year. 

Input

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Runout

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Inflation-adjusted Runout

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Revisiting Recommended Assumptions

As discussed in our posts of July 12, 2013 and October 11, 2013, and in the Journal of Personal Finance paper (originally written in February, 2014), we have been recommending the following assumptions for annual budget determinations under the Actuarial Approach: 

• Expected annual rate of return on savings: 5% (a nominal interest rate) 
• Annual desired increase in payments/inflation: 3%,
• Expected payout period (in years): Until age 95 or life expectancy if longer.

In the absence of significant changes in interest rates, we recommend continued use of these assumptions for 2015 retiree budget determinations.
 
The remainder of this post will discuss the rationale for continuing these recommended assumptions.

Investment Return and Inflation Assumptions

In prior discussions, I have tied the expected future nominal expected rate of investment return on accumulated assets to the approximate interest rate "baked into" immediate annuity purchases.  For this purpose, I have used the immediate annuity purchase rates made available on the Income Solutions website.

According to this website, as of November 26, 2014, a premium of $100,000 could purchase a monthly immediate annuity of $571 for a 65 year old male and $544 for a 65 year old female.  Assuming a life expectancy at age 65 of 22.9 years for a 65-year old male and 24.9 years for a 65-year old female (based on the Society of Actuaries 2012 Individual Annuity Mortality Table with 1% per year mortality improvement, a link to which is available in the "Other Calculators/Tools" section of this website), I have determined that the interest rate inherent in these annuity purchase rates is about 4.3%.  This rate is slightly lower than the 4.6% rate I approximated last February using the same approach.  This change may be due to the use of more conservative mortality assumptions, declining interest rates or some combination of the two.

While I have no problem if a retiree wants to use an investment return assumption lower than 5% (particularly if the retiree is heavily invested in fixed income securities), I continue to believe that an annual 5% nominal return can be reasonably justified by retirees with relatively diversified investment portfolios.  I would caution, however, against assuming higher nominal (or real) investment returns based on increased investment in equities as those strategies carry more risk that should be reflected in the assumption.

Consistent with Wade Pfau's research, I believe budgeting should assume a real rate of return of about 2% per annum, so I am retaining the 3% per annum inflation assumption combined with the 5% investment return assumption as my recommended economic assumptions for 2015 budgeting.   

Mortality

As discussed above, the Society of Actuaries has released several new mortality tables which show significant mortality improvement has taken place in recent years.  For example, life expectancy for a 65-year old male has increased by about a year under the new Individual Annuity Mortality Table (with 1% annual improvement).  Under this revised table, a 65-year old male has about a 24% probability of surviving until age 95, while this probability is about 33% for a 65-year old female.  Note, however, that this new table is based on mortality experience for individuals who buy immediate annuities from insurance companies and presumably have better than average health.  By comparison, life expectancies under the 2010 Social Security tables (with 1% mortality improvement), with experience based on essentially the U.S. population are 17.6 years for 65-year old males and 20.4 years for 65-year old females, respectively.  While some argument can be made for increasing the "live to 95" assumption by a year (at least for females), I continue to believe that this assumption is reasonable.  Of course, if you are already in your late 80s, you need to look at longer possible payment periods.

If you are the rare retiree who has a good idea when you are going to die, feel free to use your knowledge in your budgeting.  If you are like most of us, you should plan to live longer than your life expectancy, at least relatively early in your retirement.   The problem with doing this is that this increases the probability that you will die with more (unspent) assets than you desired.  To some extent, this is simply the cost of not buying an annuity.

The chart below shows projected budget amounts (in inflation-adjusted dollars) for a 65-year old retiree with $600,000 in accumulated assets under the Actuarial Approach (and recommended smoothing) using two different approaches for determining the remaining payout period.  The first approach uses the retiree's life expectancy (based on the SoA 2012 Individual Annuity Table) while the second approach uses the "live until 95" approach recommended in this website.  Investments are assumed to earn 5% per annum, inflation is assumed to be 3% per annum and the retiree is assumed to spend exactly the budget amount each year.  This chart illustrates the problem with using one's life expectancy each year and having the misfortune? of surviving. 

(click to enlarge)

Don't Use the 4% Withdrawal Rule--And For Gosh Sake, Don't Use it With a Reset Button

In his November 26 article, "Why Retirees Now Have to Question the 4% Withdrawal Rule," Jeff Brown suggests modifying the 4% Rule to make it more flexible rather than maintaining its "set-and-forget" characteristic and employing a lower safe withdrawal rate as some advisers have suggested in light of current low yields on fixed income investments.  Mr. Brown says,

"So how do you get from here to the living-large lifestyle [The 4% withdrawal at initial retirement increased by inflation] described above? With flexibility. You don't need to skimp every year to prepare for a disaster that might never happen so long as you can cut spending if it does.  That way, if the $1 million portfolio [at initial retirement] were to fall to $700,000, you could hit reset and withdraw only 4 percent of the new amount -- $28,000 instead of $40,000 plus inflation. If the fund were to recover, you could hit reset again and take 4 percent of the new amount, then go back to annual increases to offset inflation."
 
There is nothing magical about 4%.  It happens to be a reasonable withdrawal rate if you are a currently age 65 planning for a thirty-year retirement, you are using the assumptions we recommend for the spreadsheet tools on this website and you have no other annuity income or plans to leave money to heirs.  If you go to the runout page of the Excluding Social Security V 2.0 spreadsheet on this site, you will see that the budget withdrawal from savings under the circumstances described above is 4.34% at age 65, 4.99% at age 70, 5.97% at age 75, 7.60% at age 80 and 10.89% at age 85.  This is just mathematics based on a declining expected payout period as one ages.  Thus, any approach that hits the 4% restart button at an age after 65, is going to miss the mark.

If you are going to utilize a flexible approach that increases or decreases spending budget amounts based on actual experience (be it from investment experience more or less than assumed or spending variations), you are better off using the Actuarial Approach and hitting the reset button on that approach each year to stay on track.  If you want to have some smoothing in your spending budget from year to year, use the smoothing approach we recommend.

Its coming up to the end of the year.  This year again, we will revisit some of the example people we have looked at over the past couple of years to determine 2015 spending budgets for them in light of 2014 experience.  Once again, we will illustrate how effective and how easy the Actuarial Approach budgeting process can be.

