Warning Labels Needed for Systematic Withdrawal Plans (SWPs)?

As discussed in our post of October 27, 2016 and November 11, 2016 Advisor Perspectives article, adding

• the amount determined under one of the many systematic withdrawal plans (SWPs) advocated by retirement experts today (like The 4% Rule, for example) to 
• income available from other sources in retirement

may, in many cases, produce a spending budget that is inconsistent with a retiree’s spending objectives.

Yet, much like in the 1960’s when cigarette smoking was much more prevalent, literature advocating new and improved SWPs is ubiquitous.  For example, just this month in his Forbes article, Dr. Wade Pfau compares ten SWPs that he unfortunately misclassifies as “retirement spending strategies.”

As suggested in our Advisor Perspective article, to avoid misleading financial advisors and DIY retirees, advocates of using SWPs should make it clear that simply adding the amount developed by their SWP algorithm to income available from other sources may not be consistent with a retiree’s spending goals in retirement.  Since the Surgeon General’s cigarette warning labels have been quite successful in helping to curb cigarette smoking in the U.S., we suggest a similar approach for SWPs.   We propose the following “Actuaries’ warning label” be attached to each SWP:

ACTUARIES’ WARNING:

In addition to the normal investment and longevity risks associated with utilizing a systematic withdrawal plan (SWP), adding income from other sources to withdrawals determined under this SWP may NOT produce a reasonable spending plan in retirement. 

Now, to avoid misleading our readers, we must disclose here that the actuaries proposing this “Actuaries’ Warning” are the two retired actuaries responsible for this blog.  We want to make it very clear that our opinions do not represent those of the entire actuarial profession.  On the other hand, we would be more than happy to have one or more of the various actuarial organizations join us in proposing the use of such a warning.

What is Wrong with SWPs?

Why are we so down on SWPs?

• SWPs are withdrawal approaches, not strategies focused on sustainable spending.  They tell you how much you can withdraw from your investment portfolio, but they don’t tell you how much you can afford to spend during the year.  As discussed in our December 16 post, we believe retirees need to know approximately how much they can spend. 
• SWPs assume that all non-recurring expenses in retirement, such as long-term care costs, bequest motives and unexpected expenses, will be funded through some other unspecified resources. 
• SWPs aren’t coordinated with income from other sources in retirement.  An SWP determines an amount to be withdrawn from one’s investment portfolio each year.  That amount is determined without regard to other income that may be available to the retiree that year.  If income from other sources is front-loaded, back-loaded or simply varies from year to year, adding the amount determined by the SWP algorithm to income from other sources will generally NOT produce a reasonable spending budget for that year. 
• Even if income from other sources is relatively constant in real dollar terms over the retiree’s lifetime planning period, adding the SWP amount to the income from other sources during a year may not produce a spending budget that is consistent with the retiree’s spending objectives.  For example, a retiree with only an investment portfolio and a Social Security benefit that has already commenced may desire to have decreasing spending budget in future years, in real dollar terms.  For this retiree, this desire implies that she should have front-loaded withdrawals, not withdrawals that are expected to be constant in real dollar terms.

How can you get a Reasonable Spending Budget?

Well, you came to the right place.  Instead of using an SWP, you (or your financial advisor) can use the basic actuarial principle of matching the present value all your assets with the present value all your spending liabilities, discussed in this website, to develop a spending budget that is consistent with your financial goals in retirement.  We have also Excel Actuarial Budget Calculator (ABC) workbooks to make this task easier for you.

Thank You, Bud

In his December 2 article, “6 reasons why young people must save more”, Henry K. “Bud” Hebeler makes compelling arguments in favor of planning for retirement and the need for younger workers to save more.  His article is a good complement to our previous post on retirement planning for Millennials. 

Bud concludes his article by saying, “Start planning for retirement. Workers need to know how much to save each week or month, and retirees need to know how much they can spend. Plans will never be perfect and must be redone periodically. Periodic updates provide the feedback that corrects our past assumptions for returns, inflation and life expectancies.”  He chides individuals for failing to plan, “considering the many retirement program available free on the internet.”

We couldn’t agree more with Bud.  It is, however, somewhat embarrassing to us that he has managed to capture the essence of our 200+ blog posts in just a few concise sentences. 

You can find Bud’s free planning tools at Analyze.com, a website that we have recommended in our “Other Calculators and Tools” section for years.  You can use our Actuarial Budget Calculators or one of Bud’s many tools to give you the “data points” necessary to make reasonable spending/saving decisions.

