It’s Time to Perform Your Annual Actuarial Valuation

As part of our ongoing effort to encourage you to think more like an actuary when it comes to your personal finances, this post will recommend that you to perform an Actuarial Valuation based on your personal data as of January 1, 2018, and prepare an “Actuarial Report” to document your thought process and your planning decisions.  The purposes of this exercise are to:

• Review how well you did in 2017 
• Develop 2018 spending budget “data points” 
• Finalize your 2018 calendar year spending budget (or spending/savings budget for pre-retirees) 
• Document the assumptions, data and adjustments used to determine your final 2018 spending budget, and 
• Collect and save information that may be useful for your future actuarial valuations
  

The first step in the actuarial valuation process is to gather all your relevant personal financial data as of January 1, 2018.

Measuring How You Did in 2017
 
We hope that you saved your data as of January 1, 2017 and documentation of your 2017 spending budget calculations.  With this data you should be able to determine how you did in 2017, by approximating the items in the following equation:

2018 Accumulated Savings

=

2017 Accumulated Savings

+

2017 Investment Income

+

2017 Income from Other Sources

–

2017 Amount Spent

Solving for these amounts and comparing them with amounts expected, based on your 2017 calculations, will enable you to determine your total actuarial gain/(loss), by subtracting Expected 2018 Accumulated Savings from Actual 2018 Accumulated Savings.  If your actual 2018 BOY Accumulated Savings exceeds your Expected 2018 Accumulated Savings, you experienced an “actuarial gain.”
 
Similarly, you can determine your gain/(loss) by source by comparing actual amounts experienced in 2017 with expected values (based on the 2017 actuarial valuation) for the following items:

• investment income 
• income from other sources 
• spending
  

Since it looks like equities will have earned about 20% during 2017 (based on the S&P 500 index at the time of writing), those of you who invested a significant portion of your Accumulated Savings in equities probably experienced actuarial gains on investment income during 2017.  All things being equal, these investment gains will translate into a larger Actuarial Budget Benchmark (ABB) for 2018.  We will discuss below, however, whether you might want to save some of these gains in a Rainy-Day Fund rather to use them to increase your 2018 spending budget.
 
Developing 2018 Spending Budget “Data Points”
 
As discussed in our post of April 20, 2017, the process of deciding on your 2018 spending budget involves considering a number of “data points.”  The data points may include, but are certainly not limited to, the following:

• Your 2017 Spending Budget or actual 2017 spending increased with inflation or some other percentage increase 
• Your 2018 Spending Budget recommended by your financial advisor or someone else, 
• Your 2018 Actuarial Budget Benchmark (ABB) 
• Your desire to avoid significant fluctuations in spending 
• Your desire to be conservative 
• Your scenario testing (discussed in our post of November 26, 2017) 
• Recurring and non-recurring spending plans for 2018, etc.
  

For the first item above, we recommend using the same increase announced for Social Security cost of living increases for 2018: 2%.  If you develop your spending budget based on desired future increases of inflation minus 1%, however, your preliminary 2018 Spending Budget “data point” would be your 2017 spending budget increased by 1% (2% ‒ 1%).

As previously discussed in many of our previous posts (most recently in our post of November 6, 2017), we encourage you to develop your ABB as another data point in your budget setting process.  The ABB is a budget developed using basic financial economic principles by comparing the market value of your assets with the approximate market value of your spending liabilities (i.e., the theoretical cost of purchasing currently available insurance annuity contracts to cover your future spending).  The purpose of the ABB is to gauge how conservative or aggressive your current spending strategy is.  Armed with this benchmark, you can choose the level of spending with which you are comfortable and, just as important, you can monitor how aggressive your spending is each year by annually comparing it with your annually revised ABB. Recommended assumptions to develop your ABB as of January 1, 2018 are summarized in the overview tab of our Actuarial Budget Calculator (ABC) workbooks and, with the possible exception of using different Lifetime Planning Periods (LPPs) for couples, are unchanged from last year.  

