How Did You Do This Year?

The purpose of this quick post is to encourage you to track and save a comparison of your actual spending vs. your spending budget every year in your spending budget file.  If your spending budget significantly deviates from the budget determined using the Actuarial Approach, you may also want to track that difference.  While the Actuarial Approach automatically adjusts your future budgets for actual investment experience and actual spending (if used without smoothing), it can be helpful for future budget setting purposes to have a sense of how well you have done historically when it comes to following your spending budget.  For example, if your history shows that you have constantly overspent your budget, you may be understating your spending needs when developing  your budget.  Or, if your history shows that your overspending relative to your budget is increasing from year to year, this can be a signal of financial problems on the horizon.  On the other hand, a history of ever widening under-spending relative to budget  provides evidence that you may be too conservative with your spending. 

Do you need to track your spending exactly?  While it may be helpful to do so,  particularly if you develop your spending budget as the sum of several different categories,  it probably isn't necessary.  If you know all of the items in the equation below other than your spending, you can solve for the amount you spent during the year.

End of Year Assets = Beginning of year assets + investment income + income from other sources (such as Social Security, pensions, annuities, etc.) - amount spent

Regarding the other important assumptions used in developing your spending budget, you can also track how well you did on your investments vs. your assumed rate of return and actual inflation vs. assumed inflation.  Of course, every year that you and your significant other (if you have one) survive to work on a new year's spending budget should be considered a good year. 

Happy budgeting and wishing you all the best in the upcoming year.  

Happy New Year—Time to Determine Your Spending Budget for 2016

It’s that time of year again to sit down to determine your spending budget for the upcoming year.  See our post of December 21, 2015 for a discussion of our recommended assumptions for 2016 spending budgets.  It just takes a little data gathering and number crunching, but you will find that the time it takes will be well worth your while.  Yes, you may have to miss an entire half of one of the upcoming important football games. 

The rest of this post will illustrate the Actuarial Approach for Richard Retiree, the hypothetical retiree we have visited each year around this time for the past three years.  The last time we visited Richard was in our post of January 1, 2015 when he developed his 2015 spending budget.  To refresh your memory, Richard retired on December 31, 2012 at age 65.  After a good investment year in 2014, Richard decided to take $100,000 of his January 1, 2015 accumulated savings and segregate these assets in a "rainy day fund" for unexpected future expenses.   This left him with $821,853 in investments, his annual Social Security benefit of $20,340 and an annual life annuity of $15,000 from which to develop his spending budget for 2015.    He also owns his home, but he does not consider his home equity to be part of his assets for budget setting purposes, as he plans to use the proceeds from the sale of his home to cover future long-term care expenses.  He has no heirs so, he plans on having $10,000 or more available upon his death to cover death expenses. 

Last year, he determined his essential expenses to be $55,000 and he decided that he would invest 33% of his assets in equities and 67% in fixed income securities.  His total spending budget for 2015 was $66,884 ($31,544 from accumulated savings + $15,000 from his annuity + $20,340 from Social Security). 
 
He earned a 2% rate of return on his rainy day fund and didn't use that fund for any emergencies during the year, so as of the end of 2015, he has $102,000 in the rainy day fund.  His total investment return for 2015 on his non-rainy day investment funds was $15,000.  Since his equity investments were down mid-way through 2015, Richard decided that he would try to limit his spending somewhat during the year and he ended up spending just $59,000 (including taxes).  Thus, at the end of 2015, his non-rainy day accumulated savings are $813,193 ($821,853 (beginning of year assets) + $20,340 (Social Security benefit) + $15,000 (annuity benefit) + $15,000 (investment return) - $59,000 (total amount spent). 

For 2016, Richard (who is now age 68) has decided that he will break up his total spending budget into several different component categories and dedicate assets to each separate category:

Long-term care:  Richard has looked into the cost of assisted living and nursing home care in his area and has determined that the cost of three years of assisted living and one year of nursing home care would be about $180,000.  He assumes that selling his home would cover this cost, even if long-term care costs increase at a faster rate in the future than the projected proceeds from selling his home, but he will continue to monitor the reasonableness of this assumption in the future.

Unexpected Expenses:  Richard has $102,000 in this account and does not consider the money in this account for determining his 2016 spending budget.

Essential Health-Related Expenses: Richard's current health related costs are about $5,000 per annum.  He goes to the "Excluding Social Security V 3.1" spreadsheet in this website and solves for how much of his accumulated savings he would need to provide a stream of payments starting at $5,000 per year and increasing by 4.5% per year over a 27 year period (95 minus his current age of 68) assuming he earns 4.5% per annum on the assets.  He determines that this amount is $135,000.

Essential Non-health Related Expenses:  Richard has determined that his annual essential non-health related expenses are about $50,000.  Since his Social Security benefit for 2016 remains at $20,340, he will need $29,660 ($50,000 - $29,660) from his annuity and withdrawals from his accumulated savings.  He again "backs into" how much accumulated savings plus his $15,000 annual annuity benefit will provide a stream of payments starting at $29,660, increasing by 2.5% per annum and leaving a fund of $10,000 at the end of 27 years.  He determines this amount to be about $390,900.

Non-Essential Expenses:  Richard has $813,193 in assets not allocated to his rainy day fund or his long-term care fund.  He subtracts the amounts dedicated to his essential expenses discussed above to develop a total of $287,293 ($813,193 - $135,000 -$390,900).  This is the amount he will dedicate to future non-essential expenses.  He develops the portion of his spending budget attributable to non-essential expenses by inputting this amount in the spreadsheet as accumulated savings, 4.5% investment return, 0% future desired increases and a period of 27 years.  This gives him a non-essential expense budget of $17,793.  Richard knows that assuming 0% future increases for this item means that if all assumptions are realized in the future, his non-essential expense budget will not keep up with inflation.  Richard also knows that he could be even more aggressive with this "front-loading" by assuming a payment period equal to his expected life expectancy (about 20 years under the Society of Actuaries' 2012 Individual Mortality Table with mortality projection) rather than a 27-year period, but he is happy with this result. 

Total Spending Budget for 2016:  Richard's total spending budget for 2016 is 72,793 ($5,000 for essential health related expenses + $50,000 for essential non-health related expenses + $17,793 for non-essential expenses).  This budget is higher than the spending budget for 2015 of $66,884 even though Richard did not enjoy a particularly good year in 2015 investment-wise.  This difference is primarily due to Richard's decision to somewhat front-load his non-essential expenses (in terms of real dollars).  He decides that 2016 will be a year of more travel while he still able to do so.  Richard notes what the expected amount of assets will be in each dedicated fund at the end of 2016 so that he can monitor his progress during 2016 and make spending adjustments if necessary (or possible).

Richard decides that he will talk to his investment advisor about how best to invest the various funds dedicated to his expense components.  He feels that funds dedicated to essential expenses should be much more conservatively invested than his funds dedicated to non-essential expenses, and he may consider buying additional immediate annuities during 2016 if purchase rates become more favorable.  He also decides that he feels much more comfortable with his decision to break up his expenses into separate categories, make different assumptions about how these expenses may increase in the future and treat them separately for investment purposes.  And he feels infinitely more comfortable using this approach rather than using a "safe" withdrawal rate that doesn't consider his situation or goals.

Recommended Assumptions to Develop 2016 Spending Budgets under the Actuarial Approach

This post updates my 2015 spending budget recommendations of February 14, 2015 and December 3, 2014.  For 2016, Instead of recommending one set of assumptions for your entire spending budget, I will recommend different sets of assumptions for different component categories of expenses, as discussed in several of my recent posts (see the post of June 7, 2015 for an example).   If you separate your budget into these different categories, your overall spending budget for 2016 will be the sum of the various component categories.  You (and/or your financial advisor) may wish to consider segregating the assets dedicated to each expense category and adopting different investment strategies for these various dedicated funds.  Each year you will compare assets in each dedicated fund with the liabilities for future expected expenses and make necessary budget adjustments and/or transfers between dedicated funds if appropriate.  As a general rule, benefits payable from Social Security, pension plans and annuities are used to satisfy essential expenses first. 

Essential non-Health Related Expenses

In brief, I recommend the same assumptions for this category of expenses as I recommended for 2015 in my post of February 14, 2015.  As for prior years, I have recommended an investment return assumption that is close to the interest rates “baked into” immediate life insurance annuity quotes.  Current immediate annuity purchase rates for a 65-year old male with a life expectancy of 22.9 years (based on the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with mortality improvement) are consistent with an interest rate just a little bit lower than 4.5%.  Therefore, I believe that the recommended investment return assumption for 2015 of 4.5% per annum is reasonable at this time.  If the Fed continues to increase interest rates or immediate annuity rates change for other reasons, we may need to revisit this assumption during the year (as was the case in 2015).  I continue to believe that a 2% spread between the investment return assumption and the inflation/desired increase assumption is reasonable and that 95 minus the retiree’s age, or life expectancy if greater, should be used for the expected payment period.  See my post of December 3, 2014 for a graph that illustrates why I recommend using this expected payment period rather than life expectancy for this expense category. 