Johnson’s Social Security Reform Proposal Will Require Millennials to Save 4% More of Their Annual Pay, on Average, to Replace Benefit Reductions

On December 8, House Ways and Means Social Security Subcommittee Chairman Sam Johnson introduced legislation (referred to here as the Johnson proposal) that he claims “will permanently save Social Security.”  His press release notes that, “this year, the Trustees Report warned workers will face a 21 percent benefit cut starting in 2034 if Congress does not reform the program.  Chairman Johnson’s legislation, the Social Security Reform Act of 2016 (H.R. 6489), puts Social Security back on a sustainable path…”  The Johnson proposal would achieve this “sustainable path” primarily by reducing future benefits for today’s younger workers by an even larger percentage, on average, than 21%.

Readers of our previous blogposts are reminded that the success of any proposed change in Social Security in achieving a permanent fix depends on realization of assumptions made by the Social Security Trustees at the time of reform, and there is no guarantee that these assumptions will be accurate for the next 75 years (and no mechanism in the current law to maintain actuarial balance in the future if the assumptions prove to be inaccurate).  In fact, common sense tells us that it is highly likely that actual experience will deviate from the assumptions made for 75 years or longer.  Therefore, any statements that claim to permanently save the System need to be viewed with a high degree of skepticism.

The graph below, from the December 8, 2016 letter from the Social Security Office of the Actuary to Congressman Johnson scoring his proposal, shows projected costs under current law and under the Johnson proposal for the next 75 years, as a percentage of taxable payroll under the 2016 Trustee’s Report Intermediate Assumptions about the future.  Under these assumptions, it appears that, on average for years after 2050, the Johnson proposal would reduce System costs (benefits) (the red and blue dashed line) compared with current law benefits by about 25% or more, and even below benefit levels anticipated if no reform action is taken (the dark black line).

(click to enlarge)

So, it looks like while most participants in Social Security would experience some degree of benefit reduction relative to current law under the Johnson proposal, benefits for Millennials and generations that follow would be most affected.  Note that the reductions depicted in the graph are averages and the actual benefit reductions relative to current law for some Millennials might be larger than 25% and reductions for others might be less.  Also, note that while the anticipated reductions for Millennials relative to current law are significant, they are not much larger than reductions required if no reform action is taken.  And there are probably some Millennials (and their employers) who might prefer the Johnson proposal to having to pay increased FICA taxes in the future (which the above graph shows to be somewhere in the 3.5%-4% neighborhood in total from employees and employers under current Trustees assumptions).

The Johnson proposal is just a proposal, and it may not be enacted.  However, Millennials may want to factor proposals like this one in their current spending/savings decisions.  We encourage Millennials, other pre-retirees and their financial advisors to use our Actuarial Budget Calculator (ABC) for Pre-Retirees annually to develop reasonable spending/savings budgets.  The following is an example showing how a hypothetical Millennial could use the ABC to determine how much more she should be saving today to replace future benefit reductions anticipated under the Johnson proposal.  The example also shows how our hypothetical Millennial can use the ABC to calculate the savings rate needed to satisfy her retirement goals if assumptions about her continued employment are not realized in the future.

Example

Let’s look at a 30-year old unmarried female (who we will call Ann) who is currently saving 10% of her gross pay of $50,000 each year, has accumulated $25,000 in savings (some pre-tax and some after tax) and has no other assets.  Her employer matches her 401(k) contributions $.50 on the dollar up to 6% of her pay, but her employer does not sponsor a defined benefit pension plan.  For planning purposes, Ann makes the following assumptions:

• Her investments will earn 4% per annum each year in the future 
• Inflation will be 2% per annum 
• Her compensation will increase by 3% per annum 
• She plans to cease employment and fully retire at age 69 (39 years from now) and commence her Social Security benefit at that age 
• She will contribute at least 6% of her pay annually to her employer’s 401(k) plan to obtain the maximum matching employer contributions 
• The present value of her unexpected expenses are $25,000 
• The present value of her expected long-term care costs are $75,000 
• She desires to leave $100,000 at her death (in nominal dollars and $27,605 in inflation-adjusted dollars) to cover her anticipated end-of-life expenses 
• She has no other anticipated non-recurring pre-retirement or post-retirement expenses 
• She expects to live until age 95
  

Her retirement goals include:

• retiring on or prior to age 69 and 
• having a first year of retirement real dollar spending budget that is at least 75% of her real dollar spending budget in her last year of employment, and 
• having her spending budget increase in retirement by 1.5% per year (inflation minus 0.5%) for the rest of her life to cover her estimated recurring annual expenses.
  

Ann uses the Social Security Online Quick Calculator to estimate her Social Security benefit commencing at age 69 under current law expressed in today’s dollars of $25,692 per annum. She then increases this amount for 39 future years of 3% per year pay increases (assuming a constant replacement ratio) to develop an estimated Social Security benefit under current law of $81,367.  She enters this amount in the Input and Results tab for Social Security (commencing in 39 years) and the assumptions and data discussed above.  She determines that if these assumptions are exactly realized, she must save at least 8% of her pay each year to achieve her retirement goals assuming no change in Social Security.