As noted above, if you invested significantly in equities in 2017, it is likely that you enjoyed some investment gains.  In order to avoid significant fluctuations in spending and to be more conservative, you may wish to put some or all of your unexpected 2017 investment gains in a Rainy-Day Fund.  One way you can do this is to increase the amount entered in our Actuarial Budget Calculators (ABCs) for the present value of unexpected expenses and non-recurring expenses.  We have no idea when the equity market will see its next “correction,” but it does seem prudent to us to plan on one.  You may wish to use our 5-year forecast tabs (in the ABCs for single retirees and pre-retirees) to see how a significant correction in 2018 could affect your 2019 ABB.

Finalizing Your 2018 Spending Budget
 
Based on the data points discussed above (and possibly others), you can finalize your 2018 Spending Budget.  And while we use the terms “final” and “finalize,” you can always revise your final 2018 spending budget during the year if economic conditions or your personal situation changes.
 
Documenting Your 2018 Actuarial Valuation
 
Actuaries generally document their work in what is called an “Actuarial Report.”  We encourage you to document your work in sufficient detail that you can figure out next year what you did to develop your final 2017 Spending Budget.  This process can be as simple as printing out the “Input and Results” tab of the ABC workbook you used and writing notes on it.  Or you may save the workbook with your notes in a file on your computer.
 
Maintaining an Historical Record
 
In addition to documenting your work in developing your 2018 Spending Budget, we encourage you to maintain an historical record of your spending budget calculations.  This historical information will provide you with additional “data points” that you can use to refine future spending budget determinations.  We have provided a sample spreadsheet for this purpose that will reside in our “spreadsheets” section.  We aren’t trying to make you do a bunch of unnecessary busywork, so feel free ignore items in this spreadsheet you don’t feel like maintaining.  This is just a spreadsheet that we use ourselves to maintain historical information.  We have started the spreadsheet with 2017 information, but if you have information for earlier years, feel free to add that earlier information to your personal spreadsheet. 

(click to enlarge)

Conclusion

Instead of watching some of those college football games this year, we recommend that you take some time to think about your personal financial situation and do some planning.  We recommend that you perform an actuarial valuation of your assets and spending liabilities, and document your thought process in an Actuarial Report that you can revisit next year during college bowl season.  We also recommend that you maintain this information each year so that you can use the historical information to make better assumptions and spending decisions.
 
Happy New Year and Happy Budgeting from Ken and Bobbie.

Better Budgeting with the IRS/RMD Table? — Part II

Several of our readers have asked us to comment on the recently released 145-page report entitled Optimizing Retirement Income by Integrating Retirement Plans, IRAs and Home Equity, authored by Dr. Wade Pfau, Joe Tomlinson, FSA and Steve Vernon, FSA.  The report is a collaboration between the Stanford Center on Longevity and the Society of Actuaries.  Since the report was authored by two actuaries and reviewed by many actuaries (including me), our readers wondered how the recommended strategy contained in this report compares with the Actuarial Approach we advocate here at How Much Can I Afford to Spend in Retirement.  Unfortunately, the two strategies contain some significant differences that may or may not be successfully explained by desires to appeal to different target audiences.  

The authors advocate what they call the “SS/RMD Spend Safely in Retirement Strategy.”  For those who do not want to wade through all 145 pages in the full report, the strategy is summarized in Steve Vernon’s shorter 19-page marketing piece entitled, “How to ‘Pensionize’ Any IRA or 401(k) Plan.”  Briefly, the approach anticipates deferring commencement of Social Security until age 70 and using a Systematic Withdrawal Plan (SWP) known as the IRS/Required Minimum Distribution (RMD) rule to determine annual withdrawals from the individual’s (or couple’s) account balances.   

We discussed the potential downsides of using the IRS/RMD approach recommended by the authors in our post of October 3, 2017.  The reasons we are not big fans of using this approach include:

• The IRS/RMD SWP is quite conservative 
• SWPs frequently do not coordinate well with other sources of retirement income 
• SWPs generally do not adequately recognize non-recurring expenses in retirement and do not anticipate different rates of increase in future recurring expenses 
• SWPs generally don’t permit “budget shaping” to meet individual retirement goals, and 
• SWPs generally don’t do a particularly good job of helping you with pre-retirement planning
  

Feel free to read our October 3 post if you want more explanation of these reasons for not liking the IRS/RMD approach, as we will not be repeating them in this post.