Measuring Personal Retirement Plan Liabilities

I'm pleased to see that several retirement pundits are extolling the virtues of measuring personal retirement plan liabilities and comparing those liabilities with accumulated assets to help individuals plan for retirement.   This approach is comparable to what actuaries do for pension plans and is the basis for the Actuarial Approach advocated in this website.

In his November 22 article, "Is Your Retirement Fully Funded," Robert Powell says:

"If you want to get a sense how best to generate income in retirement, consider doing what corporate pension plans do. Determine the “funded status” of your personal retirement plan."
 
In his guest article in The Retirement Café, Michael Lonier says:

"The household balance sheet, not portfolio theory, is the foundation of personal financial management, anywhere in the lifecycle. A solid understanding of the household balance sheet provides the basis for a reasonable and practical way to solve the puzzle of how to best use household resources to fund retirement or reach other goals."
  
Finally, as discussed in our post of November 16, a recent survey by Russell Investments concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).

The Actuarial Approach for determining a spending budget in retirement matches current personal assets with the retiree's liabilities, where such liabilities are defined as the present value of level real dollar spending over the retiree's expected lifetime.  The spreadsheet tools included in this website not only determine liabilities based on these constraints, but can be used to determine liabilities under other constraints.  For example, if a retiree determined that she could spend $75,000 per year, but wanted to know the liability associated with her "essential" level of spending of $50,000 per year, she could use a trial and error process to determine what level of accumulated savings produced a spending budget of $50,000 per annum.  That amount would be her liability for essential expenses.  Similarly, as discussed in our previous post, individuals close to retirement can use the spreadsheet tools (and the trial and error process) to determine what level of accumulated savings (or liability) will produce their desired level of retirement income.

So You Think You Are Financially Prepared to Retire? Use our Spreadsheet Tools to Test

Generally the focus of this website is to help individuals who are already retired establish an annual spending budget.  From time to time, however, I will venture into the "how much do I need to retire" side of the retirement challenge.   This post is aimed at individuals who are close to retirement but are unsure of whether they have sufficient financial assets to meet their needs throughout retirement.  

This exercise is very similar to what I wrote about in my August 31 post--Managing Your Spending in Retirement--It's Not Rocket Science, except the first step in testing to see whether you are financially prepared to retire is to determine your spending needs in retirement.  Generally this is done by looking at your normal expenses for a year, subtracting expenses that you don't expect to have in retirement (such as Social Security taxes and work-related expenses) and adding expenses you do expect to incur in retirement (such as increased travel and leisure expenses).  Don't forget to factor in taxes that you will need to pay in retirement.

The second step in the process is to determine your total expected income for a year from all sources, such as Social Security, accumulated savings, pensions, annuities, earnings from part-time work and other sources of income.  This is where the spreadsheet tools available on this website come into play.  If you are not going to defer commencement of your Social Security benefit, use the "Excluding Social Security V 2.0" spreadsheet and add in your estimated Social Security benefit (and any other fully inflation indexed annuity benefit and expected earnings from employment) to the total spendable amount.  If you do plan on deferring your Social Security benefit, use the "Social Security Bridge" spreadsheet.  Note that for this step you may wish to exclude some of your accumulated assets, such as home equity or other assets, on the theory that such assets will be available for unexpected (or lumpy) expenses in retirement.  I suggest that you input the assumptions we recommend in addition to your specific data.

The third step in the process is to compare the results of the second step with the first step to see if the two numbers line up.  If the result of the second step is significantly lower than the result of step one, you may not be financially ready to retire.  If you are not as conservative as I am, you can input higher investment return assumptions and/or lower inflation assumptions to see how these changes can affect your expected annual income.  But remember that there are no guarantees when it comes to expected income from accumulated savings and the more liberal (or wishful) you make the assumptions, the more likelihood that future real spending will have to be reduced.

Normally at this point in my posts I provide an example of how this test might work.  I'm not going to do that this time.  Having recently read the quote attributed to Benjamin Franklin, "Tell me and I forget.  Teach me and I remember.  Involve me and I learn", I'm going to encourage you to kick the tires on these spreadsheets.  Take a few minutes to crunch your own numbers.  You'll find it a worthwhile exercise.

Does Your Financial Advisor Develop Your Annual Spending Budget Based on How Much Assets You Have and How Long You Might Live?

Lets assume that you and your Financial Advisor meet approximately annually to determine your spending budget for the year.  If you don't actually have a Financial Advisor, then you and/or your spouse are acting as your own Financial Advisor.  In a recent survey of Financial Advisors by Russell Investments, 234 Financial Advisors were asked how they develop spending budgets for their clients near or in retirement.  25% responded that they based their approach on levels of pre-retirement spending, 22% indicated that they used a rule of thumb like the 4% Rule, 19% indicated that they used some variation of the Bucket Strategy, 16% indicated that they compared assets with future liabilities and 18% indicated some other approach. 

The Russell Investments survey concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).

Along the same line, in an interview for Advisor Perspectives, Nobel Laureate Bill Sharpe provided his views on developing spending budgets and the 4% Rule (and other Safe Withdrawal Rate Rules):

"What you spend should depend upon (1) how much you’ve got and (2) how long you think you might live, or the range of possible lengths of life. The 4% rule is fine on both fronts on day one. For example – you’ve got $1 million and you’re 65. Spend $40,000. This may be just fine.

After the initial year, however, what you spend with this rule has nothing to do with how much you have, or for that matter, how long you expect to live. Most importantly, it doesn’t depend how much you have at the moment. Any rational person would say, “What you spend ought to depend upon how much money you have.” Isn’t that self evident?  A rule that doesn’t do that after year one doesn’t make any sense. And this should be the end of the discussion. But we see such an approach advocated in many places."

Finally, Dirk Cotton provided similar views in his entertaining blog of October 27,2014 entitled "Spherical Cows."  Commenting on the use of Safe Withdrawal Rate approaches, Dirk said,

"One of my favorite Spherical Cows is the one used to calculate sustainable withdrawal rates. SWR models assume that a mythical investor will continue to spend the same amount of money each year from savings, even after it becomes obvious that he or she is about to deplete their retirement savings. The models take a percentage, say 4%, of initial portfolio value and subtract that fixed dollar amount ($4,000 from a $100,000 portfolio in this case) from the portfolio balance every year, counting the number of years before the portfolio is depleted.