If you use the recommended assumptions for this category, your effective goal for this budget component is to have relatively constant real dollar future essential non-health related spending at least until your late 80s. 

Essential Health Related Expenses

Historically, health related expenses have increased about 1.5% to 2% faster per year than non-health related expenses.  Given Medicare’s financial situation, there also appears to be trend toward passing these higher costs disproportionately to higher income individuals.   If you consider yourself to be a relatively “higher income” retiree, I recommend that you use the same assumptions as above for this category, except with 4.5% annual desired increases (as opposed to 2.5%) for this category of expenses.  If you do, then the fund you need to have to support these expenses this year will simply be your current expected payout period multiplied by your current essential health related expenses (adjusted if you considered some of your current expenses to be unusual and non-recurring in nature).   So, for example, if you are currently age 65 (with a 30-year expected payout period) and $7,000 in current health related expenses, such as for premiums, co-pays, deductibles and non-insured prescription costs), then you should have current assets dedicated to future essential health related expenses of about $210,000 (30 X $7,000).

Long-Term Care Expenses

Since not everyone will require long-term care or they will pay for it with home equity that they don’t consider assets available for other expenses, this can be a difficult category to budget for.  Data from the National Care Planning Council suggests that for those individuals who require long-term care, the average length of stay in an assisted living facility is about 2.5 to 3 years with many leaving the facility to go to a nursing home or another facility that provides more intensive (and expensive) care.  The council also indicates that about 75% of the cost is covered by the family, not insurance.  I recommend that you investigate current assisted living facility and nursing home costs in your area and plan on about 3 years at the assisted living facility and one year at a nursing home.  For example in California average assisted living facility costs are about $45,000 per year and nursing home costs are almost double that amount, so budgeting about $200,000 for this expense would not be unreasonable if you plan on enjoying long-term care in California.  I would also assume that these costs would increase by 4.5% per year (inflation plus 2%) so that you would need a dedicated fund of about $200,000 today to cover this future expense.  If you do plan to use some or all of your home equity to pay for this expense, you should include an estimate of the home equity you plan to use in your current assets, when comparing your assets with your liabilities.
 
Other Unexpected Expenses

When establishing your spending budget, you will probably want to set aside a reasonable amount of assets dedicated to meeting unexpected future expenses (or a “rainy day” fund not dedicated to any of the other expenses discussed in this post). 

Non-Essential Expenses and Bequests

If you have assets remaining after dedicating them to fund the other expense buckets above, you can use these assets to fund non-essential expenses such as travel, entertaining, dining out, gift giving, etc.  Your bequest motive can also be included in this category or in the Essential non-health Expense category.  Since some experts indicate that non-discretionary expenses are likely to decrease in real dollar terms as we age, it may be reasonable to assume less than 2.5% annual increases in future non-essential expenses or a shorter expected life period than recommended for essential expenses.   If you do use these less conservative assumptions for determining how much you can withdraw from your non-essential asset account, you should realize that unless investment returns exceed the 4.5% assumption, your withdrawals from this account will likely decrease on a real basis over time.   Note that amounts entered as bequests in our spreadsheets are nominal amounts and not real dollars, so if you want to leave real dollar amounts, you will have to increase the nominal amounts with assumed inflation. 

We will illustrate operation of the 2016 assumptions in January when we revisit Richard Retiree and help him develop his 2016 budget and see how it compares with the budgets we calculated for him for 2015 and 2014. 

Avoiding the Other Road to Ruin

In Dirk Cotton’s post of December 11, Positive Feedback Loops:  The Other Road to Ruin, he draws a clever analogy between positive feedback loops (such as in a public address system) and financial ruin in retirement and illustrates his analogy with some southern story telling about a couple named Jim and Linda.  According to Dirk,

“Each year that Jim and Linda spent more than planned from their portfolio increased their probability of ruin. The continual shrinking of their portfolio value as the market fell increased it even more. Soon that probability of ruin was a lot more than the original 5%.

Their portfolio spending strategy had drifted into a positive feedback loop… wherein every year that they overspent from their savings they increased the risk of portfolio ruin, reduced their capacity to recover when the market did, and decreased the amount of spending that would be considered safe the following year, increasing the probability that they would need to overspend yet again.”

Dirk uses his analogy and example (as well as citing research by Larry Franks, Stout and Mitchell) to argue that reducing spending when investments fall significantly decreases the probability of financial ruin.  While poor investment returns can certainly pose a problem for retirees, keeping spending constant (or increasing it) during a period of poor returns is the “other road to ruin.”

Dirk’s story illustrates why I advocate a dynamic spending strategy (the Actuarial Approach) that automatically adjusts for investment experience (good or poor) as well as prior spending (over or under).  His post also ties in very well with my post of December 10, where I encourage retirees (and their financial advisors) who prefer “safe” withdrawal approaches (and the associated spending stability) to develop an action plan by kicking the tires on their spending strategy.   They can do this by using the 5-year projection tab in our spreadsheet to determine just how far away from the actuarially determined spending budget they are willing to go in their quest for budget stability before they decide they need to make a change. 

Another Researcher Concludes that a Combination of Annuities and Asset Withdrawals is Generally More Effective than 100% of One or the Other

Like Dr. Wade Pfau’s research (discussed in our post of July 25, 2015), Mark Warshawsky’s research concludes that “A combination strategy of asset withdrawals and purchases of immediate life annuities provides the best balance of lifetime income and flexibility.”  He illustrates the financial benefits of combining the immediate annuity purchases and asset withdrawals for a couple both age 65 who choose to annuitize 15% of their assets initially and gradually increase the portion of their annuitized assets to 25% over a twenty year period. 

Mr. Warshawsky argues that single premium immediate annuities are more effective than qualified longevity annuity contracts (QLACs) and therefore, as a policy matter, should receive at least as favorable tax treatment under the Required Minimum Distribution (RMD) rules afforded QLACs.  He proposes a specific change to current regulations that would make the RMD treatment consistent, in his opinion. 

As has been discussed many times in my posts, I am a big fan of diversification of retirement income sources.  Therefore, I applaud the research of Messrs. Pfau and Warshawsky and remind readers that the Actuarial Approach is one of the few approaches out there that properly coordinates withdrawals from invested assets with life insurance annuities (be they immediate annuities or QLACs).

Use Our Revised Spreadsheet to Keep Your (or Your Client’s) Safe Withdrawal Rate (SWR) Approach on Track

After our post of December 7 entitled “Is the Actuarial Approach Really the Only Financial Planning Software Capable of Helping You Formulate an Actual Financial Plan?” Michael Kitces graciously responded by indicating that, based on a quick review our spreadsheet, it did not appear to him to represent the “financial planning” he had in mind in his post. He said,

“To say ‘just recalculate your spending based on your account balance annually’ is not what I consider a viable real-world solution for most people, because it translates 100% of market volatility into an identical amount of spending volatility on a 1:1 basis, and most people can’t handle that much spending volatility. Nor do they need to. In a world where retirees only spend 3%-4% of the portfolio, there’s no reason to cut your core spending by 20% because the OTHER 97% of the portfolio has a temporary/short-term downdraft. That’s the whole point (indirectly) of the safe withdrawal rate research – when your spending is sufficiently low, you don’t have to cut spending in down markets, because you’ve left enough available to ride out the volatility.”

While I do advocate a dynamic approach that periodically adjusts a retirees’ spending budget (or budget components) for actual experience, I do see Michael’s point (and there is no question in my mind that the man is extremely bright, an excellent writer and tremendously productive) . That is why I also recommend using a budget smoothing algorithm, and I take great pains to talk about spending budgets rather than the amount to be spent in a year (which is up to the retiree and may or may not be equal to the retiree’s spending budget). In other words, the retiree can always smooth her spending either by smoothing the spending budget or by spending more or less than the spending budget determined using the Actuarial Approach without smoothing. The key advantage of the Actuarial Approach over an approach such as the Safe Withdrawal Approach is that you always know how much you can spend to keep your current assets in balance with your current liabilities (the present value of future spending budgets based on reasonable assumptions and desired spending goals). With an SWR approach (which I feel is kind of a “head-in-the sand” approach that relies on past results which may or may not be repeated), the retiree doesn’t really know when spending can (or should) be increased (or decreased) or if it should be changed, by how much, which I felt was the primary concern expressed in Michael’s post.