We will, however, take another shot at explaining why we believe the IRS/RMD SWP is generally pretty conservative, more so even than the Actuarial Approach with recommended assumptions.

Contrary to the author’s statement that “the account balance in taxable retirement accounts (such as traditional IRAs and 401(k) accounts) is divided by the participant’s life expectancy to determine the minimum required withdrawal amount for the coming year,” the denominator in this calculation is generally the joint life expectancy of the participant and a hypothetical beneficiary ten years younger than the participant.  In addition to the participant’s account balance being divided by this conservative joint life expectancy, the withdrawal rate is developed utilizing a 0% discount rate.  Thus it produces a significantly smaller annual withdrawal than anticipated under the Actuarial Approach, all things being equal.  We recommend annuity based pricing to determine a person’s (or couple’s) spending budget, and our approach is frequently criticized as being too conservative.  The table below, however, clearly shows that the IRS/RMD approach is even more conservative than the Actuarial Approach.

(click to enlarge)

 
This conservatism does, of course, make it a “safer” approach, but potentially at the cost of not spending enough, not providing adequate income in retirement, and leaving a larger-than-desired estate.  Note that for comparison purposes, the table assumes that the individual’s account balance is the individual’s only asset.  Also note that the table compares withdrawal rates for individuals, and the comparisons could be closer for couples, particularly for couples with significant differences in ages.

Conclusion

The authors argue that their Spend Safely strategy is a straight-forward solution for “ordinary workers” who lack the skills necessary to understand the math that may be involved with retirement planning.  This may be true.  However, we don’t believe that the Spend Safely strategy is truly an “optimal solution”, particularly for Intelligent Numbers People (INPs) who aren’t afraid to do a little number crunching to get a better answer.  The Actuarial Approach is a flexible process that provides “data points” that can be used to help individuals and couples make better financial decisions and help them achieve their financial goals in retirement.  Its basic principles can be applied globally.  The Spend Safely strategy, on the other hand, is an inflexible rule of thumb approach, appropriated from Internal Revenue Service regulations that were designed to force retirees with pre-tax accumulations in U.S. qualified defined contribution plans and IRAs to take distributions from these plans so that the U.S. government could collect its taxes.

As we indicated in our post of October 3, even though we are not big fans of the IRS/RMD approach to help individuals make spending decisions in retirement, we have no problem if defined contribution plan sponsors wish to offer something like this approach as a distribution option in their plans.

When Can I Afford to Retire and When Should I Commence my Social Security Benefits?

This post will address two of the more difficult financial questions confronting individuals who are considering retirement:

• When can I afford to retire, and 
• When should I commence my Social Security benefits?
  

Many factors enter into the decision of when to retire.  Our focus in this post will be strictly limited to the considerations of when retirement may be financially feasible.  We will not be covering the many non-financial questions/issues associated with ceasing employment and joining the ranks of the retired population.

To help you answer these questions and plan for the future, we encourage you to use the Basic Actuarial Equation or our Actuarial Budget Calculator (ABC) workbooks and our recommended assumptions to develop hypothetical spending budget decision “data points” based on alternative assumed retirement ages and assumed Social Security benefit commencement ages.  We will use these workbooks and a hypothetical worker named John to illustrate the calculations.

Before we dive into John’s numbers, we want to talk about the general impact on expected retirement income of continuing to work vs. retiring and deferring commencement of your Social Security benefit (the Social Security deferral strategy).  While it is common for retirement experts to tout the benefits of the Social Security deferral strategy as a way to maximize retirement income, we find that continuing to work (and at the same time deferring commencement of Social Security benefits) produces much larger increases in expected retirement income than retiring and employing the Social Security deferral strategy.

John’s calculations will show that if he retires and defers commencement of his Social Security benefit, he can expect his real dollar spending budget to increase by about 1% for each year of deferral (or slightly less if John is not in “excellent” health), whereas it increases by about 8% for each year that he continues to work.  Therefore, while we agree that the deferral of Social Security commencement strategy is probably “better than a poke in the eye with a sharp stick”, your decision of when to stop working is generally going to be a more significant driver of the amount of your spending budget in retirement than your decision of when to commence your Social Security benefit.

When can I afford to retire?  How much is enough?

