This post is a follow-up to several of my recent posts on Social Security financing. It is a call to my profession to fulfill its mission and vision by advocating adoption of a basic actuarial principle for Social Security: ensuring sustainability of the program through automatic maintenance of the actuarial balance between expected system assets and liabilities on a going-forward basis.
Background
The American Academy of Actuaries is the public voice of the actuarial profession on public policy issues. In its June, 2016 Issue Brief, An Actuarial Perspective on the 2016 Social Security Trustees Report, the Social Security committee of the Academy said, “The Social Security Committee believes that any modification to the Social Security system should include sustainable solvency as a primary goal.” The issue brief goes on to define this term as follows:
“Sustainable solvency means the program is not expected to deplete reserves any time in the 75-year projection period, and trust fund ratios are expected to finish the 75-year projection period on a stable or upward trend.” This is essentially the same definition used by the Social Security actuaries, who are a little more precise and talk about Sustainable Solvency “under a given set of assumptions.” This is an important distinction because sustainable solvency depends to a significant degree on exact realization of assumptions made about the next 75 years.
The concept of Sustainable Solvency was developed by the Social Security actuaries to address the problem of unrecognized deficits after the end of the 75-year projection period. This concept did not exist at the time of the 1983 amendments, as discussed on our post of May 17, 2016, “What went wrong with the 1983 Social Security Fix?” when Congress supposedly “solved” the program’s financial problems for the next 75-years by reducing the 75-year actuarial deficit in existence at that time to zero. Note, however, that with the additional requirement with respect to the trend at the end of the 75-year projection period, Sustainable Solvency is essentially the same as the 75-year actuarial balance requirement used in the 1983 Amendments.
As part of the annual Trustee’s report, the Social Security actuaries perform an actuarial valuation of the program by comparing program assets with program liabilities under various sets of assumptions about the future. The most publicized results of these actuarial valuations are the expected trust fund exhaustion date and the 75-year actuarial deficit under the Intermediate (or best estimate) assumptions. For many years now the Trustees and the actuarial profession has been using the results of these valuations to encourage Congress to act sooner rather than later to bring the program back into actuarial balance under the Intermediate set of assumptions. For example, the Academy’s most recent Issue Brief said, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.”
When reform proposals are now submitted to the Social Security actuaries for scoring, the Social Security actuaries determine whether such proposals meet the requirements for Sustainable Solvency based on the Intermediate assumptions used in the most recent Trustee’s Report. For example, as discussed in our post of June 16, 2016, The Bipartisan Policy Center’s Commission on Retirement Security and Personal Savings Report got very excited when the Social Security Actuaries indicated that their Social Security proposals met the requirements for Sustainable Solvency. Their report erroneously concluded “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…” These statements were erroneous because they were based on the premise that all of the Intermediate assumptions used in the 2015 OASDI Trustees report would be exactly realized in the future, which we know won’t occur.
As discussed in our post of June 16, it is foolish to believe that assumptions made by Social Security actuaries today will be accurate over the next 75 years, so a claim of Sustainable Solvency is shaky at best and potentially misleading. No sound actuarial process proclaims solvency for a period of 75 years without anticipating making periodic adjustments in future years as experience emerges.
Truly Sustainable Solution
The common sense solution to providing true Social Security sustainability is to require that the system automatically be placed in actuarial balance on a periodic basis in the future, as is the case for all sound actuarial processes. For example, current law could be changed to require the program’s tax rate be automatically changed effective for the year following an actuarial valuation that shows the program has fallen out of actuarial balance by 5% or more. Congress could, of course, take other actions to bring the program back into actuarial balance rather than have the automatic tax rate increase (or decrease) take effect.
As an example of how this automatic process might work, let’s look back at the 1983 Amendments, which were supposed to fix the system for 75 years. In 1989 (which by the way, was just 6 years after the 1983 Amendments), the system went out of long-term actuarial balance (as that term was defined at the time using a 5% threshold). If the proposed automatic adjustment had been in place at the time, a small tax increase would have been required to bring the program back into actuarial balance. Additional tax increases would also have been required in subsequent years, unless Congress took other actions. If no benefit reductions were adopted during this period, today we would have a higher tax rate but no impending significant reductions to consider.
Reasons Why the Profession Should Endorse this Solution
Here are some of the reasons why the actuarial profession should advocate in favor of this solution:
- The solution is consistent with the expressed mission statement of the American Academy of Actuaries “to serve the public and the United States actuarial profession.”