Many financial writers argue that no one really "does it that way", meaning everyone adjusts spending based on their remaining portfolio balance instead of spending a flat amount, but I have two responses to that. If no one does it that way, then everyone in the financial press should stop saying that you can do it that way.  And second, the SWR models predict outcomes for you only if you do "do it that way". (Operations Research guys say that a model is predictive only to the extent that its policies are followed.) The SWR results aren't predictive if you do something else, like adjust spending to portfolio value changes – which apparently is what everyone is actually doing."

Bottom Line:  If you act as your own Financial Advisor, you should spend the time to learn the pros and cons of alternative withdrawal strategies.  The Actuarial Approach recommended in this website uses established actuarial principles that consider how much assets you have each year and the expected payout period.  If you do work with a Financial Advisor, you should compare the budget recommended by your Financial Advisor with the budget developed using the Actuarial Approach and discuss any significant differences with your Financial Advisor.  If you are a Financial Advisor for others, you may wish to consider employing the math in the Actuarial Approach for your clients to see how it compares with whatever method you are currently using. 

100th Post--Nice Write-Up of the Actuarial Approach in the Toronto Globe and Mail

Time for a brief celebration!  This is our 100th post in our ongoing effort to help retirees develop a spend-down strategy for their self-managed assets as part of an overall process of developing an annual spending budget in retirement.  As we approach the end of 2014, I remain just as convinced as I was in 2010 with post #1 that the Actuarial Approach recommended in this website represents a better systematic withdrawal strategy than most approaches that are commonly used.

And what better way to celebrate than to have a reporter say some nice things about what we are doing.   Read Ian McGugan's recent article in the Globe and Mail.

Mr. McGugan took such an interest in the spreadsheet tool recommended in this website for determining a spending budget in retirement (Excluding Social Security V 2.0) that he kindly offered to write a "less actuarial" explanation of it.  Click here to see Mr. McGugan's nice write-up. Thanks Ian.

Our 100th Post celebration must also include special thanks to my buddy, Kin Chan, for his assistance with managing the website and pointing out all the sentences that don't make any sense. 

Revisiting the Recommended Smoothing Algorithm

I first proposed a recommended smoothing algorithm for The Actuarial Approach in my post of October 11, 2013.  The purpose of the recommended smoothing algorithm was to balance the desire to have relatively constant real dollar budgets from year to year with the need to keep spending budgets reasonably on track with the "actuarial value" determined using the applicable spreadsheet from this website (generally Excluding Social Security V 2.0), recommended assumptions and the retiree's actual data as of the beginning of each year.

In general terms the recommended smoothing algorithm involves taking the budget amount from the previous year, increasing that amount by inflation (the increase in CPI) for the previous year and making sure that the resulting value is not more than 110% of and not less than 90% of that year's actuarial value.  If the resulting value falls within the corridor, the inflation adjusted value is used to develop the budget for the year.  If the value falls above or below the corridor limit, the applicable corridor value is used in the budget calculation.

Recently, in a conversation with Ian McGugan, reporter for the Globe and Mail in Toronto, Mr. McGugan pointed out that I wasn't terribly specific about what budget amount was being used in this smoothing calculation.  Mr. McGugan (a bright guy) correctly pointed out that in the various examples contained in my website, I had inconsistently used several different amounts for the previous year's budget amount for this calculation.

I will readily admit that there was more art than science involved in developing this smoothing algorithm.  For example, I don't know whether some or all retirees who may use the Actuarial Approach would be better served with a 12% or 8% corridor.  Perhaps someone like Wade Pfau or some other retirement academician can utilize Monte Carlo modeling to develop an optimal corridor.  Similar arguments can be made with respect to the budget (or portion of the budget) that should be subject to the corridor.

If the retiree has an immediate defined benefit pension benefit or life insurance annuity as a retirement income source, she has at least three choices with respect to how the recommended algorithm can be applied:

1. to the portion of the budget attributable to accumulated savings only
2. to the portion of the budget attributable to accumulated savings plus the pension/annuity, or
3. to the total budget, including income from Social Security

If the retiree has no immediate pension or annuity income sources, then items 1 and 2 above will be the same.

Personally, I would prefer that the spending budget stay reasonably close to the actuarial value, so I will recommend that the 90% to 100% corridor be determined using the portion of the budget attributable to accumulated savings plus the pension/annuity rather than using the entire budget including Social Security, as it will produce a somewhat smaller corridor range, all other things being equal.

As a result of Mr. McGuggan's excellent suggestion to try not to confuse readers when possible, I have revised the examples in the June, 2014 article "Using the Actuarial Approach to Determine Your Annual Spending Budget in Retirement" to reflect the more specific recommended smoothing algorithm above.

I thank Mr. McGuggan for his feedback and encourage other readers to submit their suggestions for improvements to this website.

You Can Spend it Now or You (or Your Heirs) Can Spend it Later

The title of this post is a re-working of the saying used by the mechanic in the old Fram Oil Filter TV commercials.  His famous line was, "You can pay me now, or you can pay me later."  A similar principle applies to spending your accumulated savings--assets you spend today will reduce the amounts available to you (or your heirs) tomorrow and visa versa.  The trick, of course, is to figure out the best way to meet your spending objectives, including making your money last your lifetime.  This difficult "balancing act" is what this website is all about. 

It is also important to remember that most systematic withdrawal strategies produce a spending budget.  As with any other budget, you are free to deviate from the budget and spend what you feel is an appropriate amount.  Some systematic withdrawal strategies (like the Actuarial Approach recommended in this website) automatically adjust for such deviations.  Other approaches may not.   

As promised in my post of October 9, this post will discuss the systematic withdrawal approach suggested by David Zolt in his recent Journal of Financial Planning article.  Readers can also find more details about his approach in his website. 