In response to Michael’s feedback (which is always appreciated), I have modified the 5-year projection tab in the “Excluding Social Security” spreadsheet available in this website (updated with this post to version 3.1) to allow users to input different “actual” spending amounts (such as spending under an SWR approach) to see how future “actual” investment returns and actual spending amounts affect the spending budget determined under the Actuarial Approach. Financial advisors and/or their clients can then compare their desired smoothed spending with the actuarial spending budget under various investment/spending scenarios to see if (and when) changes in the SWR spending should take place.

I will illustrate with an example. Let’s assume that Bill is a 65-year old male with accumulated savings of $800,000, an annual fixed dollar pension of $12,000 per year and Social Security of $20,000 per year. Let’s further assume that Bill wants to leave $100,000 to heirs at his demise and he wants his spending to remain constant in real dollar terms until he dies (and, for illustration purposes, he doesn’t determine a separate spending budget for essential expenses, non-essential expenses, etc. as I generally recommend). Bill goes to the input tab of the spreadsheet, where he inputs the recommended assumptions, $800,000 in accumulated savings, $12,000 in immediate life annuity amount and $100,000 as desired amount remaining at death. He also inputs 2.5% as the expected rate of inflation (which is also equal under the recommended assumptions to the desired annual rate of increase in spending budget). The input tab shows that his actuarially determined spending budget for the first year (under these assumptions and input items, excluding Social Security, income from employment and other miscellaneous income) is $42,526 ($32,526 from accumulated savings and $12,000 from the pension). He then goes to the Runout and Inflation-adjusted Runout tabs and sees that if all input assumptions are realized in the future (and the expected payment period is reduced by one each year), his annual real dollar spending budget attributable to withdrawals from savings and his fixed dollar annuity will remain at $42,526 for thirty years and he will have $47,674 in real dollar assets ($100,000 in nominal assets) to pass along to his heirs.

Bill then goes to the 5-year projection tab. If he inputs 4.5% for annual investment returns for each future year and inputs the amounts shown in column L of the Runout tab for actual amounts spent, then the actuarially determined spendable amount will equal the amounts Bill has input for actual spending. But like Micheal Kitces, Bill is not interested in using the Actuarial Approach to determine the amount he wants to spend each year. He wants to use the 4% rule and he even wants to cheat a little and have his total non-Social Security spending budget (the sum of his withdrawal from savings and his fixed dollar pension in his first year of retirement) increase with inflation each year. So he inputs the following amounts for “actual” amount spent: $44,000 (.04 X $800,000 plus $12,000), $45,100 ($44,000 X 1.025), $46,228, $47,383, and $48,568. He also wants to stress test his investments to some degree, so he inputs -15% for year 3 (keeping actual returns at 4.5% for the other years). He sees that under this scenario in year 4, the actuarially balanced spending budget (excluding Social Security) decreases to $38,489, and the ratio of amount Bill wants to spend in year 4 to the actuarial spending budget is 123%. When Bill factors in his expected Social Security benefit into both amounts, however, this ratio is only about 115%. Is this ratio high enough to get Bill to change his spending in year 4 if this scenario were to occur? Who knows? However, Bill, with the possible assistance of his financial advisor, can use this spreadsheet to look at different investment/spend scenarios to determine what his “change thresholds” might be and what the specific changes would be if such thresholds are exceeded in the future.

I encourage you (and/or your financial advisor) to play with the new spreadsheet to help you develop a true financial plan that addresses actions you will try to take if your spending falls off the actuarially balanced track.

Is the Actuarial Approach Really the Only Financial Planning Software Capable of Helping You Formulate an Actual Financial Plan?

This post is in response to Michael Kitces’ excellent December 7 post entitled, Is Financial Planning Software Incapable of Formulating An Actual Financial Plan?  I can’t improve on what Mr. Kitces has to say or how he says it, so I will simply encourage you to read his post. 

There is one statement, however, that Michael makes with which I will have to disagree:

“Answering a simple planning question like ‘how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track’ cannot be easily answered with any financial planning software available today!”

With all due respect to Mr. Kitces, I’m aware of at least one website that contains financial planning software that can easily answer these questions—this one.   The Actuarial Approach utilizing the “Excluding Social Security V 3.0” spreadsheet and its 5-year projection tab is available to anyone with access to the Internet and who has Microsoft Excel.  The 5-year projection tab allows retirees to see the effect on their annual spending budget (excluding income from Social Security, income from employment or miscellaneous income such as income from rental property) of variations of future investment return from the expected investment return used to determine the baseline spending budget under the Actuarial Approach.  It also tells users how to adjust spending to get back on track. 

I knew that the Actuarial Approach was an effective approach for developing a reasonable spending budget, but I didn’t realize that it was the only approach capable of helping you (or your financial advisor) formulate an actual financial plan.  If you don’t currently use it, you might want to give it a try. 

Use the Actuarial Approach and Our Spreadsheet to Address QLAC “Challenges”

Almost eighteen months after the IRS released final regulations on Qualified Longevity Annuity Contracts (QLACs), the market for these insurance products has become more robust, and retirement experts are becoming more aware of the potential advantages associated with QLACs.  See, for example, my post of November 24, 2015.   On the other hand, retirement experts and financial advisors are also discovering that integrating these products with a retiree’s withdrawals from accumulated savings can present some challenges.  I discussed the potential pluses and minuses of QLACs in my post of July 12, 2015.  Last month, The Stanford Center on Longevity, in coordination with the Society of Actuaries’ Committee on Post-Retirement Needs and Risks, published interim results of Phase 3 of their series on optimal retirement income solutions in DC plans entitled, “Using QLACs to Design Retirement Income Solutions.” This report correctly notes that buying QLACs complicates the spending budgeting process to some degree by introducing the potential for a discontinuity before and after the date that the QLAC payments are to commence (assumed to be age 85 in the report).  The report cites three key challenges for retirees and their advisors when buying QLACs:

• Determining the percentage of initial assets devoted to the QLAC. 
• Developing a SWP [Systematic Withdrawal Plan like the Actuarial Approach] withdrawal and asset allocation that minimizes disruptions in the amount of income between ages 84 and 85.
• Deciding whether the QLAC pays a death benefit before age 85, with the resulting drop in expected retirement income.

This post will discuss how these challenges can be addressed utilizing the Actuarial Approach and the “Excluding Social Security V 3.0” spreadsheet found in the “Articles and Spreadsheets” section of this website.   We will use Max, a 65-year old male retiree, to illustrate certain concepts.   At the beginning of the year, Max has accumulated savings in an IRA of $800,000 and an annual Social Security benefit of $20,000 per year.  To simplify the example, we are going to assume that Max uses the recommended assumptions to determine how much of his accumulated savings may be spent in his first year of retirement (i.e., he does not disaggregate his expenses into categories such as essential, non-essential, etc and use different assumptions or desired spending patterns for each spending category).  Under the recommended assumptions (and assuming no amounts to be left to heirs), he determines that $34,802 of his accumulated savings (4.35% of $800,000) may be spent during the first year, and therefore his total spending budget for the year, including Social Security, is $54,802 ($34,802 + $20,000).

Before he finalizes his spending budget for the year, he decides that he would like to see what the effect might be if he were to buy a QLAC with some of his IRA money.  So he goes to Immediateannuities.com and determines that if he pays an immediate premium of $100,000 he could receive a single life annuity commencing at age 85 of $4,406 per month ($52,872 per year) with no benefit payable to him or his heirs if he dies prior to age 85.  He then goes back to the spreadsheet on this website and enters $700,000 instead of $800,000 in accumulated savings ($800,000 – the $100,000 premium for the QLAC), $52,872 in Annual Deferred Annuity benefit to commence in the future and 21 as the Deferred Annuity commencement year.  All the other input items remain the same as above.  The spreadsheet tells him that $38,337 of his accumulated savings (5.48% of $700,000) may be spent during the year and his total spending budget would be $58,337 ($38,337 + $20,000 from Social Security, or about 6.5% higher than his spending budget without the QLAC).  He looks at the inflation-adjusted runout tab and sees that if all the assumptions are realized in the future (and inflation is 2.5% per annum), the sum of the withdrawal from savings plus the fixed dollar benefit from the QLAC is expected to be $38,337 in each of the next 30 years.  He also sees that his expected accumulated savings is only $85,184 at age 85 when payments from the QLAC are to commence as compared with inflation-adjusted assets of $319,524 at age 85 if he didn’t buy the QLAC.  Thus, while buying the QLAC can increase Max’s real dollar spending budget, it comes at the cost of increased spending from accumulated savings and therefore lower expected accumulated savings in later years, all things being equal.  Max also looks at the effect on his spending budget of starting his QLAC at age 80 rather than 85 and the effect of buying a QLAC with various death benefits, by inserting the different benefit amounts payable under different payment forms for a $100,000 premium from Immediateannuities.com.