- It is consistent with the Academy’s vision statement that “financial systems in the United States be sound and sustainable…”
- According to the Academy’s 2015 Public White Paper, Sustainability in American Financial Security Programs, “The American public relies on the promises made under many different financial security programs—whether they are public programs like Social Security and Medicare or offered through the private sector such as employer-sponsored pension plans or insurance products. The public must have confidence that these programs can be sustained and continue to meet their goals.” I believe adoption of the proposed solution would increase public confidence in the system.
- The proposed solution is consistent with the Academy’s Social Insurance Committee’s belief that, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.” Clearly, frequent automatic adjustments would involve earlier implementation and would be less disruptive than infrequent, more disruptive reforms.
- The proposed solution is consistent with the Academy’s public policy objective “to address pressing issues that require or would benefit by the sound application of actuarial principles.” If current law already provided for such automatic adjustments, I can’t imagine that the profession would support legislation to eliminate them. So, why the reluctance to endorse them?
- Endorsement of this solution is an opportunity to enhance the profession’s public image. Conversely, failure to endorse this solution increases the possibility of damaging the profession’s reputation. The reputational risk involved with Social Security financing may be even greater than the risk associated with performing actuarial valuations for public pension plans.
Conclusion
Sustainable solvency as defined by the profession and Social Security actuaries is a misnomer and is potentially misleading. It is based on exact realization of assumptions made for the next 75 years that will not come true. True system sustainability can be achieved through periodic adjustments to maintain the system’s actuarial balance as actual experience emerges.
The 1983 Amendments failed to provide us with system sustainability, and we are looking at significant reform proposals as a result. This time around, however, the changes should result in a more sustainable program on which the American public can truly depend. It is time for us to remember the old proverb, “fool me once, shame on you; fool me twice, shame on me.” We shouldn’t just accept a reform “fix” that is similar to the “fix” adopted in 1983. For this reason, I call on the actuarial profession to step up its game and advocate true system sustainability through automatic periodic adjustments to keep the program in actuarial balance on a going forward basis.
In his most recent CBS MoneyWatch article, my friend and fellow actuary Steve Vernon reminds us that home rich/cash poor Americans can use their home equity to fund their retirement. He discusses various ways this can be done, including downsizing and reverse home mortgages. He concludes his article by saying, “It's simply common sense to carefully consider how to deploy all the retirement assets you own.” Well, thank you very much, Steve, because careful consideration of how to deploy all the retirement assets you own is what the Actuarial Approach for developing a reasonable spending budget is all about.
The basic concept of the Actuarial Budget Calculator spreadsheet provided in this website is to match your retirement assets (including the present value of future Social Security benefits, pension benefits and future sales of other assets) with the present value of your future spending budgets and the present value of your bequest motive (called Desired Amount of Savings Remaining at Death in our spreadsheet). And don’t be frightened by the fact that the calculations involve present values; our Actuarial Budget Calculator spreadsheet does them for you.
Before I give an example of how you can use the Actuarial Budget Calculator spreadsheet to “deploy” your home equity, I would like to, once again,point out that even though it may be common sense to deploy all your assets to meet your retirement spending objectives, you generally won’t find much discussion of how to accomplish this with rule of thumb withdrawal approaches such as the 4% Rule or other safe withdrawal rate approaches. What you do hear with those approaches is something like, “trust us, based on complicated Monte Carlo modeling, if you invest your accumulated savings at least 50% in equities, you will have a 95% chance of not running out of money.” On the other hand, with the Actuarial Approach, you develop a reasonable spending budget based on your best estimates of future experience and your financial situation.
Recently one of my readers wanted to know how to determine a reasonable spending budget during a period of time prior to commencing his Social Security benefit recognizing, that he had a fair amount of equity in his home in addition to a fair amount of more liquid accumulated savings. I’m going to change his fact situation somewhat for simplicity sake. Let’s assume that
“David” is age 65,
no longer working,
has $500,000 of liquid accumulated assets,
$400,000 of equity in his home, and
he projects his Social Security benefit will be $30,000 per year when he commences it at age 70 (in 5 years).
David believes that, in about 15 years, he will downsize his house to a condominium and,at that time, he will be able to pull out about 50% of his equity. He wants to use what he can pull out when he downsizes to increase his current spending budget. David wants to use the remaining 50% of his equity for long-term care costs when he no longer can live by himself in his condominium. Thus, David estimates the present value of the equity he will be able to pull out of his current home when he downsizes to a condominium at $200,000 (half of the $400,000 of equity in his home). David assumes that his home equity will increase by 4.5% per year, the same assumption he makes for investment return on his more liquid accumulated savings.