In summary, Mr. Zolt uses a Hybrid safe withdrawal/actuarial approach.  He incorporates Monte Carlo modeling using historical returns from 1926-2013 and then uses a deterministic approach similar to the Excluding Social Security V 2.0 spreadsheet in this website (which he calls the Target Percentage Test) to monitor whether spending remains on track during retirement.   In general, if the proposed withdrawal in any year, measured as a percentage of remaining accumulated assets, falls below the Target Percentage, Mr. Zolt's approach would require the retiree forgo that year's cost of living increase.  His most recent article proposes another alternative to forgoing the entire cost of living increase if the test is failed. 

The first case study in Mr. Zolt's recent article describes how his approach could work for a couple, both age 63 with $650,000 in accumulated retirement assets, total Social Security benefits of $3,000 per month and a fixed dollar $1,000 per month benefit from a pension plan.  Based on his Monte Carlo analysis,  Mr. Zolt determines that this couple has a "superb" chance of making the money last with an initial withdrawal rate of 5.7% if they are willing to forgo cost-of-living increases whenever the proposed withdrawal for the year measured as a percentage of accumulated assets exceeds the Target Percentage for this couple.  By comparison, if we input this couple's data in our Excluding Social Security V 2.0 spreadsheet and use our recommended assumptions , we would get an initial withdrawal rate of 3.57%.  There are two reasons why Mr. Zolt's initial withdrawal rate is much higher than ours for the same couple:  1) We use different assumptions for future experience and 2) The Actuarial Approach attempts to keep total retirement income (including income from the fixed dollar pension) constant from year to year in real dollars. 

Using Mr. Zolt's Target Percentage spreadsheet, we can determine that if payments are to last 32 years and increase by 3% per annum, the couple's assets must earn a minimum of 7.7% per annum.   Tables 1 and 2 below compare spending budgets every five years produced by Mr. Zolt's approach (assuming the target percentage is determined using 7.7% investment return, 3% cost of living increases and payment for 32 years) vs. the Actuarial Approach (using recommended assumptions) assuming future experience is either 5% investment and 3% inflation (Table 1) or 7.7% investment return and 3% inflation (Table 2).  Table 3 compares spending budgets assuming future experience of 7.7% per annum and 3% inflation, but changes the assumptions used under the Actuarial Approach to 7.7% investment return and 3% inflation while Table 4 assumes future experience of 5% per annum and 3% inflation, but the assumptions used under the Actuarial Approach are changed to 5% investment return and 0% inflation.  Under all four tables, the retired couple is assumed to spend exactly the spending budget under either approach each year.

Under the assumptions for future experience in Table 1, spending budgets decline significantly in real terms under the Target Percentage Approach.  The couple's money does, however, last the entire 32 years.  Under the Actuarial Approach and recommended assumptions, spending budgets remain constant from year to year in real dollar terms.  Under the assumptions for future experience in Table 2, spending budgets decline somewhat under the Target Percentage Approach as the approach does not adjust spending from accumulated savings to make up for inflation erosion of the fixed dollar pension benefit.  Under the Actuarial Approach (using recommended assumptions), the more favorable investment experience produces significant increases in the spending budget in later years. 

The purpose of Tables 3 and 4 is to illustrate that similar results can be achieved under the Actuarial Approach by varying assumptions used to determine the annual spending budgets from the recommended assumptions. 

Which approach is right for you?  There is no easy answer to this question.  Both approaches are dynamic in that spending budgets may need to be increased or decreased during retirement since both approaches involve annual checking to see how last year's spending budget increased with inflation compares with an actuarially determined target.  The Actuarial Approach using recommended assumptions assumes future investment returns will be 2% real, while Mr. Zolt's approach uses a real rate of return closer to 4.7%.  His approach also does not consider the effects of inflation on other fixed dollar income (such as pensions or annuity contracts) or amounts desired to be left to heirs.   There is nothing mathematically superior about either approach.  While Mr. Zolt's approach can be made more conservative by using more conservative target percentages, his reliance on historical rates of return makes his approach less conservative (more likely to involve decreasing real dollar spending budgets in future years) than the Actuarial Approach (which tends to tie investment return assumptions more closely to interest rates inherent in current immediate annuity contracts).  This may be ok for some retirees, as long as they understand that higher amounts spent early in retirement mean smaller spending budgets later, all things being equal.  Other retirees, however, may be less concerned if the spending budget increases in later years as a result of more favorable than assumed experience.   Being a retired actuary, I tend to favor the more conservative approach.   But, in the end, the bottom line of this post is the same as its title, and it is up to you to determine how conservative you want to be in determining your spending budget (and your actual spending) from year to year.  

  

       

       

Thank You Michael Kitces

In his October 22 blog post, Michael Kitces points out several of the problems associated with Monte Carlo modeling and determination of "safe withdrawal rates" based on assumptions about future experience that will not be realized.  Mr. Kitces suggests that the solution lies in "reframing" the model outcomes.  He says, "consider what happens if we actually call it a probability of adjustment, instead of a probability of failure. When we frame the outcomes as failures, the nature [sic] response from clients is to think up terrible images of what failure might look like, and then seek to avoid it at all costs. But when we frame the outcomes as “adjustments” it leads to very different – and much more productive – conversations instead, such as “How big would the adjustment be? When would I have to make the adjustment? How will I know when it’s time to adjust?”

He also expresses concerns about surpluses that are ignored in the safe withdrawal rate determination, saying, "it’s not just the probability of failure that’s misnamed. It’s also the probability of success, which is more like a probability of Excess. It’s the likelihood of having excess money left over, and sadly makes no distinction about how much will be left over! A Monte Carlo analysis in traditional retirement planning software treats having $1 left over the same as $1M and the same as $10M – they’re all “successes” – yet clients would react to this very differently. When you call it a probability of “excess” it again raises the question “how much of an excess are we talking about?” and a more productive conversation."

While I agree with Mr. Kitces' assessment of the problems, in my opinion, reframing the outcome is not the answer.  The actuarial approach suggested in this website automatically provides valuable input for Mr. Kitces "productive conversations."  As indicated in my previous post, retirees need to wean themselves off the safe withdrawal rate Kool-Aid and  live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.

20 Years of Drinking the "4% Rule" Kool-Aid

This month's Journal of Financial Planning celebrates the twentieth anniversary of publication of the article, "Determining Withdrawal Rates Using Historical Data", by William P. Bengen.  This article formed the basis for what is now known as the "4% Rule" or "4% Withdrawal Rule."