Despite the possibility of having lower accumulated savings in later years, Max likes the increase in his real dollar spending budget that he can achieve with the single life QLAC with no death benefit payable starting at age 85, and decides to see what the effect would be if he paid $125,000 for a QLAC (the maximum under the IRS for Max under current regulations) rather than $100,000.  So he enters $675,000 in accumulated assets ($800,000 - $125,000), a $66,096 deferred annuity amount (from Immediateannuities.com) and 21 as the commencement year.  The program tell him that the “goal cannot be achieved”, which means that under the input assumptions, total constant dollar spending from withdrawals and the QLAC for the entire input period cannot be achieved (input accumulated savings are insufficient to meet the constant dollar spending goal).  Max has a number of options at this point, including living with a possibility that there will be a discontinuity in his real dollar spending budget at (or after) age 85.  For example, if he inputs 20 years for the “expected payout period”, zero deferred annuity and $675,000 of accumulated assets, he can expected, under the recommended assumptions to have an annual real dollar spending budget (not including Social Security) of $40,300 prior to age 85 and a fixed dollar benefit from the QLAC of $66,096 ($40,336 in real dollars at age 85 and decreasing thereafter, not including Social Security). 

So, let’s assume that Max chooses the no death benefit QLAC commencing at age 85 with the $100,000 premium.  Every year in the future, he will re-run the spreadsheet with new numbers and assumptions.  Depending on his actual investment experience, he could run into one or more years in which he sees “goal not achieved” if he suffers significant investment losses.  For example, if he inputs a -20% investment return in the first year of the 5-year projection (in the 5-year projection tab), he will see “value” which is equivalent in the 5 year projection tab to “goal not achieved.”  If this possibility is bothersome to Max, he has a number of alternatives, including choosing to buy a QLAC that pays lower benefits or investing his accumulated savings more conservatively to avoid significant losses.

I’ve used Max to illustrate how the Actuarial Approach and its simple spreadsheet can be used (along with QLAC quotes from Immediateannuities.com or from some other source) to address the three “challenges” associated with buying QLACs described above.  The authors at The Stanford Center on Longevity state that “Integrated SWP/QLAC strategies are ‘easier said than done’.”  I agree.  However, if you like the basic concept of a QLAC, I encourage you to play with our spreadsheet to determine how much QLAC you may want to buy and to use the spreadsheet and the Actuarial Approach to coordinate your pre-and post QLAC commencement periods.  Almost all other systematic withdrawal approaches are not even in the same league as the Actuarial Approach in terms of effectively addressing the three challenges discussed in the Stanford/SoA interim paper.

5 Ways to Increase Your Near-Term Retirement Spending Budget

In our post of August 31, 2014, Managing Your Spending in Retirement—it’s Not Rocket Science, we set forth a simple four-step process for managing spending:

Step 1:  Develop a reasonable spending budget

Step 2:  Determine your spending needs/living expenses for the upcoming year

Step 3:  Compare results of Steps 1 and 2 and make necessary adjustments to bring them into balance (i.e., reducing expenses, increasing the budget or some combination of these two actions), and

Step 4:  Rinse and repeat at least once a year.

For purposes of this post, we will assume that you have crunched your numbers, the result of Step 2 is larger than the result of Step 1 and you would prefer to increase your near-term spending budget rather than decrease your current living expenses.  We will look at some of your options.  Remember, however, that since you can either spend more in the near-term or you (or your heirs) can spend more later, you may not be all that comfortable increasing your risk of possible real dollar spending reductions as you get older under some of the more aggressive approaches below.  You can use the spending spreadsheets in this website to quantify the possible effects on your current spending budget of adopting these approaches.

1. Find part-time work or other sources of income.  Perhaps the best way to increase your current spending budget is to go out and find additional sources of income.   This can involve a part-time job such as becoming an Uber driver or additional income from renting out one of your rooms through an organization like Airbnb.  If you are lucky, it may involve an inheritance from one of your relatives or friends.  It can also involve reverse mortgages or funds you expect to receive in the future from the sale of your home or from other assets. 
2. Defer commencement of Social Security and/or purchase immediate or deferred annuities.  As discussed in previous posts, implementing these approaches (which involve mortality pooling credits) can enable you to increase your near-term spending budgets because some or all of the future expenses you previously needed plan for will be covered by these lifetime guarantees.
3. Use more aggressive assumptions.  The recommended assumptions for determining a spending budget for 2015 under the Actuarial Approach were:  4.5% investment return, 2.5% inflation and an expected age at death of 95 (or life expectancy if greater).   The rationale for selecting these assumptions was discussed in more detail in our post of February 14, 2015, but suffice to say that many investment advisers would find a 4.5% annual rate of investment return (2% real) to be relatively conservative for most investment portfolios.  Also, until you reach your late 80s, the recommended expected lifetime assumption is longer than life expectancy, which could also be perceived as a conservative assumption.  I stand by my recommended assumptions (for the reasons noted in the February 14 post), but if you are willing to increase your risk of future real dollar spending decreases, you can develop your budget by running the spreadsheets in this website with higher assumed real rates of investment return and/or lower expected payment periods.
4. Use more aggressive assumptions only for non-essential expenses.  This is a variant of item 3  for individuals who aren’t comfortable taking the risk of being too aggressive for all expenses, particularly essential expenses, but are more comfortable assuming an increased risk of declining future real dollar non-essential expense budgets.  Some experts believe that such expenses generally decline with age.
5. Increase your budget by X%.  This final option is equivalent to making a conscious decision that you are going to spend what you want as long as it is within x% of your calculated budget.  Clearly if you do this on a consistent basis, you are more likely to experience decreases in future real dollar spending budgets, but this may not be a significant issue for you.  

Of course it is also important to remember that in addition to increasing the risk of declining real dollar spending later in retirement as a result of too much spending early in retirement, spending budgets can also go up or down temporarily as a result of investment performance.  If you want to stress test your spending budget for variations in investment performance, you can model future experience with the 5-year projection tab in the “Excluding Social Security V 3.0” spreadsheet. 

Retirement Researcher Endorses Qualified Longevity Annuity Contracts

In his recent article in Advisors Perspectives, Why Advisors Should Use Deferred Income Annuities, Dr. Michael Finke touts the benefits of including Qualified Longevity Annuity Contracts (QLACs) in a retirement portfolio.  Dr. Finke is a Professor and Director, Retirement Planning and Living at Texas Tech University. 

I agree with the points made by Dr. Finke, as his article is very similar to my post on the pluses and minuses of QLACs on July 12, 2015.  Readers who want to dive deeper into QLACs can also revisit my posts of May 28, 2015, April 26, 2015, February 25, 2015, July 31, 2014 and July 26, 2014 for further discussion. 

As I have indicated many times in this blog, The Actuarial Approach is probably one of the only strategic withdrawal approaches that easily and properly coordinates withdrawals from investments with benefits payable from a QLAC. 

Year end is coming soon.  Next month I will be re-visiting my recommended assumptions for developing 2016 spending budgets. 

Let me take this opportunity to wish all my readers a happy and safe Thanksgiving.

Actuary Discovers Chinks in Monte Carlo Modeling Armor

In his recent article in Advisor Perspectives, fellow actuary Joe Tomlinson raises serious credibility concerns about Monte Carlo simulations that use historical data to calculate the expected equity premium for stocks when such simulations are used to determine how much wealth to spend down during retirement.    Mr. Tomlinson points out that out limited statistical evidence regarding equity premiums produces levels of uncertainty that are unacceptable to most clients. 

As I have indicated in prior posts (see for example my posts of July 15 of last year and January 24th and 25th of this year), I am not a buyer of the supposed superiority of Monte Carlo modeling as a tool for developing reasonable spending budgets for retirees.  These Monte Carlo models are also frequently used to develop static withdrawal strategies (see my last post for discussion of the superiority of dynamic over static approaches).  Mr. Tomlinson article confirms some of my major concerns about using Monte Carlo simulations and static approaches.

While the simple spreadsheets provided in this website can accommodate higher equity premium investment return assumptions, I recommend (at least for determining essential expense budgets) that retirees use an investment return assumption that is approximately equivalent to interest rates baked into single premium immediate life annuities at the time of determination.  For example, an immediate monthly life annuity of $582 ( yesterday from Income Solutions.com) for a 65-year old male with a life expectancy of 274 months under the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality projection translates into approximately a 4.5% annual interest rate.  As I have previously indicated, including riskier assets in your portfolio (such as equities) can increase your expected rate of return, but it will also generally increase variability and therefore may not increase your annual spending budget over the long-run. 