She estimates the approximate reduction in the value of her Social Security benefit under the Johnson proposal to be 75% of her projected benefit under current law of $81,367 (or $61,025).  She inputs that new Social Security benefit in the ABC and, keeping all the other assumptions the same, reruns the ABC.  Under the Johnson proposal, to achieve her same 75% replacement goal, she must increase her savings rate from 8% of her pay to 12% of her pay each year.

In addition to being concerned about Social Security benefits, Ann also worries that she may not be able to work at her current employer (or at another comparably paying job) for 39 years.  She decides to rerun her Johnson proposal numbers assuming she ceases full time employment at age 62 and works in part-time employment at 40% of her previous gross pay for 7 years, with such pay increasing with inflation (2%) each year but assumes her Social Security benefit will still commence at age 69.  Under this scenario, she determines that she must save 15% of her pay each year until age 62 to meet her retirement goals.

Finally, she decides to look at what her required savings rate would be under the Johnson proposal if she is laid off at age 62 and doesn’t want to, or otherwise can’t, work at all after that age.  Under this scenario, she calculates that she must save 20% of her pay each year to meet her retirement goals.

Ann uses these “data points” to determine that she probably should be trying to save closer to 20% of her pay each year rather than the 10% she had been targeting previously.

Note that while our hypothetical worker has determined that she may need to save an additional 4% of her pay to replace the anticipated reduction in the value of her Social Security benefits if the Johnson proposal is enacted, the amount of increased savings necessary could vary significantly from individual to individual and will depend on many factors.  For example, while higher paid Millennials may experience larger than average Social Security benefit reductions, not all their pay may be subject to FICA tax, so they may not need to save as much as 4% of their gross pay to replace the reductions anticipated for them under the Johnson proposal.

We Have New and Improved Actuarial Budget Calculator (ABC) Workbooks

Just in time for your 2017 calendar year spending budget determinations, we have developed separate ABC Excel Workbooks for Retirees and Pre-Retirees.  These new workbooks (named Actuarial Budget Calculator for Retirees and Actuarial Budget Calculator for Pre-Retirees) are now available in our Articles and Spreadsheets section.  These two separate workbooks replace the Actuarial Budget Calculator V 1.2, which was primarily a workbook for retirees that included a separate tab for pre-retirees.  We have not changed the Present Value Calculator V 1.1 (PVC), which can still be used to calculate present values that may not be handled directly by the ABC’s.   Please try out these new workbooks and give us your feedback and suggestions for improvement.

ABC for Retirees—What’s New?

The new ABC for Retirees has much the same functionality of ABC V 1.2.  We have added the ability for users to input expected part-time employment income so that the present value (PV) of such income can be considered as another source of income, and therefore an asset to be used in the actuarial spending budget calculation.   This input item can also be used for sources of income that are immediately payable but are anticipated to be paid only for a limited period of years.   For example, if you don’t have part-time employment income, but you do expect to receive payment of a loan from a family member for the next 5 years, you could enter annual expected payments from the loan in this item.   If that doesn’t work, you can always use the PVC to calculate the present value of the loan repayments and enter this amount as the present value of other income.

We have also made other changes to the ABC for Retiree Workbook, including changing the name of the first tab to “Input and Results” and we have added a “Workbook Overview” tab that includes an explanation of the workbook and some of the general budget advice previously discussed in our blogposts.  As noted above, we have also deleted the Pre-Retiree tab. 

Finally, instead of inputting the PV of non-recurring expenses such as unexpected expenses and long-term care expenses in the Budget by Expense-type tab, we have provided inputs for these items in the Input and Results tab and the two runout tabs include separate runouts for accumulated savings and accumulated savings adjusted for the net present value of input PV items (items entered as present values rather than expected annual income and start dates of such income).   The difference between these two runout items is the accumulated value of the net input PV items which is assumed to be paid or received at some point prior to the end of the lifetime planning period.

ABC for Pre-Retirees—What’s New?

The tabs in this workbook are all new, with a focus on helping pre-retirees develop reasonable actuarial spending/savings budgets.   The tabs for this workbook are similar in operation to the tabs in the ABC for Retirees except there is no Budget by Expense-type tab at this time to help pre-retirees select a single assumption for increases in recurring expenses after retirement.

Instead of producing an immediate actuarial spending budget as developed by the ABC for Retirees, the ABC for Pre-Retirees produces an expected first year of retirement actuarial spending budget based on the data and assumptions (including rate of annual savings and desired years until retirement) entered into the Input and Results tab and compares the real dollar value of this projected spending budget with the real dollar value of the individual’s spending budget expected in the final year of employment to measure how the individual’s standard of living will be affected by retirement under the anticipated financial plan.

Assumptions and Encouragement

Both workbooks include our recommended assumptions (in the gray box in the Input and Results tab as well as in the Workbook Overview tab) for 2017 actuarial budget determinations.