In this month's Journal article, Jonathan Guyton, CFP, offers his thoughts on the original research performed by Mr. Bengen, and Mr. Guyton's article contains glowing praise from many others for Mr. Bengen's research.  According to Mr. Guyton, "Bill Bengen framed a deceptively complex question and crafted and elegant simple answer that remains relevant two decades later for hundreds of thousands of financial advisers and easily 100 million retirees."

As someone who doesn't understand the appeal of the 4% Rule, or it's many safe withdrawal rate progeny, please forgive me if I don't enthusiastically join in this celebration.

Based on historical returns provided by Ibbotson Associates' Stocks, Bonds, Bills and Inflation 1992 Yearbook, Mr. Bengen noted that hypothetical individuals who retired in each year from 1926 to 1976 who invested at least 50% of their assets in equities and who withdrew 4% of accumulated assets in the first year of retirement and increased that amount by inflation each year would be expected to have their assets last at least 30 years (Figure 1b of Mr. Bengen's article).  As a result of this analysis of these historical returns, Mr. Bengen concluded that it was "safe" going forward for almost all retirees to withdraw 4% of accumulated assets in the first year of retirement and increase that first year amount by inflation for subsequent years if they invested at least 50% of their assets in equities and rebalance their portfolio each year.  In fact, Mr. Bengen said, "It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible and in no cases less than 50 percent."

I agree with the concerns expressed about the 4% Rule expressed by researcher Nobel Laureate, William Sharpe in his article, "Staying Flexible on Retirement Spending" (highlighted in my second post in 2010) where he points out the problems inherent in combining a fixed spending strategy with investment of a portfolio with variable returns. 

I list what I believe to be the many shortfalls of the 4% Rule in this website and in my recently published article in the Journal of Personal Finance.  For brevity sake, I will not be re listing them here.  Suffice to say that the 4% Rule requires the retiree to have faith that historical performance is a good indicator of future experience and the retiree should "stay the course" irrespective of actual investment returns or spending. By comparison, the Actuarial Approach advocated in this website suggests looking to see whether the retiree is "on track" on an annual basis and making appropriate adjustments.  

In the twenty years following release of Mr. Bengen's original research, many researchers have suggested modifications to the 4% Rule to deal with its significant shortcomings and to refine the assumptions and methodology (Monte Carlo modeling) used to forecast future experience.  In fact, an example of such refinement is also featured in this month's Journal of Financial Planning entitled, Retirement Planning by Targeting Safe Withdrawal Rates, by David Zolt, CFP, EA, ASA, MAAA.  This is an update of Mr. Zolt's original article which I discussed in my post of May 23rd of last year.  Like many suggested modifications to Mr. Bengen's original work, Mr. Zolt has dealt with some of the problems, but his approach and various tables are much more complicated than Mr. Bengen's "elegant simple answer."  I will be discussing Mr. Zolt's approach in a subsequent post.

Bottom line:  Retirees who invest in risky assets should not expect those assets to produce a fixed level of real income in retirement as implied by the 4% Rule or other safe withdrawal rate approaches.  They need to use a dynamic withdrawal approach (like the Actuarial Approach advocated in this website) and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.
 

Don't Be Worried and Confused About Making Your Money Last in Retirement

Last year, Merrill Lynch and Age Wave released a report titled, "Family & Retirement: The Elephant in the Room."  Figure 16 of this report listed the results of a survey describing the greatest worries different generations had about living a long life.  The top two worries cited by both the "Silent Generation" and the "Baby Boomer Generation" were "running out of money to live comfortably" and "being a burden on my family" (which is arguably partially related to the worry of running out of money).   In fact, these two concerns were cited by more than 60% of the survey respondents. 

The September issue of the AARP Bulletin contained an article about the five steps to a happy retirement, including Step Number 5--Make Your Money Last by Jane Bryant Quinn.  I have to say that this article was unfortunately one of the most confusing articles from Ms. Quinn that I have read.  She initially indicates that the 4% Rule is the gold standard for financial planners.  According to Ms. Quinn, "If you stick to that rule and are properly invested, your money should last for at least 30 years and, in most cases, much longer. You should be financially safe."  She then asks a number of experts what they think and, not surprisingly, the safe withdrawal rates vary from 2.5% to 5.5%.  She closes by advising retirees to "prepare to be nimble", "stay the course" and "begin again with the money you have left if you sell when the market falls and miss the upturn."  With advice like this, no wonder many retirees are confused and worried about running out of money or becoming a burden on their families.   

One of the big problems with the 4% Rule and other "safe" withdrawal strategies is that after the first year, you have no real way of knowing whether you are still "on track."  In addition, these approaches are based on assumptions that may not apply to your specific situation.  To be less confused and worried about overspending (or underspending) your accumulated savings, you should use the Actuarial Approach recommended in this website.

The Actuarial Approach automatically adjusts for actual experience as it emerges and annually lets you know whether you can increase your spending or whether you should decrease your spending based on your personal situation and objectives.

4% Constant Withdrawal Approach Leaves Much to be Desired (and Probably Too Much to Heirs at Death)

In his September 23 post, Neal Frankle touts the benefits of the 4% Constant Withdrawal Approach (together with increased investment in equities) as a way to easily and significantly increase income in retirement.

To use the favorite phrase of perhaps the most famous actuary of the 20th Century, Robert J. Myers, I am constrained to disagree.  I outline the shortcomings of the 4% Constant Withdrawal Approach in my February, 2014 article (published in Volume 13 Issue 2 of the Journal of Personal Finance, p. 51).  In summary, the method: 

• Doesn't coordinate well with other sources of retirement income,
• Doesn't smooth results from year to year,
• Doesn't attempt to provide constant real dollar income from year to year, and
• Produces far too low withdrawals in later years of retirement, resulting in under spending and larger than intended amounts left to heirs at death.

As an example of the last bullet, under the recommended assumptions for the Actuarial Approach (and assuming no other retirement income), the withdrawal rate for a 30-year expected payout period is 4.34%, for a 20-year period is 5.97% and for a 10-year period is 10.89%.  Therefore, a constant 4% withdrawal approach would not be expected to significantly boost retirement income as a retiree ages when compared with withdrawals expected under the Actuarial Approach.

