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!