There are 41 college football bowl games taking place in the next month.  Instead of watching each and every minute of all these games, we encourage you to take an hour (or maybe only as much as a half time) to sit down and plan your spending/savings budget for 2017 in the next month or so.  You’ll be glad you did. 

Happy Holidays from the team at How Much Can You Afford to Spend and Happy Budgeting!

Why is the American Academy of Actuaries Painting Such a Rosy Picture of Social Security’s Long-Term Financing Problems?

Added December 8, 2016:  In response to this post, the AAA has added several caveats to its Social Security Game in an effort to avoid providing potentially misleading information about the System's long-term financial situation.  The Academy's Game with the new caveats can be found here.

From time to time, we deviate (slightly) from our primary mission to offer our thoughts on Social Security’s (the System’s) financial condition.  We do this because:

• the System appears to have long-term financial problems, 
• the System’s future benefit and tax provisions can be changed at any time by Congress, and 
• changes in System benefits and taxes can affect almost everyone’s financial situation.

Thus, the financial condition of the System and the resulting uncertainty about its ability to pay scheduled benefits in the future should be an important consideration for individuals in the U.S. when developing their current spending/savings budgets.

How Big Is Social Security’s Problem?

There is considerable confusion regarding the size of the System’s long-term financing problem.  In the American Academy Actuaries’ (AAA) “Social Security Game,” the AAA claims the System’s problem can be “fixed” with approximately a 23% increase in the current System tax rate.  This is one option of many in the menu developed for the Game.

Using CBO and Trustees Assumptions to Estimate the Size of the Problem

On the other hand, as discussed in our May 17, 2016 post, Steve Goss, the Chief Actuary of Social Security has said, “Remedying OASDI’s [Social Security’s] fiscal shortfall for 2034 and beyond will require a roughly 25 percent reduction in the scheduled cost of the program, a 33 percent increase in scheduled tax revenue or a combination of these changes.”  Thus, based on the Trustees’ assumptions about the future, the Social Security’s Chief Actuary believes the problem is much larger than as indicated by the AAA.  In his recent testimony before the House Subcommittee on Social Security, Keith Hall, the Director of the Congressional Budget Office (CBO) noted that, based on CBO’s assumptions, their estimate of the System’s long-term problem was even greater than the Social Security Trustees’ estimate.

The graph below, shown in Figure 2 of Mr. Hall’s testimony, shows projected Social Security Tax Revenues and Outlays for the period 2000-2090 under both the CBO’s and Trustees’ assumptions.  This graph does a very good job of quantifying the projected shortfall between System revenues and scheduled benefits from the period 2030 to 2090 under the two sets of assumptions.  Under either set of assumptions, the shortfall is projected to be relatively constant, when measured as a percentage of the country’s projected Gross National Product for this period.   One can fairly easily see from this graph that the projected shortfall in revenues is relatively close to the 33% figure quoted by Mr. Goss under the Trustees assumptions, and something in the neighborhood of 45% under the CBO assumptions.  These figures can be confirmed by comparing projected 2090 outlays with projected 2090 tax revenues in the first section of Table 2 of Mr. Hall’s testimony.1 Under either set of assumptions, we are talking about significantly higher tax revenue shortfalls than the 23% figure claimed to “fix” the System in the AAA’s Social Security Game.  If you prefer to think in terms of necessary benefit reductions rather than required tax increases, the percentages are about 25% under the Trustees’ assumptions and about 30% under the CBO assumptions.2

  
AAA’s Fix 
     
So why has the AAA low-balled the size of the System’s long-term problem, when even the System’s Chief Actuary (using the Trustees’ assumptions) has indicated that we are looking either at much higher potential tax increases or benefit reductions?  Unfortunately, it is not clear to me why a profession that prides itself in “substituting facts for appearances” and “demonstrations for impressions” would want to provide this potentially misleading information.   In fact, Precept 8 of the profession’s own Code of Conduct expressly requires that an individual actuary “who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.”  It doesn’t appear to me that the AAA has taken such reasonable steps, but technically the Code of Conduct doesn’t apply to the organization representing the profession, only its individual members.

Planning Implications of Future System Reform

It is important to note that the 25% decrease in scheduled benefits (or approximately 30% under CBO assumptions) will automatically take place when the System’s Trust Fund runs out of assets if Congress fails to act prior to the Trust Fund Exhaustion date.  This is effectively an across-the-board decrease in benefits payable to beneficiaries at that time.  If Congress acts prior to the Trust Fund Exhaustion Date (by increasing tax revenue, decreasing benefits or some combination of the two), it is likely that some individuals will be less affected and some will be more affected than they would be under the default across the board benefit reduction scenario.