Complimentary Posts From Steve Vernon

It is always nice to get a compliment--even if it comes from a friend.  Out of the blue last week, my friend, Steve Vernon, Research Scholar for the Stanford Center on Longevity and blogger for CBS MoneyWatch, decided to say a couple of nice things in his blog about our website and the Actuarial Approach for determining a spending budget.  His posts are A simple tool for figuring retirement income and How much can I spend in retirement?

As usual, Steve does an excellent job of discussing his topic in a straight-forward and understandable (i.e., non-actuarial) manner.  I just have just a couple of "clarifying" comments:

Steve indicates that you can input the amount of Social Security in the spreadsheet tool.  This isn't the case.  The "Excluding Social Security V 2.0" Excel spreadsheet is designed to produce a number that you can add to any inflation-indexed income you receive, such as Social Security, to determine your spending budget.

While Steve discusses the need to periodically adjust withdrawals to reflect events that have occurred (which I believe is more important than the sophistication level of the spending tool employed), he does not discuss the smoothing algorithm I recommend in this website.  I believe that it is important to smooth the gains and losses that will occur in the future in a reasonable manner.  And I believe the smoothing algorithm we recommend is an important part of the Actuarial Approach.  

Lastly, although it makes for a good story, I did not develop the Actuarial Approach and website to figure out my own retirement spending budget (although I certainly do use it).   As a defined benefit pension actuary, I became concerned about how individuals will have to "self-insure" their retirement in a defined contribution (401(k)) world over ten years ago while I was still working.  At that time, I pitched my ideas to Dallas Salisbury and others at the Employee Benefit Research Institute (EBRI), AARP and other organizations representing retirees as well as my own professional actuarial organizations.  I thought that my approach could help retirees better manage the risks involved in determining how much they could afford to spend each year.  Apparently, these organizations disagreed.  When I did receive feedback, I was told that my approach was either too complicated or not complicated enough.  This feedback was a source of frustration for me.  When I was close to retiring, my friend and co-worker at Towers Watson, Kin Chan, offered to help me set up this website to help me communicate the approach.  It is an offer that he now, I'm sure, regrets as I send him new thoughts to post every few days.

Managing Your Spending in Retirement--It's Not Rocket Science

This post once again takes on the so-called experts who say that most retirees aren't smart enough or motivated enough to properly manage their spending.  For some reason, they believe that individuals who have managed to live within their means prior to retirement (and even save money) will no longer be able to do so during retirement.  I believe that with a little bit of effort and the tools provided in this website most retirees can do a reasonably good job of managing their spending in retirement.  It is really as simple as following these four steps:

Step 1:  Develop a Reasonable Budget--Using one of the spending spreadsheets and the recommended assumptions set forth in this website, determine how much total income you can spend for the upcoming year (from Social Security, pensions, annuities, withdrawals from accumulated assets and income from employment).  To determine your "income" from withdrawals, you may need to adjust your current accumulated assets for events expected to occur in the future.  For example you may add the present value of amounts you expect to receive, such as gains from downsizing your home, expected inheritances, re-payments of loans owed you, etc.  Conversely you may subtract the present value of such items as future loan repayments you owe or amounts you wish to set aside for unusual future expenses (as discussed in the previous post).  The June, 2014 article in the articles and spreadsheets section of this website provides a brief description of how to use the Actuarial Approach to determine a spending budget and includes several posts that provides examples of these adjustments.

Step 2:  Determine Your Spending Needs/Living Expenses For the Upcoming Year--Most retirees keep track of their expenses, so they have a pretty good idea of normal living expenses.  To this amount add an estimate for other expenses you expect to incur.  Don't forget to include taxes that you may need to pay.

Step 3:  Compare the Results of Step 2 with Results of Step 1 and Make Necessary Adjustments--If the results of Step 2 are higher than the results of Step 1, you may need to reduce some of your expenses for the year or you may need to increase your income.  You can increase your income by working more or you can revisit the assumptions used to develop your budget.  For example, you may be comfortable developing a budget that is not expected to remain constant in real dollar terms from year to year, so this adjustment may increase your spending budget for the current year (at the expense of reducing it for future years, all things being equal).  Alternatively, you may simply decide that it is not important to have your expenses match your budget for the upcoming year.

Step 4:  Repeat Steps 1-3 at Least Once Per Year--This is not a "set-and-forget" process.   You need to periodically (I recommend doing this once each year at the beginning of each calendar year) revisit the three step process described above to reflect investment gains and losses, changes in assumptions, deviations of actual spending from the budget or other changes.  I recommend using the recommended smoothing algorithm in this website for this purpose.  Under this smoothing algorithm, you generally increase your budget by the increase in inflation over the previous year unless your budget falls outside a 10% corridor around the "actuarial value" produced by the spreadsheet.  Depending on actual results, your budget may increase or decrease from year to year.

That's it!  Yes, it takes some work and some discipline but after the first time it will probably take you less time than you take to plan your next trip, fill out your NCAA tournament brackets or make your fantasy league picks. 

Budgeting Around "Lumpy" Expenses

There may come a time during your retirement where you are looking at an expense that may blow your annual budget.  Examples of such expenses include the purchase of a new car or vacation home, helping your children purchase a new home, paying for a wedding, etc.  This post will take a look at several different ways you can handle these "lumpy" expenses under the Actuarial Approach. 

In summary, there are quite a few reasonable ways to adjust your budget for unanticipated expenses under the Actuarial Approach. In many ways, developing a budget for retirement is more of an art than a science. Irrespective of what your budget is, you are the one who decides how much of your available assets you will spend each year. After all, it is only a budget, and no one is going to force you to live within it. On the other hand, if you believe you will have unanticipated expenses in the future, it may be prudent to reserve for such expenses by reducing the accumulated assets you have available for normal retirement expenses and establishing a separate unanticipated expense fund.

Before discussing the different ways to adjust your budget for unexpected expenses, lets provide some facts for a hypothetical retiree so that we can illustrate the impact of using the different approaches:

Raymond retired at age 65.  At that time, he had accumulated assets of $500,000, a fixed dollar pension of $10,000 per year and Social Security of $24,000 per year.   He used the Excluding Social Security V 2.0 spreadsheet in this website with the recommended assumptions.  Because he wanted to leave some of his assets to his daughter, he developed his initial spending budget by inputting $100,000 in the amount to be left to his heirs. 