Using the Actuarial Budget Calculator, David enters
$500,000 in accumulated savings,
$30,000 in Social Security benefits commencing in 5 years,
$200,000 as the present value of other sources of income and
the recommended assumptions (4.5% investment return, 2.5% inflation and 30- year retirement period).
He has no bequest motive.
Since we are going to use the Budget by Expense tab and look at the components of David's spending budget, we don't need to make an assumption about the desired increase in David's total spending budget in the input tab.
The present value of David’s retirement assets under these input items and assumptions is $1,181,925 (plus the 50% remaining equity that is assumed to cover David’s long-term care costs).
David assumes:
$50,000 for the present value of unexpected expenses,
$35,000 increasing with inflation for essential non-health expenses and
$7,000 increasing with inflation plus 2% for essential health costs.
He then goes to the Budget by Expense-type Tab of the spreadsheet and budgets
$0 for long-term care costs (because they are to be covered by his condominium equity), and the three assumptions above.
This leaves him with $117,367 for the present value of his non-essential expenses, which he decides to spread over his expected retirement as the same constant dollar per year, giving him a current year non-essential spending budget of $6,895 and a total current year spending budget of $48,895. Note that because he is not currently receiving Social Security benefits, this amount must come entirely from his liquid accumulated savings and represents about 9.8% of his current liquid assets.
While a 9.8% withdrawal from David’s liquid assets is relatively high, he knows that withdrawals from his liquid assets will decrease when he starts collecting his increased Social Security benefit and he also knows that if he runs low on his liquid assets, he can choose to downsize his home earlier than planned to take out some of his equity. He also knows that his situation will change each year and he will have to revisit his calculations annually to make necessary adjustments.
Had he been advised to use the 4% Rule, there is no telling what portion of his liquid accumulated savings David would have decided to spend. $20,000 (= .04 x $500,000)? $20,000 plus the amount of the Social Security benefit he could have received if he wasn’t deferring? Something more than this based on his knowledge that he has a fair amount of home equity?
With the Actuarial Approach, David has set aside money for long-term care, future unexpected expenses, future essential expenses and future non-essential expenses. This is the real benefit to David of doing a little number crunching rather than blindly relying on some rule of thumb approach.
Recent research has shown that some retirees may be underspending their assets in retirement. In their article, “Spending in Retirement: Determining the Consumption Gap”, Researchers Browning, Guo, Cheng and Finke noted, “retirees seem to spend much less than theory would predict. Rather than spending down savings during retirement, many studies have found that the value of retirees’ financial assets hold steady or even increase over time.” These researchers refer to this phenomenon as “the Consumption Gap.” The Society of Actuaries “2015 Risks and Process Survey” report that I discussed in my previous post noted a similar trend. In this post, I will outline how the Actuarial Approach discussed in this website can address this issue for retirees who may not be happy with their current spending levels.
With respect to this consumption gap, Browning et al speculate that “Fear, failure to plan, and a lack of confidence in pre-determined drawdown strategies may be significant contributors to the conservative consumption observed among retirees,” and “Feelings of inadequate preparation may shift retirees’ mindsets from decumulation to preservation.” Figure 1 of the Society of Actuaries’ report notes the following top five significant concerns expressed by surveyed retirees (percentage indicating very or somewhat concerned by the item).
- You might not have enough money to pay for a long stay in a nursing home or a long period of nursing home care at home (58%)
- The value of your savings and investments might not keep up with inflation (52%)
- There might come a time when you (and your spouse/partner) are incapable of managing your finances (48%)
- You might not have money to pay for adequate health care (47%)
- You might not be able to maintain a reasonable standard of living for the rest of your life (45%)
As I have previously said, the purpose of this blog is to help retirees (and their financial advisors) develop reasonable spending budgets. I’m not here to tell you how much you should actually spend each year. If you want to spend less than your actuarial spending budget each year and grow (or preserve) your assets in retirement, that is fine with me. If these are your goals in retirement, far be it for me to tell you that your goals are wrong.
If, on the other hand, your underspending in retirement is driven by the concerns/fears summarized in the Society of Actuaries survey above (or some other fears) and you would spend more if you were convinced you could afford to do so, then this is where the Actuarial Budget Calculator may be helpful to you. Unlike most rule of thumb asset withdrawal strategies (like the 4% Rule or other Safe Withdrawal Rate approaches) that are mathematically designed to have an x% probability of not running out of money over a given period of time as long as assets are invested in a certain manner, historical returns are achieved in the future and exactly $Y real dollars are withdrawn each year, the Actuarial Budget Calculator enables you to match your liabilities with your assets, using your best estimates of future experience (or conservative estimates if you prefer) regarding the economy, your investment returns, your expected period of retirement, your future essential and discretionary expenses, etc. Thus, rather than simply worry about whether you will have enough money to pay your expected long-term care costs, make reasonable assumptions about when and how much those costs might be and set aside funds today to cover those expected costs. We discussed how you might do this in our post of January 12th of this year. Similarly, you know that you will have unexpected future expenses that will not be covered by your annual x% withdrawal, such as home repairs or a new car. Don’t simply worry about how those expenses will be paid; make reasonable assumptions about when and how much these costs might be in the future and set aside funds today to cover these costs.