Determining when you can afford to retire is a personal decision based on many factors, including:

• Your tolerance for risk 
• Your personal financial situation 
• Your retirement goals
  

Common rule of thumb (ROT) suggestions for when you can afford to retire include when you have accumulated 10 or 11 times your annual compensation or when your retirement income replaces 70%-80% of your pre-retirement annual compensation.  We have even read that you should determine your “retirement number” using one of these ROT approaches and then double it.

Unfortunately, we cannot tell you exactly how much you will need in order to feel financially prepared to retire.  We can, however, provide you with a process to follow, workbooks to help crunch the numbers and a benchmark against which you can measure your progress at meeting your retirement age goal.

In order to replace about the same level of your spending after retirement as before, we recommend that you target about an 85% replacement level of spending.  After retirement, you will no longer be subject to work-related expenses such as FICA (Social Security and Medicare) taxes, and your federal income taxes should be lower than before retirement.   It is important to note that the target we recommend is 85% of your pre-retirement spending and not 85% of your pre-retirement pay.  So, if on average, you are saving about 10% of your pay just prior to retirement, your target would be 77% (.90 X .85) of your pre-retirement pay, and if you are saving 25% of your pay just prior to retirement, your target would be 64% (.75 X .85) of your pre-retirement pay.  So, if you want a lower retirement spending budget target, all you need to do is save more prior to retirement.  Also note that the 85% target is an average that might be a little low for higher compensated individuals and a little high for lower compensated individuals.

Of course, if you plan to spend more after retirement than before, for example by traveling more, or you just want to be more conservative in your planning, you will want to target a higher spending replacement level.  While research generally shows decreased levels of spending both at and after retirement, your situation may be different and you should plan accordingly.

Example

Facts:  John was born on January 15, 1954 and is divorced.  He believes that he is in excellent health.  He is making $50,000 per year and is currently saving about 15% of his pay for retirement.  He has $400,000 in accumulated savings and if he retired and commenced his benefit in January, 2018, his Social Security benefit (estimated from the Social Security Online Quick Calculator) starting at age 64 would be $1,212 per month.  His employer matches his 401(k) contributions $.50 on the dollar up to six percent of his pay.  He has about $200,000 of equity in his home.  He has no mortgage and no longer pays alimony.

Retirement Goals:  While John enjoys his job, he is starting to think about retirement.  He does not want to become a financial burden on his son and wants to leave $50,000 in today’s dollars to his son upon his death to cover funeral and other miscellaneous expenses.  John believes that his spending after retirement will be about the same (in real dollars) as his non-work-related spending prior to retirement.  And while he may travel more early in his retirement, and he expects his health-related expenses will increase faster than inflation in the future, he believes that his other spending may decrease in real dollars as he ages.  Therefore, he is comfortable targeting constant real dollar recurring annual spending during his entire period of retirement.   Using the 85% recommendation, he determines his initial real dollar spending target in retirement to be of about $36,125 (.85 (1 minus John’s savings rate of 15%) X .85 X John’s pay of $50,000).

Assumptions: As a first step, John uses our recommended assumptions and our Actuarial Budget Calculator (ABC) for Single Retiree workbook to determine his Actuarial Budget Benchmark (ABB), assuming he retires on December 31, 2017 and commences his Social Security benefit at age 64.  He assumes that his home equity will cover his expected long-term care costs and he budgets $25,000 as the present value of his unexpected expenses.  He also assumes that he will retire completely and not take a part-time job.  After going to the Actuaries Longevity Illustrator, John selects a lifetime planning period (LPP) of 30 years based on his assumption of excellent health and the 25% survival probability level.

Initial Calculation

Based on the facts and assumptions discussed above, John calculates an ABB for 2018 of $29,661.  The screenshot below shows the details of this calculation. 

(click to enlarge)

Retire but defer Social Security commencement:  Based on his initial calculation, John decides to explores other planning options that will get him closer to his annual spending replacement target of $36,125.  He has heard that he can increase his retirement income after retirement by deferring commencement of his Social Security benefit.  So, he looks at the impact on his 2018 spending budget of retiring and deferring commencement of his Social Security benefit until age 70.  If he defers commencement of his benefit until age 70, it will be $1,846 per month before cost of living increases, which is equal to his $1,212 benefit divided by his early retirement factor of .8667 and further increased by 8% per each year of deferral after his normal retirement age of 66.  With six years of assumed cost of living increases of 2% per annum, his expected age 70 Social Security benefit is $2,079 per month.