His resulting first year budget is $51,733 ($24,000 from Social Security, $10,000 from his pension and $17,733 from withdrawals).  In the first year of retirement, his accumulated assets earn 10%.  In the second year of his retirement, his accumulated assets earn 3%.  Let's assume that CPI increases were 2% in each of his first two years of retirement and further assume that Raymond spends exactly his total budget each year.  To determine his budget in subsequent years, Raymond applies the smoothing approach recommended in this website to the sum of his pension and withdrawals and then adds his Social Security benefit for that year.

Since the budget amount (prior to adding Social Security) increased by inflation in each of his first two years of retirement remains inside the 10% corridor around the actuarial value, Raymond determines his budget for his second year of retirement by increasing the first year pension and withdrawals of $27,733 by 2%.  This equals $28,288 so he withdraws $18,288 from his accumulated savings and his total budget for his second year is $52,768 ($24,480 from Social Security, $10,000 from the pension and $18,288 from withdrawals).

Late in his second year, Ray determines a preliminary budget for his third year.  He increases the pension and withdrawal from the previous year of $28,288 by 2% to get a sum of $28,854 for a total budget of $53,824 ($24,970 from Social Security, $10,000 from the pension and $18,854 from withdrawals.  At the beginning of his third year of retirement, he has $527,572 in accumulated assets.  By comparison, the actuarial budget for his third year (based on the spreadsheet without smoothing) would be $55,094 ($24,970 from Social Security, $10,000 from the pension and $20,124 from withdrawals).

But, let's assume that at the beginning of his third year of retirement, Ray discovers that he has an upcoming expense of $40,000 at some time in the near future.  How should he adjust his third year budget in light of this new expense?

Approach #1--Restart the Actuarial Approach

Under Approach #1, Ray redetermines his budget for year 3 reducing his assets at the beginning of year 3 by $40,000 (even though all of this expense may not occur in year 3).  So, instead of inputting $527,572 in assets to determine the actuarial budget, he enters $487,572 and a 28 year remaining period.  The resulting total budget is $53,265 ($24,970 from Social Security, $10,000 from the pension and $18,295 from withdrawals). 

Approach #2--Treat the Unexpected Expense as Any Other Gain/Loss (Including Deviations of Withdrawals from Budget)

Under Approach #2, Ray inputs $487,572 into the spreadsheet as his accumulated assets (the same as in Approach #1).  Using the smoothing method, he compares the result of the spreadsheet calculation ($28,295 = $10,000 from the pension and $18,295) with the previous years total increased by 2% inflation ($28,854).  Since the amount from the previous year increased by inflation falls within a 10% corridor around the actuarial value, Ray adds $28,854 to his Social Security benefit of $24,970 to get the same budget for his third year that he had prior to recognition of the unexpected expense. 

Approach #3--Recognize the Expense in Budget Over a limited Period

Ray doesn't feel comfortable with the negligible or no decreases in budget resulting under the first two approaches and feels that spending an extra $40,000 in accumulated saving should be recognized in his spending budget over a shorter time-frame.  Therefore, under Approach #3, Ray decides that he will reduce his spending budget for each of the next four years by $10,000 per year.  To accomplish this, Ray will add $40,000 to his reduced assets of $487,572 in year three and will determine the same budget (without recognition of the extra expense) of $53,824.  From this amount, he will subtract $10,000 to get a third year expense budget of $43,824.
To determine the budget in year 4, Ray will follow the regular actuarial process, but instead of adding $40,000 to his beginning of year assets, he will only add $30,000.  He will then subtract $10,000 from the resulting budget.  He will continue this process for two more years until there are no more adjustments to the inputted assets and no more $10,000 subtractions from the budget.  Depending on whether Ray actually pays attention to his spending budget, this approach is more conservative than the first two, but results in approximately a $10,000 increase in his annual budget when the expense is fully recognized. 

Approach #4--Reduce Amount Desired to be Left to Heirs

Yet another approach is to use either Approach #1 or Approach #2 and reduce the amount previously input for the bequest motive.  This approach may be perceived to me more reasonable if in fact the unanticipated expense is in reality a pre-payment of one's bequest motive (such as a gift to assist a child purchase a home).

The Actuarial Approach vs. the "Bucket System"

This post welcomes yet another challenger to my claim that the Actuarial Approach is a better withdrawal strategy for you to use to develop a reasonable annual spending budget in retirement.  The challenger in this post is called the "Bucket System" and an example of its use is set forth in this Bankrate article.

Under the Bucket System, Jason Flurry proposes to establish three separate investment buckets (with increasing levels of investment risk) and a strategy for draining those buckets over time to provide retirement income to a hypothetical 55-year old couple with $2 million in accumulated assets.  His proposal would be expected to provide the couple with income of $60,000 per year for the first ten years of retirement.  In order to facilitate a comparison of the approaches, I am going to assume the following additional facts:  

1. the couple has earned combined Social Security benefits of $4,000 per month payable at age 65 (before any increases in inflation),
2. investment return per annum for the Bucket System equal to the percentages specified in the example (0% for Bucket 1, 4% for Bucket 2 and 6% for Bucket 3
3. 5% per annum investment return for the Actuarial Approach
4. 3% per annum inflation
5. no other sources of retirement income, no desire to leave significant amounts to heirs, expected payout period under the Actuarial Approach of 40 years at initial retirement, and
6. the couple expects to commence their Social Security benefits at age 65.  They expect the total annual amount of their Social Security benefits at that time (with 10 years of inflation at 3% per annum) will be $64,508 ($4,000 X 12 X 1.3439).

Under the Actuarial Approach, the couple uses the Social Security Bridge spreadsheet from this website, enters $2,000,000 in assets, expected Social Security of $64,508, number of years until commencement of Social Security: 10, zero to be left to heirs and the other recommended assumptions for the spreadsheet.  The resulting withdrawal for the first year is $103,340.  And, if the assumptions are exactly realized each year (and the couple spends exactly the total budget amount each year), each future year's total budget (Social Security plus withdrawals) until the couple reaches approximately age 91 is expected to remain at $103,340 per year in real (inflation-adjusted) dollars. 