The Budget by Expense tab of the Actuarial Budget Calculator allows you to develop a comprehensive spending budget that can cover all your future expected and unexpected expenses as well as your desired bequest motive. You can be as conservative as you like in developing your total spending budget. And, as discussed in the last post, you can even set up a Rainy Day Fund to mitigate future investment losses. After making reasonable assumptions and developing a reasonable spending budget, you just might find that you can spend more today than you think. And even if you can’t increase your current spending, you might be able to increase it in the future if the assumptions you made about the future turn out to be too conservative. Unless your goals include growing your assets, you need to find the appropriate balance between spending too little and not spending enough. As we discussed in our post of October 12, 2015, it is important not to let fear unduly influence this task.
I agree with Browning et al when they specifically point to a lack of confidence in popular draw-down strategies as a significant contributor toward underspending by retirees. I also agree with the authors’ statement that, “Retirement income conversations may need to move away from sustainable withdrawal rates toward strategies that maximize spending for a given level of financial assets, while addressing client concerns about uncertainties.” This is exactly what you can do with the Actuarial Approach. It can provide you with the information and knowledge you need reduce your stress and help you get past these fears.
Inspiration for this post comes from an article by Joe Tomlinson in Advisor Perspectives entitled, “Retirement Planning and the Impact of Investment Market Performance” and a survey entitled, “The Society of Actuaries 2015 Risks and Process of Retirement Survey.” This post is also a follow-up to my previous post regarding using The Actuarial Approach to mitigate sequence of return risk and my post of June 27, 2015 entitled, “You Can Save During Retirement Too.” The primary focus of today’s post is to discuss the use of a Rainy Day Fund to reduce or mitigate year to year variations in spending budgets.
In his article, fellow actuary Joe Tomlinson uses Monte Carlo modeling to “stress” several different “withdrawal” strategies including the 4% Rule and “actuarial approaches” like the one I recommend in this blog. Joe’s models incorporate an average Equity Risk Premium assumption of 3% and T Bond returns of 0.5% to determine which withdrawal strategies are the most resilient in a “stressed” economic environment. Of course frequent readers of my site are well aware that I advocate development of reasonable spending budgets and specifically advise against using “withdrawal strategies” to “tap one’s savings.” Notwithstanding its emphasis on withdrawal strategies, Joe’s article is worth reading, and he reaches a number of interesting conclusions for budgeting during “stressed” economic conditions, including:
- “Although the 4% rule is widely used in retirement research, it is not well suited to real-world retirement planning.”
- “actuarial approaches” don’t reduce the average failure rate [based on Joe’s unique definition of failure discussed more below], but do reduce the average shortfall associated with failure. In addition, actuarial approaches increase average “consumption”, reduce average bequests but increase the volatility of consumption from year to year.
- Smoothing the actuarial approach can reduce volatility of consumption from year to year, but it does not reduce the average failure rate. On the other hand, using a relatively large portion of ones accumulated savings to purchase an annuity can significantly reduce both volatility of consumption from year to year and also avoid Joe’s definition of failure.
Like most retirement researchers using Monte Carlo modeling, Joe assumes that retirees will spend (or consume) exactly their spending budget every year. I call assumptions like this one “Monte Carlo reality” as opposed to “reality.” As a practical matter, retirees frequently spend what they want or need to spend during a year without regard to their spending budget (if in fact they have one). This brings us to the second item of inspiration for this post: the most recent Society of Actuaries survey. Unlike the theoretical Monte Carlo world, this survey attempts to capture what retirees actually do.
There is a lot of good material in this survey, but I am going to focus on the strategies that retirees are actually taking to manage risks in retirement as background for the discussion that follows. The survey results for this item are summarized in Figure 53 and for those already retired, the strategies with the highest percentage “already done or plan to do” include:
- Eliminate all your consumer debt (86%)
- Cut back on spending (76%)
- Try to save as much as you can (74%)
The strategies with the lowest percentages for retirees include:
- Work in retirement (30%)
- Buy a product or choose an employer plan option that will guarantee income for life (22%)
- Postpone taking Social Security (20%)
- Postpone retirement (12%)
Figure 59 shows that 85% of surveyed retirees would reduce expenditures significantly if they were running out of money due to unforeseen circumstances.