So, what does this all mean to retirees and pre-retirees in the U.S. who are counting on certain levels of future Social Security benefits?   That is the $64,000 question.  Will you be one of those individuals whose benefits are mostly unaffected or will you be one of those individuals whose future benefits or taxes will be significantly affected?  To paraphrase Harry Callahan in the movie “Dirty Harry” (by deleting the ending pejorative), “you’ve gotta ask yourself one question.  Do I feel lucky?  Well, do ya…?”

History has shown us that, when making changes to the System, Congress has been more inclined to reduce benefits and increase taxes mostly for those who are not close to retirement age.  Thus, it is unlikely that Congress will allow the default across the board benefit reduction scenario to take place.  On the other hand, it is also unlikely that Congress is going to place the entire burden of shoring up the System on the shoulders of our younger workers.  It appears likely that those with relatively higher incomes (young and old) will be asked to bear a significant portion of the increased cost in this next round of System reform.

The System is currently funded primarily with payroll taxes.  It is possible that the next round of System reform may involve other sources of revenue.  In any event, your current financial planning should consider the possibility that the scheduled (or actual) Social Security benefit you input in our Actuarial Budget Calculator worksheet may be reduced in some manner, your future taxes increased or some combination of the two.  Unfortunately, the changes necessary to truly “fix” the System may be larger than you thought.

Notes:

1. Projected Percentage Shortfall in Revenues using Projections for 2090:
(6.34 – 4.29) / 4.29 = (20.08 – 13.59) / 13.59 = 48% using CBO assumptions
(6.14 – 4.63) / 4.63 = (17.68 – 13.33) / 13.33 = 33% using Trustees assumptions

2. Necessary Percentage Benefit Reductions using Projections for 2090:
(6.34 – 4.29) / 6.34 = (20.08 – 13.59) / 20.08 = 32% using CBO assumptions
(6.14 – 4.63) / 6.14 = (17.68 – 13.33) / 17.68 = 25% using Trustees assumptions

Using Multiple “Data Points” to Determine How Much You Should Spend

The primary purpose of this website is to help individuals (with possible assistance from their financial advisors) determine how much they can afford to spend each year.  Our website was initially established in 2010 to help retirees with this issue, but we have recently expanded the scope of our purpose to address this issue for pre-retirees as well.  We have developed several spreadsheets that utilize basic actuarial principles to help individuals develop reasonable spending budgets.  And while we believe the development of a reasonable spending budget is an important part of an individual’s spending decision process, it is but one “data point” of several  that may be considered.  This post will discuss other possible data points that may also be useful in your spending decision process.

Applying the ABC Data Point

The Actuarial Budget Calculator (ABC) contained in this website determines a spending budget for the current year by mathematically balancing an individual’s assets (current assets and the present value of future income from other sources) with her current and future spending liabilities.  Thus, significant increases or decreases in the individual’s current assets from one year to the next can result in some volatility in the actuarially calculated spending budget from year to year.  As we have said many times in this blog, we have no problem if a retiree chooses to smooth her spending budget from year to year or to smooth her actual spending.  In fact, we have suggested that retirees consider establishing a “rainy day fund” after one or two favorable investment years to be available in subsequent unfavorable years as one approach to mitigate such fluctuations.  Thus, last year’s spending level may be another “data point” to consider.

The ABC with Recommended Assumptions Data Point

We understand that some of the users of the ABC do not use the recommended assumptions to determine their spending budgets.   These users may feel that because they invest a significant portion of their assets in risky investments, our recommended investment return/discount rate is too conservative and does not represent their best estimate.  We also understand that some retirees and/or their financial advisors may use any number of non-actuarial approaches to determine spending budgets.  And this is fine, too.  We don’t insist that the ABC using recommended assumptions is the one and only true answer.  However, we do suggest to these individuals that they also run the ABC with the recommended assumptions as another data point, for comparison purposes.  The ABC with recommended assumptions produces an actuarially calculated spending budget under the assumption that assets will be invested in relatively low-risk investments (approximately interest rates imbedded in life annuity products).  A significant positive difference between the retiree’s spending budget and this actuarially calculated budget can provide a measure of how much extra risk the retiree is “capitalizing” through his or her investment strategy.  In any event, running the ABC with recommended assumptions provides another data point that tells the retiree how far off the “actuarially balanced” track she may have strayed with her current spending strategy.

ABC Run-Out Tabs Data Point

The ABC also provides run-out tabs that show future spending and assets if all assumptions are realized in the future and spending exactly follows the budget plan.  In situations where the retiree expects to receive income from deferred sources (such as from a future sale of an asset or from deferred annuity contracts) the run-outs may show assets declining precipitously prior to receipt of the deferred income if spending continues course.  In such situations, the run-out tab information can serve as another data point in the spending decision process.

ABC 5-Year Projection Tab Data Point

In the 5-year projection tab, the ABC also provides the capability to model future investment and spending experience that differs from assumptions.  The results of this tab can be useful for developing contingency plans in the event actual experience deviates significantly from assumed experience and can also provide another data point in the spending decision process.