The Actuarial Approach is a dynamic approach that involves periodic (usually annually) remeasurement of the retiree’s assets and liabilities and possible periodic adjustments to the spending budget, not a one-and-done static approach developed using Monte Carlo modelling.  I caution you to question the data used in Monte Carlo simulations producing a spending budget for you that significantly differs from the budget you (or your financial advisor) develop using the Actuarial Approach.  

Budget Pun of the Day (My first and probably my last one):  You’ll feel Stuck with your debt if you don’t properly Budge it.

Retirement Researcher Quantifies Benefits of Dynamic Withdrawal Strategies

Thanks to Nelson Murphy for drawing my attention to an article in the Summer, 2015 edition of The Journal of Retirement Research, by David Blanchett, Head of Retirement Research for Morningstar Investment Management.  The article is entitled, “Dynamic Choice and Optimal Annuitization.”  This article is fairly technical, but I found the investment of time and energy required to wade through it to be generally worthwhile.

As a result of his analysis, Mr. Blanchett concludes that “there is a significant potential benefit to retirees who implement dynamic strategies.”  He defines  static strategies as those where the retiree makes decisions only at retirement (such as the 4% withdrawal rule or other types of safe withdrawal rule approaches) and dynamic strategies as those that involve intelligent changes during retirement (such as the approach advocated in this website).  He also looked at dynamic vs. static annuitization strategies, but the differences in these two types of strategies was not as significant.

The dynamic withdrawal strategy used by Mr. Blanchett is approximately mathematically equivalent to the approach advocated in this website (assuming the retiree has no fixed dollar immediate or deferred annuities, no fixed dollar pension benefits and no specific bequest motive) and the same assumptions are used for investment return, inflation and mortality.  If, instead of using the recommended assumptions in this website, you use Mr. Blanchett’s assumptions of 3% investment return, 2.5% inflation and life expectancy based on the Society of Actuaries 2012 Individual Annuity Mortality Table (without mortality improvement), you will develop roughly the same withdrawal rates shown in Exhibit 1 of Mr. Blanchett’s article.

Through his simulations, Mr. Blanchett also develops optimal levels of annuitization for retirees with different shortfall preferences, different bequest motives and different expected life expectancies.  Of course the results of any analysis like this are dependent on the assumptions used and the assumed portfolio investment mix over the life of the retiree.  The future economic assumptions employed by Mr. Blanchett include a 2.5% inflation rate, 3% bond yields, 9% per annum equity returns (with a standard deviation of 9.4%) and 50 basis point annual fee.   The retiree is assumed to maintain a 40% equity/60% fixed income portfolio throughout retirement.  While the optimal level of annuitization developed by Mr. Blanchett using these assumptions was lower with the dynamic withdrawal strategy than with the static withdrawal strategy, there were still some scenarios where annuitization was still optimal.  Even though he assumed a 6.5% annual real rate of return on equities, on average annuitization was optimal for at least 25% of the retiree’s portfolio (in addition to Social Security) under these modeling assumptions as shown in his Exhibit 2.

Mr. Blanchett concludes that “implementing a dynamic withdrawal strategy alone (without annuities) resulted in higher levels of utility-adjusted wealth than a static withdrawal strategy that included both optimal immediate annuitization as well as dynamic annuitization.”  He also concludes that delaying purchase of annuities for a while does not significantly affect outcomes for retirees compared with immediate purchase of annuities at retirement.

Bottom line:  There were two things I liked about Mr. Blanchett’s research:  1) He favored a dynamic withdrawal approach very similar to the approach advocated in this website and 2) depending on their preferences and circumstances, retirees should consider investment of some percentage of their retirement portfolio in annuities.

Social Security Reform—Some Solutions are More Sustainable than Others

As discussed in my posts of March 1 and May 3 of this year, I occasionally get drawn into commenting on US Social Security System financing issues. While these issues are somewhat technical, I believe they are important and, in the long run, can affect many of the individuals who visit my site looking for advice regarding budgeting in retirement.  Therefore this post will be another Social Security financing article with the purpose  of warning my U.S. readers  about frequently made claims regarding the long-term sustainability of specific reform proposals.  As we get closer to 2034 (the trust fund exhaustion date expected for Social Security under the intermediate assumption set selected by Social Security actuaries and the System’s Trustees in the most recent Trustees’ report), we are seeing a rash of proposals to solve the System’s financial problems.  Many of these proposals quantify just how much of the System’s “funding problem” will be solved by a specific reform proposal.  For example, in the American Academy of Actuaries recently released “Social Security Game,” the Academy states that raising the payroll tax from 6.2% to 7.4% (for both employees and employers) “will solve 85% of the problem".  Further, if you combine that change with a 1% decrease in the cost of living increase, the Social Security Game will tell you, “Congratulations, You have won the game by fixing Social Security.” 

While I understand the Academy’s desire to engage the public in a discussion about Social Security’s reform options, I am concerned that statements such as these can mislead the public and our policymakers.  I was frankly surprised (and more than a little disappointed) that my profession (a profession that claims to serve the public, one that stresses sustainability in our financial systems and one that has stated it “believes that any modification to the Social Security system should include “sustainable solvency” as a primary goal) is ignoring the concept of “sustainable solvency” and is claiming in this “Game” that eliminating Social Security’s current 75-year actuarial deficit will solve Social Security’s financial problems.  It should be noted that the Academy is not the only organization to utilize the 75-year actuarial deficit in this manner.  

While reducing the 75-year actuarial deficit is a reasonable first step, there are two problems with any proposed reform
options that simply reduce Social Security’s 75-year actuarial deficit to zero: 

1. Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period.  Over time, these deficits will emerge in the actuary’s annual calculations.
2. There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities.  Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources. 

We need look no further than the 1983 Amendments to Social Security (which eliminated the 75-year actuarial deficit in existence at that time) for an example of how these two problems interacted to put us in the financial position in which we presently find ourselves.   Social Security Administration Actuarial Note Number 2015.8 tells us that of the total increase in the 75-year actuarial deficit of 2.69% of taxable payroll since 1983, 70% of the increase (or 1.90% of taxable payroll) was attributable to changes in the valuation date (problem #1 above), leaving 30% (or .79% of payroll) attributable to all other causes.  Since no action was taken in response to these emerging deficits over the past 31 years (problem #2 above), we are now looking at projected trust fund exhaustion in 2034 under the best estimate assumptions. 

As a result of these two problems, Social Security is now looking at a shortfall of projected revenues compared with projected expenditures.  And we have unlimited supply of possible actions that Congress can adopt to address this shortfall, generally involving some combination of revenue increases and expenditure decreases.  Because it was discussed on page 25 of this year’s annual Trustees’ Report, I’m going to focus on two alternative reforms involving only tax increases.  I’m doing this to illustrate reform option concepts, not to recommend that reform options should only involve tax increases.   The same concepts generally apply if expenditure reductions or combinations of revenue increases and expenditure decreases are adopted. 

The graph below shows two alternative tax rate scenarios that would be expected, if all the intermediate assumptions made in the 2015 Trustees’ report were exactly realized over the next 75 years, to cover projected System benefits over the next 75 years, leaving almost no trust fund at the end of 2089.  Under the “wait for trust fund exhaustion” alternative, we would keep the tax rate at its current combined employer-employee level of 12.4% until 2034 at which time it would increase to 16.1% and then gradually increase thereafter (I have assumed straight-line increases) to 17.4% in 2089.  I have also assumed that the necessary tax rate for years thereafter would remain at the 17.4% level.   The second option shown in this graph is the “75-year solution (2015)” which reduces the 2015 75-year actuarial deficit to zero by increasing the current tax rate from 12.4% to 15.02% in 2015.  Since this solution only lasts for 75 years, the graph shows that the tax rate would also need to be increased in the year 2090 to 17.4% when the trust fund accumulated under this option would be expected to be depleted.  This graph illustrates a very important financial principle:  the magic of compound interest.  Even for a program that many experts claim is a pay-as-you-go system, you can pre-fund your liabilities.  By contributing 15.02% for 75 years, you can avoid higher tax rates for the period 2035 to 2089.  The concepts illustrated in this graph are also used by individuals who argue that fixing the system now can avoid higher tax rates or lower benefit levels later on.  Of course this same argument can be employed by those who would like to see smaller periodic adjustments to the program rather than infrequent large increases (to address Problem #2).