Figure 159 tells us that only 22% of surveyed retirees had a plan for spending down financial assets while the rest had no plan or planned to grow assets or maintain asset values in retirement.
Thus, the survey tells us that rather than buy annuities, most retirees are managing their risk in retirement by reducing their spending during poor economic times and saving some of their assets during good economic times.
Unlike failure under the 4% Rule (which requires actually running out of money), Joe defines failure under the actuarial approaches as any future year during which his sample couple’s annual spending budget drops below $70,000. This strikes me as an arbitrary measure of failure as the couple could simply spend more than their budget in such a year or they could transfer assets from funds earmarked for discretionary spending purposes. It is somewhat hard for me to believe that a couple with $1.5 million in assets and $40,000 in annual Social Security income is going to perceive a temporary spending budget less than $70,000 as being a failure. Rather than looking at this as failure, it seems to me that most retirees view a temporary reduction in their spending budget as simply the price to pay for investing in risky assets rather than buying an annuity.
Joe is right, however, that, all things being equal, an actuarial approach can produce a budget that is more volatile from year to year than the 4% Rule or other safe withdrawal rate approaches. Joe is also right that one way to dampen the budget volatility of an actuarial approach is to invest some of the assets that were invested in risky assets into less risky assets, such as annuities. I happen to like annuities and have written favorably in this blog about the potential advantages of combining annuities with investments. However, given their dismal endorsement in the SoA survey, it is clear that they are not everyone’s cup of tea. Fortunately, there are other ways to either smooth budgets or to smooth spending.
It is important to point out once again that budgets are not equal to actual spending, so when Joe says that “the tradeoff [of going to an actuarial approach] is that the year to year volatility of consumption increases significantly, he is not being 100% accurate. In Joe’s Monte Carlo reality where budgets equal spending equals consumption, this may be true, but in reality, either budgets or actual spending can be smoothed when investment returns are volatile. One approach, as mentioned by Joe in his article and by me in my previous post, is simply to smooth the budgets produced by the actuarial approach. Another approach, which I discussed in my post of June 27, 2015, is to set-up and use a “Rainy Day Fund” (RDF). Under this approach, investment gains (investment returns in excess of those expected based on the investment return assumption) are transferred to the RDF while investment losses (to the extent they are covered by the RDF) are transferred back to the fund used to determine the budget when needed. The RDF assets are ignored for budget determination purposes and are intended to be used during periods of poor investment performance, or to be used for other expenses when and if the RDF becomes too large.
To illustrate how the RDF can work, let’s use the same example we used in the previous post (a 65-year old retiree with $500,000 of accumulated savings, $20,000 annual Social Security benefits and a first year spending budget of $41,751), but with the following sequence of actual investment returns over the next five years: 10%, 0%, 20%, -5%, 4.5%. At the end of the first year, expected assets are $499,770, but actual assets are $526,074 (assuming the retiree spends exactly the budget amount for the year). Therefore, the retiree will transfer the investment gain of $26,304 from the budget fund to the RDF. Transferring this amount will keep the second year spending budget constant in real dollars at $41,751. Because of the less than expected investment return in the second year, the retiree will transfer assets back from the RDF to the budget fund to maintain the constant $41,751 real dollar budget and the RDF will drop to $4,817 as a result. The same process is used for subsequent years. The graph below compares spending budgets prepared by the Actuarial Approach with no smoothing with the Actuarial Approach utilizing the RDF approach. Amounts are shown in inflation adjusted dollars. At the end of the fifth year, the RDF would contain $31,934. Note that the gains and losses transferred back and forth from the RDF could also include gains and losses other than investment gains and losses and the annual gain/loss would be easily determined as the difference, if any, between actual end of year assets (including the RDF) and expected end of year assets shown in the Actuarial Budget Calculator run out tab. If the RDF falls to zero, then budgets would have to be reduced as discussed in the previous post.
 |
| click to enlarge |
This graph shows that for certain investment sequences volatility in year to year spending budgets can be avoided through the use of the Actuarial Approach with an RDF. This can be important for those retirees who are concerned about such volatility but who may not want to spend significant amounts of their savings on annuity products to manage this risk. Alternatively, you can live with the volatility, spend what you want and simply use the Actuarial Approach with no smoothing to periodically justify adjustments in your spending.
