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.