 

(click to enlarge)

In an effort to deal with Problem #1 above, the Office of the Actuary of the Social Security Administration developed the concept of “sustainable solvency.”  Under this concept, “the projected trust fund ratio is positive throughout the 75-year projection period and is either stable or rising at the end of the period (emphasis added).”  As with other ways to solve system problems, there are a number of ways that sustainable solvency can be achieved.  For example, in addition to a 75-year solution, you could adopt additional tax rate increases that take effect 65 or 70 years from now so that the relatively low trust fund ratios at the end of the period remain stable at the end of the 75-year period.  Because there exist many different ways to achieve sustainable solvency, the Trustees’ Reports do not quantify changes necessary to achieve it.  Also, for this reason, organizations like the American Academy of Actuaries focus only on communicating the presumably more quantifiable 75-year solutions.  It should be noted, however, that even though adoption of a reform package that achieves sustainable solvency will address Problem #1 above, it does not address Problem #2 above.  
 
The graph below modifies the graph above by inserting a third line, labeled “sustainable solvency solution (2015)”.  This line is estimated by me.  As discussed above, there are many different approaches that could achieve sustainable solvency, but I have selected one (a level tax rate similar to the approach used for The Canada Pension Plan) that I would expect to meet the criteria for sustainable solvency under the assumptions described above.  This approach would involve an immediate 3.6% of taxable payroll increase in the current tax rate of 12.4% to about 16%.  By comparison, the 2015 Trustees’ report indicates that the shortfall over the infinite projection period is 3.9% of taxable payroll.  Note also that this graph could have a fourth line representing a combination of the 75-year solution and periodic increases after 2015 to address the expected deficits that would occur as a result of Problem #1.  This line would be expected to start at about the 15% of pay level and slowly increase as deficits are recognized.  This fourth line would be expected to end above the sustainable solvency (2015) line and below the 75-year solution line. 


 

(click to enlarge)

Conclusion—Some Solutions are More Sustainable than Others
   
In its Public Policy White Paper, Sustainability in American Financial Security Programs, the Academy’s Public Interest Committee said, “Sustainability is enhanced when the funding source and the benefits promised remain balanced over the lifetime of the program.”  I agree and further believe that Social Security solutions that anticipate significant tax increases in the future (other than perhaps ones to phase in tax increases over a relatively short time period) to support promised benefit levels are less sustainable than approaches that don’t.  For this reason, I caution readers to question 75 (or lower)-year solutions, and, as part of the next round of system reform, I encourage policymakers to adopt an automatic approach designed to maintain the balance between system assets and liabilities in the future.  As suggested in my May/June, 2015 Contingencies article, we can learn a lot about sustainable solutions in the U.S. from the actions taken almost 20 years ago to reform The Canada Pension Plan.  In furtherance of its mission, I also encourage the Academy to advocate these more sustainable solutions rather than appearing to endorse problematic 75-year “solutions” in their “Game.”

Actuaries Release Five New Issue Briefs on Retiree Lifetime Income

As a follow-up to their 2013 Public Policy Discussion Paper, “Risky Business—Living Longer Without Income for Life” (discussed in our post of June 20, 2013), the American Academy of Actuaries’ Lifetime Income Risk Joint Task Force recently released a flurry of Issue Briefs on Retiree Lifetime Income.  The five issue briefs are titled,

1. Retiree Lifetime Income:  Choices and Considerations 
2. Retiree Lifetime Income:  Product Comparisons
3. Risky Business:  Living Longer Without Income for Life—Legislative and Regulatory Issues
4. Risky Business:  Living Longer Without Income for Life—Actuarial Considerations for Financial Advisers, and
5. Risky Business:  Living Longer Without Income for Life—Information for Current and Future Retirees

The Issue briefs can be found on the Task Force’s webpage.  There is a lot of good material contained in the issue briefs, and I encourage you to read some or all of them.  
  
The stated goal of the Academy’s Task Force is to educate the public, financial advisors, employers, the media, lawmakers and regulators on the risk of inadequate guaranteed lifetime income.  As may be expected from a group of actuaries with this goal, the issue briefs tend to stress the advantages of risk sharing (or risk pooling) arrangements (annuities and defined benefit pension benefits).  However, this most recent batch of issue briefs does not focus exclusively on the advantages of annuity products and the disadvantages of structured withdrawal programs.   They do acknowledge that there can be advantages of combining the two approaches.  For example the following guidance is contained in the Actuarial Considerations for Financial Advisers brief:

“A judicious use of pooling-based solutions, integrated with appropriate investment strategies, can often yield a more favorable financial result than one that fails to take pooling into appropriate consideration.”

I was also pleased to see that the Financial Advisers brief included the following recommended task, which is a common theme expressed in my website

“Assuring that recommended systematic withdrawal strategies meet client objectives and also appropriately reflect the existence or absence of pension benefits or insurance-based solutions that incorporate risk-pooling features.”

Sharp-eyed readers who go to the Task Force website may see my name included as a Task Force member.  Yes I did recently join this group, but for the most part, most of these Issue Briefs were drafted prior to my arrival. 

Does New Math Clearly Demonstrate that People Should Delay Commencement of Social Security Benefits When Possible?

Apologies to my non-US readers as I will once again take on the subject of when to commence US Social Security benefits.  This post is in response to the October 23 article in The Wall Street Journal entitled, "The New Math of Delaying Social Security Benefits”, in which Dr. Pfau concludes, “the math is clear:  People should delay claiming when possible.”

As I have discussed in several prior posts (most recently in posts of September 25, 2015, April 16, 2015 and August 9, 2014) and based on the “old math” built into the simple Social Security Bridge spreadsheet on this website, deferring commencement of Social Security benefits can be a reasonably good strategy for many individuals, but it may not be all that it is cracked up to be by the media experts. 

I’m going to use the same example person in this post as Dr. Pfau used in his article (which I suggest that you read because I’m not going to repeat the entire example here).  His example person sets aside assets of $316,800 in a non-interest bearing account to pay herself $39,600 per year (the age 70 Social Security benefit without CPI increases) during the eight year bridge period (from age 62 to age 69) during which no Social Security benefits are paid.  He then determines that the initial withdrawal rate at age 62 from remaining assets necessary plus the withdrawals from this artificial Social Security replacement account to meet a $60,000 annual real dollar total income level is only 4.22% vs. a 4.69% initial withdrawal rate necessary to meet the $60,000 total income level if she commences her Social Security benefits at age 62.  From this comparison of initial age 62 withdrawal rates, Dr. Pfau concludes that it is financially advantages for everyone to defer commencement of Social Security from age 62  until age 70.

If we assume inflation of 2.5% per year and we assume that the example retiree wishes to pay herself the expected age 70 Social Security benefit in real dollars each year during the bridge period, she will need to set aside assets of $345,951.  Under these assumptions, the initial age 62 withdrawal percentage to achieve the $60,000 income target will be 4.49% ($60,000 – $39,600)/ ($800,000 - $345,951) vs. the 4.69% withdrawal rate if she commenced Social Security at age 62.  This example still favors the deferral strategy, but not by quite as much.

If we also assume investment return of 4.5% per annum on the example retiree’s assets not set aside for bridge purposes, at age 70, she will have remaining assets of $428,583 to go with her Social Security benefit of $48,249 ($39,600 plus eight years of CPI increases of 2.5% per annum).  By comparison, if she commenced benefits at age 62, she would have $738,560 of remaining assets at age 70 and a Social Security benefit of $27,414.  Thus, under these assumptions, she effectively spends $309,977 ($738,560 - $428,583) of her expected assets at age 70 ($35,974 less than the $345,951 she set aside) to obtain an additional $20,835 ($48,249 - $27,414) of fully CPI-indexed Social Security benefits commencing at age 70. 

As noted in prior posts on this subject, deferring commencement of Social Security can increase total retirement income under most reasonable assumptions.  This strategy also adds inflation protection and can provide larger benefits to your spouse.  If you want to retire and adopt the commencement deferral strategy, you have to be willing to dip into your accumulated savings to make it work (and therefore this strategy may involve loss of some spending flexibility).  The degree of success of the commencement deferral strategy will depend on the investment return you could have earned on the "bridge payments" you withdraw from your accumulated savings, the rate of future inflation, how long you live and how much of your accumulated savings you spend during the bridge period.  Assuming Social Security law remains unchanged, it can be an effective way to mitigate inflation risk, investment risk, and longevity risk.  In a very real sense, the decision to defer is analogous to using your savings to purchase additional longevity insurance/real annuity income.  However, under most reasonable assumption scenarios, you aren’t likely to see the increases in total retirement income that you might have expected from reading articles on this subject by the retirement experts. 

I recommend that retirees who are reasonably comfortable spending a significant portion of their accumulated savings up front during the bridge period consider the commencement deferral strategy.  On the other hand, I am also sensitive to retirees who could have made this decision but didn’t or who are just not comfortable with this strategy.  To them I say, Don’t listen to those experts who say that not deferring until age 70 is one of the biggest mistakes you can make in retirement.  Move on with your life based on the decision you made (or will make).  If it is indeed a mistake not to defer, it is probably not the biggest mistake you will make in retirement. 