As indicated in our post of October 31 of this year, the run-out tabs also indicate what next year’s assets will be if all assumptions are realized during the budget year and spending exactly follows the budget, so this number is also another data point in determining this year’s spending if it looks like assets at the end of the year will be significantly different from this number.

Historical Record Data Points

We encourage retirees to maintain a record of prior years’ spending budget calculations and prior years’ expenses.  This historical information can also serve as additional data points to help with future spending decisions.  The information can also be useful in selecting assumptions about the future, particularly about future assumed increases in various types of expenses.

Your Gut Instinct

As we said in our post of October 17 of last year, “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.”  This brings us to our final data point – your gut instinct.  As we have said many times in this website, it is ok to spend less than your spending budget.  It may also be ok to spend more sometimes (but, please don’t use this as your excuse for running out and buying a big boat).  Once you have gathered sufficient information, you and your significant other, if you have one, need to make the final call on your spending.

Gathering all these data points to make spending decisions may seem like a lot of extra work.  For some retirees (those with just one or two sources of retirement income, for example), it may not be necessary or worthwhile to gather this additional information.  For those with more complicated situations (including those with multiple sources of retirement income), it may.  You must find the appropriate balance between the time you spend managing your retirement and just enjoying your retirement.  We are here to help you (or your financial advisor) find the best answer for your specific situation.

Deferring Commencement of Social Security Benefits is Ok, Deferring Retirement is Better—Part II

This post is a follow-up to our post of April 28, 2014, where we looked at the effect on a hypothetical 65-year old’s annual spending budget under the following scenarios:

1. Retiring at age 65 and commencing Social Security immediately, 
2. Retiring at age 65 and deferring commencement of Social Security until age 70, and 
3. Continuing to work 5 more years, retiring at age 70 and commencing Social Security at 70.
   

We concluded that while Scenario #2 might increase one’s spending budget by something in the neighborhood of 5%-10% over Scenario #1, Scenario #3 might increase one’s spending budget in retirement by 40% or more.

Now, in a recent study entitled, “Is Uncle Sam Inducing the Elderly to Retire”, the authors use some mysterious (to me) methodologies to conclude that the financial benefits of continuing to work an additional five years is much lower than the 40% figure we previously developed.  The authors conclude, “We find that if all elderly now working were to continue to work for five more years, they would, on average, raise their sustainable living standards (annual discretionary spending per household member with an adjustment for economies in shared living) by roughly 5 to 8 percent depending on their age and position in the resource distribution.”
 
As an actuary, my first reaction is to look at some numbers to see what they support.  So let’s use the Actuarial Budget Calculator (ABC) to look at a 65-year old male making $50,000 per annum gross wages.  Let’s assume he has $200,000 in accumulated savings and his home equity will cover his future expected non-recurring expenses. 

If we go to the Social Security Quick Calculator, we see that if this hypothetical individual retires and begins commencement of his Social Security benefit immediately, he would receive approximately $1,275 per month based on the assumptions made for his prior earnings history by the calculator.  The calculator also indicates that if he has no future employment income but he defers commencement of his benefit until age 70, his age 70 benefit in today’s dollars would be approximately $1,806 per month, and if he continues to work until age 70, his age 70 Social Security benefit would be $1,932 in today’s dollars.

Let’s assume that our hypothetical individual desires to have future spending budgets keep pace with inflation and uses the assumptions we recommend for the ABC.  He has no bequest motive.

For Scenario #1 (inputting an annual Social Security benefit of $15,300 – monthly benefit of $1,275 – starting immediately and $200,000 of accumulated savings), we get an annual spending budget of $24,011.

For Scenario #2 (annual Social Security of $23,928 – monthly benefit of $1,806 increased by 5 years of assumed inflation starting in 5 years), we get an annual spending budget of $25,842, an increase of 7.6% over Scenario #1.

For Scenario #3, we input an annual Social Security benefit of $25,597 (a monthly benefit of $1,932 increased by 5 years of inflation) starting in 5 years.  We then go to the new pre-retirement tab and assume that our hypothetical individual will receive annual 2% per annum pay increases, will save 10% of his pay each year and will not receive any additional pre-retirement income (such as a matching employer contribution).  Under this scenario, our hypothetical individual is expected to have a real dollar spending budget of $45,000 for 5 years and, at age 70, his real dollar spending budget is expected to decrease to $35,530 and remain at that level for the rest of his life.  Note, however, that this ultimate real spending budget is almost 48% higher than the Scenario #1 spending budget. 

Yes, he will have FICA taxes, income taxes, work-related expenses and savings that will need to be paid while he continues to work.  However, he had these expenses in prior years, so these are not new for him if he continues to work.   And, yes, he will not be receiving Social Security benefits while he works (of course he could if he wanted starting at his Social Security Normal Retirement Age of 66, but he decides to defer).