By comparison, if all assumptions are realized under the "Bucket System" set forth in the article (and the couple spends the total budget amount each year--withdrawal plus Social Security), the total budget (in real dollar terms) is expected to increase significantly when the couple starts commencement of Social Security and again after 15 years when income from the third bucket kicks in.  The figure below shows a comparison of the expected total budget amounts under the two approaches from the couple's age 55 until they reach age 90.  I calculate that there will be in excess of $3.2 million in assets (including about 871,000 in Bucket 2) remaining at age 91 under the Bucket System vs. $749,489 at age 91 under the Actuarial Approach.  Note that this amount ($749,489) is shown in the run-out tab of the Social Security Bridge spreadsheet.  If you can't see the run-out tab, you need to maximize the spreadsheet window. 

Of course, actual future experience will not exactly follow assumed experience.  That is why it is important for a systematic withdrawal approach to automatically adjust for actual experience.  Under the Actuarial Approach this is easily accomplished:  As long as the previous year's budget amount increased by the increase in inflation for the previous year falls inside of a 10% corridor around the actuarial value, you stay with the previous year's value increased by actual inflation.  Automatic adjustment occurs under the Bucket System after the 15 year when the couple uses the IRS Required Minimum Distribution (RMD) rules to determine distributions.  As mentioned in previous posts, budget amounts can vary significantly from year to year under RMD approach as there is no smoothing of the actual experience.

The three major problems with the Bucket System (based on the facts of this example) from my perspective are: 1) it does not coordinate well with expected commencement of Social Security benefits, 2) it does not anticipate future inflation and 3) it uses the RMD rules to determine distributions from Bucket 3.  As a result of the first two problems, the matching of retirement income to the energy level of the hypothetical couple may not be optimal.  During the first ten years of their retirement, when they may wish to enjoy a more active life style including travel and adventure, their retirement income is significantly restricted relative to expected income in later years.  In addition, RMD is more likely to leave more money to heirs than desired.

Note that the Actuarial Approach produces an expected budget pattern under these assumptions that is constant in real dollar terms.  Some argue that retirees don't need constant real dollar income in retirement, but can accept some degree of decrease as they age, perhaps followed by an increased need much later in life.  This "smile" pattern can also be accomplished under the Actuarial Approach by inputting a lower percentage for desired increase in payments than the percentage anticipated for inflation and by inputting the expected increase in cost (for assisted living, etc.) as amounts desired to be left to heirs.  I believe it is better to factor these needs directly into the calculation than it is to use a method (such as RMD) that can simply result in unintended and undesirable deferral of spending. Of course, different spending patterns can also be achieved by consciously spending more or less than the spending budget produced under whatever approach is used.
   
 

 (click to enlarge)

Can Retirees Successfully Survive in a World of 401(k) Plans? - Part 2

I ran across three articles concerning living in a 401(k) world that might be of interest to the readers of this blog.

To get a different viewpoint from the one expressed by Professor Frolik in the last post, here is an article in Fiduciary News in which Phil Chiricotti claims, "lobbying to replace 401(k) is "lunacy" and "Not only are they not broken, but 401k plans are the most successful savings vehicle in history".

The second article comes from Brookings and argues that we don't just have a savings problem; we also have a spending problem.  "Upon retirement, households are faced with another daunting challenge--turning their accumulated wealth into security...Ultimately, a sound retirement means adept choices about both savings and spending."   Since this website is devoted to helping retirees with the "spending problem", I will have to agree with Brookings on this one.

Perhaps the most interesting of the three articles is actually a press release and a survey of retirees and near-retirees completed by T. Rowe Price.  It shows that the survey retiree group is living on significantly less income than they had prior to retirement, but 89% of respondents report being "somewhat or very happy with retirement so far."

The actual survey results contain a wealth of information, including the following:

Average sources of income in retirement:
Social Security: 43%,
401(k)/IRA: 18%,
Pension: 19%,
Earnings from employment: 8%,
Annuity income: 2%

48% of retirees have a withdrawal plan with an average withdrawal of 4.9% of accumulated assets (median of 4%). 

60% of retirees prefer to adjust spending up and down depending on the market to maintain the value of their portfolio

80% of retirees track expenses carefully and 63% stick to a spending budget

89% of retirees believe that they can adjust their lifestyle according to income

59% of retirees expect to spend their assets rather than leave significant amounts to heirs 

Of special interest to me is the fact that 63% of surveyed retirees stick to a spending budget.  Since the purpose of this website is to help retirees develop a reasonable spending budget (and one that smoothes variations due to investment performance but also adjusts the budget up and down when necessary), these survey results are encouraging to me.

Can Retirees Successfully Survive in a World of 401(k) Plans?

In his latest paper, Rethinking ERISA's Promise of Income Security in a World of 401(k) Plans, Professor Lawrence Frolik of the University of Pittsburgh School of Law, paints a reasonably depressing picture of retirement in the future.  Professor Frolik correctly points out that as employers and other plan sponsors transition out of defined benefit plans and into defined contribution plans, "retirees face formidable planning hurdles."  Not only must they be responsible for investing their retirement assets in this world, but they "must spend their retirement fund at a rate that will not exhaust it before they die, yet take a sufficient amount out, that when added to their other sources of income...will enable them to live at the level that they deem adequate." 

Professor Frolik presents an impressive argument that because of diminished physical and mental capacity, many retirees will not be up to the task.  He concludes that the use of annuities must be encouraged by our government.  He says, "unless the government does something to encourage the use of annuities by IRA owners, the financial security of many retirees will be severely compromised in the years to come.  We can expect rates of elderly poverty and increasing financial exploitation and abuse."

He pulls no punches by concluding, "The assumption that retirees can successfully manage their IRAs during their declining years is a folly.  Why any society would willfully create a retirement system that relies on the financial acumen of millions of aging individuals can only be explained as the triumph of hope over common sense and reality."

Whether you agree or not with Professor's assessment of the implications of living in the "World of 401(k)s", he does make a good argument for diversification of risks in retirement through purchase of life annuities (immediate and/or deferred) with some or all accumulated retirement assets, and he makes a good indirect argument for using a relatively simple approach like the one proposed in this website, for determining a spending budget in retirement. Under any circumstance, however, there should be a plan in place for transfer of financial responsibilities to a competent party when an individual becomes physically or mentally incompetent.