As with all my prior posts on this subject, I (and Dr. Pfau in his article) looked at non-married individuals.  The factors involved in a decision to defer can be different for a married individual under current law. 

All About that Budget

If I had to pick a theme song for this website, I guess I would have to consider Meghan Trainor’s popular song with a small modification.  While Meghan sings, “Because you know I’m all about that bass”, this website is all about a different “B” word—“Budget.”   Yes, the primary purpose of this website is to help retirees develop a reasonable spending budget.    Pretty much this entire website is devoted to this task; a task that a lot of retirees don’t even bother with, or if they do bother with it, they frequently ignore it when it comes to making spending decisions.   Does the fact that a lot of retirees don’t develop a budget or ignore their budget bother me?  Not particularly.  Unlike many experts who think that most retirees aren’t smart enough or motivated enough to manage their own money, I believe that most retirees possess the necessary skills to successfully manage their finances in retirement, much like they successfully managed their finances when they were employed.  Of course, for those retirees who can afford one, a financial advisor can be very helpful in this process.   However, when push comes to shove, it is you, Mr. or Ms. Retiree, who are ultimately responsible for making the investment and spending decisions that affect your financial situation during your retirement.  If you are reading this post, I hope it is because you are interested in learning about and taking advantage of the benefits of having a reasonable spending budget. 

You won’t find anything in this website that suggests how much of your accumulated savings or other sources of retirement income you should spend each year.  As noted above, that decision is yours based on your own personal situation.  I’m not going to chastise you for spending more (or less) that the budget amount you may develop using the Actuarial Approach.  In fact, it would be unusual if you did spend exactly the amount that you budgeted each year.  However, one of the primary benefits of developing a spending budget is to help you make your spending decisions. 

You also won’t find anything in this website that suggests that you should develop a spending budget any more frequently than annually.  There may be reasons why you may wish to develop a monthly spending budget (for example if you are trying to reduce your spending), but again, I will leave that decision up to you.

While I think it is worthwhile to track actual spending for the year to compare it with the spending budget, doing so is a fair amount of work that may not provide a lot of value to you.  There are software programs that can help you with this task, but again, tracking actual spending can be time-consuming and it is not necessary to keep your budgeting on track.  Under the Actuarial Approach, simply comparing your actual end of year assets with your expected end of year assets will give you an indication of the total gain or loss for the year resulting from the combination of spending deviations and investment deviations.  As indicated in my September 4, 2015 post, it may make sense during the middle of a year to compare actual assets with expected end-of-year assets to see how you are doing during the year for the purpose of helping you make spending decisions for the rest of the year. 

I also think it can be worthwhile to develop separate budgets for different types of expenses.  In prior posts, I have encouraged you to develop separate budgets for such different types of expenses as essential non-medical expenses, essential medical expenses, bequest motive/end-of-life expenses, other unexpected expenses and non-essential expenses.  The reason for doing this is that you may have different goals and investment strategies for these different types of expenses that may require different approaches.

Prior posts have also indicated why I think it is important to develop a spending budget that reflects the existence of other sources of retirement income that you may have.  Most other withdrawal strategies simply provide a suggested way to “tap your savings” and fail to suggest how to develop a reasonable spending budget (or budgets). 

While not every financial expert believes that budgets are essential (especially monthly budgets), many experts do.  Here are a couple of recent articles touting some of the benefits of developing a budget. 

5 Ways to Save Money During Retirement (US News)

8 Things Not to Do in Retirement (GoBankingRates)

Making Sense Out of Variable Spending Strategies for Retirees?

In his October 2, 2015 blog post, Dr. Wade Pfau, Professor of Retirement Income at The American College, reprinted his article from the Journal of Financial Planning, Making Sense Out of Variable Spending Strategies for Retirees. The stated purpose of this article was to “assist financial planners and their clients in figuring out which sort of variable spending strategy will be most appropriate for their situation [by using] simple metrics to evaluate and compare strategies.” See my post of March 19th of this year for my initial thoughts on this paper.  Today’s post will supplement my earlier post with additional thoughts on this article.

Perhaps the most interesting part of Dr. Pfau’s article is his suggestion that financial advisors use his “XYZ Formula” approach to help clients select a combination budget setting strategy (variable spending strategy) and investment strategy.  Under this approach, the financial advisor uses Monte Carlo modeling and the client’s specific information to help the client select the combination budget setting and investment strategy that has an “X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement”, where the client (with the advisor’s help) chooses the values of X, Y and Z, presumably in accordance with the client’s risk preferences.  The XYZ formula approach assumes that the client’s spending will exactly equal the client’s spending budget so determined each year.  

Even though it is based on the unrealistic assumption that retiree spending will actually equal the spending budget resulting from application of variable spending strategy,  I believe that Dr. Pfau’s approach can provide some value to retirees.  However, rather than providing a broad analysis of various combinations of budget setting strategies and investment strategies for hypothetical clients with different situations, Dr. Pfau instead holds investment allocations constant, fixes values of X,Y and Z and looks at a client that (with one notable exception) has no pension/annuity income.  The purpose of fixing these items was presumably to isolate differences attributable to differences inherent in the variable spending strategies. 

I was pleased to see the Actuarial Approach advocated in this website included in Dr. Pfau’s list of examined variable rate strategies (albeit grouped with other so-called actuarial strategies).  I was also pleased that Dr. Pfau concluded, “The actuarial methods were found to spend down wealth more efficiently.”  However,  I feel compelled in this post to (i) respond to a specific comment made in the article about application of smoothing to my approach and (ii) point out why my approach is superior to the “PMT approach” with which my approach was grouped. 

Smoothing

In his article, Dr. Pfau says, “Steiner (2014) suggested that users may smooth spending adjustments relative to the changes implied by this formula. Not all would agree, as Waring and Siegel (2015) noted that a less volatile asset allocation is a safer way to smooth spending fluctuations.”  While I certainly don’t have a problem with the position that a less volatile asset allocation is a reasonable way to manage volatility in spending budgets,  I believe Waring and Siegel’s suggestion that spending budgets not be smoothed is ridiculous.  For most retirees, a spending budget is simply a suggestion as to how much the retiree may want to spend for the year.  Only retirement academics and other Monte Carlo modelling advocates assume that retirees will actually spend their spending budget each year (and only as a calculation expediency).  It therefore makes no sense to me to require a spending budget to be based on strict (non-smoothed) application of a formula if the retiree can then choose to spend whatever he or she wants.  

Actuarial Approach vs. PMT Approach

Waring and Siegel’s ARVA (PMT) approach is essentially mathematically equivalent to the simple spreadsheet included in my website if the retiree has no fixed dollar pension or annuity income.  If the retiree has a fixed dollar pension benefit, a fixed dollar immediate annuity or a fixed dollar deferred annuity, the PMT approach can’t properly handle it.

It is ironic to me that the approach that appears to produce the most favorable results in Dr. Pfau’s article (at least in terms of initial spending rates under the given XYZ specifications) is the “Annuitize Floor and Aggressive Discretionary Spending” approach.  This isn’t really a different variable rate spending approach, but rather a combination of a different investment strategy (partial annuitization) with the Guyton decision rules.  As noted in previous posts (most recently my post of April 26, 2015), I’m not a big fan of the Guyton decision rules, but inclusion of this final option does illustrate the potential benefits of partial annuitization for risk averse clients.  It also indirectly points out the importance of using a variable spending strategy that properly coordinates with fixed dollar pension and annuity benefits.  And once again, I will end a post by noting that the Actuarial Approach is the only one of the variable spending strategies listed in Dr. Pfau’s article that does this. 

Fear of Outliving Your Savings vs. Fear of Not Spending Enough—Finding an Appropriate Balance

In his September 29 article for US News, Why You Won’t Run Out of Money in Retirement, David Ning outlines several safeguards that he believes “will prevent you from spending your savings too quickly.”  He indicates that you “aren’t likely to completely run out of money in retirement,” and therefore you shouldn’t “let the fear of outliving your savings prevent you from enjoying retirement.” One of the safeguards recommended by Mr. Ning is to withdraw only 3% or 4% of accumulated savings each year. 

I agree with Mr. Ning that retirees shouldn’t let the fear of outliving their savings prevent them from enjoying retirement.  On the other hand, simply taking steps to make sure that you don’t spend your savings too quickly (by using a conservative 3% or 4% withdrawal rate) is only part of the equation for enjoying retirement.  Another critical part of this equation is spending enough each year to maintain a certain standard of living, including spending on non-essential items.  Therefore, what retirees really need is a Goldilocks-type solution that involves not only not spending too much but also not spending too little.  Unfortunately, since no one knows, for certain, things like how long you will live, what your investments will earn, what future inflation will be, etc., there can be no such Goldilocks solution. 