The authors are undoubtedly correct that there is some confusion in the general population regarding how the Social Security Earnings Test works.  For most readers of this blog, however, the concept is not that difficult.  Per “How Work Affects Your Benefits” prepared by the Social Security Administration, “You can get Social Security retirement or survivors benefits and work at the same time. But, if you’re younger than full retirement age, and earn more than certain amounts [generally $15,720 for 2016], your benefits will be reduced.  The amount that your benefits are reduced, however, isn’t truly lost. Your benefit will be increased at your full retirement age to account for benefits withheld due to earlier earnings.”

In their analysis, the authors assume that the Earnings Test is a “pure tax on benefits”, i.e., they ignore the increase in future benefits that results.  We respectfully disagree with the reasonableness of this assumption and, as a result, find the author’s conclusion misleading.

Bottom line:  I’m not buying the author’s argument that Uncle Sam is inducing the elderly to retire through operation of its tax and subsidy policies.  Of course, results will vary from individual to individual.   For most people, however, there is still plenty to be gained financially by continuing to work.  But, don’t just take our word for it.  Use our Actuarial Budget Calculator spreadsheet to crunch your own numbers.

Pension Actuaries Discuss Best Ways to Employ Assets to Mitigate Risks in Retirement

This post recommends two recent articles written by pension actuaries:  Mark Shemtob and Steve Vernon.

I volunteer with Mark Shemtob on the American Academy of Actuaries’ Lifetime Income Task Force.  The original mission of this task force was to “address the risks and related issues of inadequate guaranteed lifetime income among retirees.”  Mark is a consulting pension actuary like I was before I retired.  He is also a Certified Financial Planner and a Retirement Management Analyst.  His recent article, “The Retiree Nest Egg—Navigating the Risks” appears in the November/December 2016 issue of Contingencies Magazine, published by the American Academy of Actuaries.

Mark’s common sense advice to baby boomers regarding retirement planning can be summarized as follows:

1. Continue to work (if you can) until you are satisfied you are financially ready to retire 
2. Consider deferring commencement of your Social Security benefit until age 70 or purchasing a longevity annuity 
3. If the sum of your Social Security and pension benefits doesn’t fully cover your fixed living expenses, consider purchasing a life annuity to cover the shortfall 
4. Have a plan to cover future health-care costs, long-term care expenses and unexpected expenses 
5. If your retirement spending strategy involves withdrawals from invested assets, make sure to monitor investment fee levels and selectively limit investment risk (perhaps by using a “bucketing” investment strategy that is coordinated with income to be received from other sources).

I worked with Steve Vernon for many years, and readers of this blog will recognize his name from the frequent references to his articles.  Steve was also a consulting pension actuary.  In his recent article, “6 retirement strategies from a local pro,” Steve discloses his own personal retirement strategy.  Not surprisingly, many of his 6 strategies are similar to those recommended by Mark.  Steve includes a couple of strategies that are not strictly financial.

I found the recommendations in Mark’s and Steve’s articles to be excellent and, for the most part, consistent with the opinions and recommendations we make in this website.   We may have small differences of opinion (like the best way to determine spending from investments, for example), but our thinking on retirement planning is not miles apart.   And maybe that is because we all think like pension actuaries.

You Want Software that Models the Effect on Your Retirement Spending Budget of Assuming Different Rates of Future Increases for Multiple Expense Categories? We’ve Got It!

I like to read the financial planning strategy posts from Michael Kitces.  I especially enjoy his weekly “Weekend Reading for Financial Planners.”  Michael is a good writer and is very prolific.  I don’t always agree with everything he says, but I give him big-time kudos for the expertise and energy he brings to financial planning discussions.

In his post of November 2, Michael summarizes much of the latest research on spending patterns in retirement.  I won’t summarize the research here again as you can simply read Michael’s post, and we have previously discussed much of this research in our posts of March 31 and August 20 of this year, entitled “Planning for Constant Real-Dollar Spending in Retirement – Is It Setting the Bar Too High (Parts I & II).”
  
At the end of his post, Michael says, “In practice, doing this kind of projected retirement spending may also be more difficult in today’s financial planning software, simply because most of the tools aren’t built to handle multiple different spending categories, each with their own inflation rates and age-banded spending cuts.”  Well, our Actuarial Budget Calculator (ABC) is not “most of the tools,” and it is built to handle 3 different spending categories:

• essential health-related expenses 
• essential non-health related expenses 
• and non-essential expenses,
  

each with its own assumed future increase rates.  You will find this useful feature in the Budget by Expense-Type tab of the ABC.  And it wouldn’t be all that difficult to modify the results of this tab to look at more than 3 spending categories, if desired.