The Actuarial Approach discussed in this website attempts to help retirees find the appropriate balance between spending too much and spending too little.   If you use our recommended assumptions to develop some or all of your annual spending budget and invest your accumulated savings reasonably well, you will likely end up with more assets than you desire upon your death (even though withdrawal rates for retirees with no pension/annuity income and no amounts to be left to heirs under the Actuarial Approach will exceed 6% at ages above 75, compared with the 3% or 4% withdrawal rate suggested by Mr. Ning.)

More effective safeguards to balancing not spending too much and not spending too little (as well as achieving ancillary goals such as: (i) having relatively predictable and stable inflation adjusted income from year to year, (ii) having spending flexibility to meet unforeseen expenses, (iii) maximizing the general level of spendable income and (iv) not leaving too much unspent upon death) include using the Actuarial Approach to develop separate spending budgets for essential expenses, non-essential expenses, long-term care/other end of life expenses, and unexpected expenses with appropriate investment strategies for the funds dedicated to these separate spending budgets as discussed in recent posts. 

Another Look at Deferral of Commencement of Social Security Benefits

My retired neighbor, Leon, is turning age 62 in the near future.   A couple of days ago, when I was out performing what our dog believes is my primary purpose in life (being his personal bathroom attendant), Leon asked me for my thoughts about whether he should defer commencement of his Social Security benefit.   Like everyone else, he had read many articles from experts who strongly recommend that retirees defer commencement of their Social Security benefits.  Leon pointed me to Michael Kitces’ April 2, 2014 post where Michael said, “the decision to delay Social Security actually represents an astonishingly valuable ‘investment return’.”  Leon had also done his “breakeven” calculations. 

I told Leon that while deferring commencement of Social Security could be financially advantageous, I believed (and my prior posts on this subject have indicated) that deferral is not necessarily a “no-brainer.”  The effectiveness of the deferral strategy depends on a number of considerations, including:  1) how long you will live, 2) how much savings you will use to “bridge” the period of deferral, 3) what investment return you could earn on your savings and 4) the rate of future inflation. 

The table below shows the increase/(decrease) in the present value of a retiree’s spendable income associated with deferring a $750 per month Social Security benefit payable at age 62 until age 70 vs. commencing the benefit at age 62 assuming various ages of death.  The table uses the same assumptions and hypothetical retiree as used in Mr. Kitces’ article.  The calculations were performed using the Social Security Bridge spreadsheet from this website.  

(click to enlarge)

The table shows that under these assumptions, individuals who live longer will benefit financially by deferring commencement of the benefit until age 70 vs. commencing at age 62, while those with shorter lives will benefit financially by commencing the benefit at age 62.   It also shows that even those individuals who choose to defer commencement until age 70 and live until age 97 are not expected to be huge winners under the assumptions used to develop this table. 

The table also provides survival probabilities to the various ages based on the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality improvement.  This mortality table (and the probabilities of survival) is available in our website in the “other calculators and tools” section.  It should be noted that this table represents mortality experience of individuals who purchased annuities and as such is more conservative (longer life expectancy) than general population mortality.   The probabilities of survival to age 97 for both males and females were not available from the tool on our website and have been estimated by me. 

One of the big differences between Mr. Kitces calculations and mine has to do with the amount of money spent by the hypothetical retiree from his accumulated savings during the eight year deferral period.  Mr. Kitces assumes the retiree will spend $750 per month in the first year of deferral and $922 in the seventh year ($750 increased with 7 years of inflation at 3% per year), whereas I have assumed that the retiree does not want to have a big jump in spendable income in year 8 and will spend the same real dollar amount of $1,672 the retiree expects to receive at age 70 during each year of the deferral ($1,320 per month in the first year and $1,624 per month in the 7th year).  The cost of deferrals (the present value of withdrawals from savings) under Mr. Kitces methodology is $65,258 while under my methodology, it is $114,853.  This is why deferring commencement looks so much more favorable in Mr. Kitces article (if you spend less today, you can spend more later all things being equal).  Of course, it would look even more favorable if the hypothetical retiree decided not to withdraw any amounts during the deferral period. 

As I told Leon, I’m not going to make a recommendation one way or another on whether retirees should defer commencement of Social Security.  It is an individual decision that involves many factors.   If you are willing to defer and don’t spend too much of your accumulated savings during the bridge period, you can generally increase your spendable income in your later years. 

Retirement Planning in an Uncertain World--Part 2

This is a follow-up to our post of August 11, 2013.  In that post, I included what I considered to be one of the most helpful (and most succinct) pieces of advice I have ever read regarding managing the risks involved in financial planning for retirement in today’s world.  In his MoneyWatch article of August 7, 2013, my friend and fellow actuary, Steve Vernon said,

"Step 1: Plan to support the life you want, using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.

Step 2: Be prepared in the event that your forecasts are wrong."

While the simple spending budget calculation spreadsheets (Excluding Social Security and Social Security Bridge) included in this website include a Runout tab (and an inflation adjusted Runout tab) that shows future year’s expected results based on exact realization of all the input assumptions, no changes in assumptions and spending each year exactly equal to the total spendable amount, retirees who use these spreadsheets should have absolutely no expectation that these projected future year’s results will actually occur.  They are primarily provided to show the user that the math works, and that under these totally unrealistic conditions, the amount left to heirs at the end of the expected payout period will equal the amount the user inputted on the input page. 

The fact that the future numbers in the Runout tabs will be wrong, however, does not invalidate the approach recommended in this website to determine a retiree’s spending budget.  The Actuarial Approach anticipates that a retiree’s assets and liabilities will be re-measured at least once a year to adjust the retiree’s budget for differences between actual and assumed experience, for differences between actual and assumed spending and for changes in assumptions.  This re-measurement process is essential for keeping the retiree on track.  I view this as part of Step 2 in the process Steve Vernon outlined above. 

There are lots of possible reasons why forecasts made today will be wrong (deviate from expected results) in the future.  These reasons include:

• Differences between actual and assumed investment returns 
• Changes in assumed future investment returns
• Differences in actual or assumed spending
• Differences in desired amounts to be left to heirs
• Differences in actual or assumed rates of inflation/desired increases in budgets to keep up with inflation
• Differences in actual or assumed longevity
• Differences in sources of income

Each of these differences can increase or decrease the retiree’s spending budget under the Actuarial Approach.  It is important for a retiree to realize that their spending budget can and will go up and down in future years depending on these changes.  As indicated in previous posts, the spending budget determined under the Actuarial Approach (with or without applying the recommended smoothing algorithm) is simply one of several decision factors that a retiree can use in the process of determining his or her actual spending for the year. 

Depending on the proportion of a retiree’s spending budget that is derived from accumulated savings invested in risky assets, differences between actual and assumed investment returns can have a significant effect on the retiree’s spending budget.  In order to give retiree’s a sense of how such deviations from the assumed investment return can affect accumulated savings and spending budgets, we have added a new tab to the “Excluding Social Security” spreadsheet (now called “Excluding Social Security V 3.0”).  The new tab is called “5-year forecast” and the only difference between the results shown in this tab and the results shown in the Runout tab are attributable to different investment returns inputted by the user for years 1-5 at the top of this tab.  If the same assumed investment return is input for each of the 5 years as is input for the assumed investment return in the input tab, the results shown in the 5-year projection will be the same as those shown in the Runout tab.  We have also provided two graphs which highlight the differences in beginning of year account balances and total spendable amounts (excluding Social Security and other inflation indexed annuities) resulting from investment experience different from assumed.  No smoothing algorithm was applied to the results in the 5-year projection. 

We encourage you play with the “actual” investment inputs in the 5-year projection to provide yourself a better sense of the investment risk you are assuming with your current investment strategy (or strategies).  As discussed in recent posts, if you have separate budgets for essential expenses, non-essential expenses, emergency expenses, etc. and different investment strategies for these different categories of expenses, you can “kick the tires” on these separate investment strategies to see if you are comfortable with the risk you are assuming for each expense category.  

Inspiration for this post and the resulting modification of the “Excluding Social Security” spreadsheet came from discussions with John D. Craig and from work by the Pension Committee of the Actuarial Standards Board on exposure drafts of a standard of actuarial practice regarding assessment and measurement of risk associated with measuring pension obligations.  Thanks to both John and the ASB Pension Committee.  Readers who are interested in John’s thoughts on Retirement Planning may find this website to be of interest.