After you have used the Budget by Expense-Type tab to develop a current spending budget utilizing different assumptions for future increases in the 3 expense categories, you can go back to the Input tab of the ABC spreadsheet to see what single rate “desired increase in future budget amounts” produces an equivalent current spending budget (if you are curious).  For example, in the Budget by Expense-Type tab you might assume future increases equal to assumed inflation for essential non-health related expenses, inflation plus 2% for essential health-related expenses and 0% increases for non-essential expenses.  Depending on the relative mix of these expected expenses, the resulting current spending budget may be equivalent to that produced in the Input tab by assuming inflation minus 0.5% increases (or some other value) in your total recurring future spending budgets.

Happy Budgeting!

Is it Time for a 2016 Spending Check?

The last thing I want to do with this post is put a damper on your holiday season, but we only have two months left in the calendar year, and for many retirees, the holiday season can involve increased expenses.  Before you generously shower gifts on your family and friends this year, you might want to check to see how you are doing so far with your 2016 spending and investments. 

As discussed in our post of September 4 of last year, if you are using the Actuarial Approach to determine your spending budget, there is a relatively easy process you can use to check to see how you are doing in terms of meeting your spending and investment targets for the year.   The Runout Tab of the Actuarial Budget Calculator you used to determine your 2016 spending budget showed your expected accumulated savings at the beginning of year 1 (2017) if all assumptions were realized and you spent exactly your 2016 spending budget.  

To see how well you have done so far for 2016, you will need to

• estimate your spending and income for the final two months of 2016 and 
• compare your estimated end-of-year accumulated savings with the beginning of year 1 (2017) amount shown in the Runout tab of the 2016-year calculation.

If your estimate of year-end accumulated savings is significantly lower than the expected value (either because of over-spending or lackluster investment returns (or a combination of the two), you might want to consider reducing some of your expenses for the remainder of the year if you can.  To see the impact of over-spending or under-earning on your 2017 actuarially determined spending budget (before any smoothing you might choose to use), just enter your end-of-year accumulated savings estimate in the spreadsheet and pretend you are doing the calculation at the beginning of 2017. 

Focus on Your Spending Budget in Retirement–Not How Much You Can Withdraw from Your Investment Portfolio

It seems like every other week some retirement expert, financial planner or investment firm is coming out with their recommendation for the best withdrawal strategy to use to tap one’s savings in retirement.  The new and improved strategy may be “fixed”, “variable,” or a hybrid of the two.  It may be a “safe” withdrawal rate (as contrasted with one that is unsafe?)  It may have “guardrails.”  It may involve using the Excel PMT financial function.  It may be a rate that retirees should “feel free” withdrawing, or it may be one of the many approaches that adjusts the 4% Rule in some manner to supposedly make it better.  I refer to these systematic withdrawal approaches as “rule of thumb” (RoT) approaches.

All of these RoT approaches miss the point.  The point of the exercise is to determine approximately how much you can afford to spend each year while meeting your financial objectives, not how much to withdraw.  Sometimes adding the amount you can withdraw under these RoT approaches to other income you may be receiving for a given year will give you something close to a reasonable spending budget for that year, and sometimes it won’t.

The current widely-followed practice of first determining how much can be withdrawn from savings and then adding that amount to other available income for the year is just bass-ackward and, in my opinion, should be changed.
 

The process recommended in this website involves

• first determining a reasonable spending budget based on sound actuarial principles and 
• then subtracting other available income for the year to determine how much, if any, should be withdrawn from accumulated savings.

Thus, the reasonable actuarially-developed spending budget and the other income you may be receiving during the year determines how much you should  withdraw from your accumulated savings, not some RoT approach that doesn’t even consider how much other income you may or may not be receiving that year.

Under the Actuarial Approach, withdrawals from savings may be much greater than or much less than withdrawals suggested by RoT approaches, and this situation may change over the period of retirement.  An example of the former situation is when income in retirement is deferred (such as when Social Security or income from an anticipated home sale is deferred).  An example of the latter situation is when income in retirement is front-loaded (such as when a retiree works in part-time employment or receives other income for a temporary period of time).

Note:  It is certainly possible that the annual income from various sources in retirement may even temporarily exceed the year’s actuarially calculated spending budget.  In that event the withdrawal from accumulated savings for that year will be negative.  In other words, instead of withdrawing and spending x% from savings that year as the retiree may do under a RoT approach, under the Actuarial Approach she would actually be saving to fund future spending needs.

If you (or your financial advisor) are currently using a RoT approach to develop your spending budget, I strongly recommend that you change your mindset (as suggested in the graphic above) and consider the Actuarial Approach as a better alternative.  At a minimum, we encourage you to compare the spending budgets developed under your approach with that developed under the Actuarial Approach and make sure you are comfortable with any significant differences.

For those of you still wondering about the graphic above:  No I am not calling for a small change (20 cents) in practice.  I am calling for a paradigm shift.