He inputs $2,079 in cell E (11) as a monthly benefit and “6” in F (11) in the Input and Results tab of the ABC for single retiree workbook.  The resulting annual spending budget for 2018 increases to $31,752, an increase of about 7% over the initial calculation of $29,661.  This works out to be about 1% for each year of deferral, but the result is still less than John’s target of $36,125.

Note that if John were in “average” health (with an LPP at the same 25% survival probability level of 28 years), the six-year deferral strategy would be expected to increase his current spending budget by about 6% and if he were in “poor” health (with an LPP at the 25% survival probability level of 26 years), by about 5%.

John likes the fact that he can increase his annual spending budget by deferring commencement of his Social Security benefit, but when he goes to the Runout tab of the workbook, he notices that his accumulated savings will be much more depleted under the Social Security deferral strategy than under the immediate commencement strategy.  In fact, if all his assumptions are realized, he would have $120,373 less in accumulated savings under the Social Security deferral strategy at the end of year 5 of his retirement. He is also somewhat concerned that future changes in the Social Security program to address the system’s financial condition may make the Social Security deferral strategy less attractive than it appears to be today.

In any event, his calculations show that the Social Security deferral strategy won’t get him up to his target spending budget, so he decides to look at more options.

Keep working:  John now looks at options which require him to keep working.  So, he decides to look at the impact on his retirement spending budget of working one more year.  He switches to the ABC for single pre-retiree workbook and enters pay of $50,000 and “1” for the desired number of years until retirement in cell B (11).  He goes to the Social Security Online Quick Calculator which tells him his benefit would be $1,325 per month in today’s dollars if he retired at age 65 and commenced his benefit at that age.  With one year assumed inflation increase, this benefit would be $1,352 per month, or $16,224 per annum.   He enters this amount in cell E (15) and “1” in cell E (17).  He enters the same 30-year LPP, 15% annual savings, 2% per annum pay increases and $1,500 for the annual 401(k) employer matching contributions.  Instead of entering $50,000 as the desired amount remaining at death in today’s dollars as he did with the ABC for Single Retirees workbook, he enters $90,568 in this workbook as the desired amount remaining at death (in future dollars) which produces the same $50,000 amount in today’s dollars.

The resulting first year of retirement real dollar spending budget based on these entries is $32,121, or about 8% higher than John’s initial real dollar retirement spending budget.

John goes through this same exercise assuming retirement in three years and develops a first year of retirement real dollar spending budget of $37,563 (or about 27% higher than his initial budget estimate) and a little higher than his target.  Another option that John explores is to work two additional years and defer commencement of his expected Social Security benefit payable at age 66 until age 70.  He develops a first-year real dollar spending budget of $36,127 under this option, which is just about equal to his real dollar spending target.

Conclusion

There are many options that John, or you, can explore when determining the appropriate time to retire.  For example, you can consider:

• Increasing your savings rate 
• Working part-time in retirement 
• Reducing your spending target 
• Tapping some or all of your home equity 
• Front-loading your real-dollar spending budget in retirement, etc.
  

Or, you can hope that your (or your financial advisor’s) investment strategies will generate the returns you will need to support your desired lifestyle in retirement.

The important “when-can-I-afford-to-retire” take-aways are:

• How much you need to accumulate to feel financially secure with your decision of when to retire is a personal decision that should be based on your financial situation and goals, and shouldn’t be based on rules of thumb. 
• You should probably do some number crunching before you decide to retire. 
• We have workbooks that can help you do this number crunching.  These workbooks consider your total assets and your total spending liabilities. 
• If you want to have about the same level of non-work-related spending after retirement as before, your first year of retirement real dollar spending budget should be somewhere in the neighborhood of 85% of your expected real-dollar spending just prior to your retirement. 
• Continuing to work is generally going to be the most effective way of increasing your retirement spending budget.

Life Expectancy vs. Lifetime Planning Period

We provide recommended assumptions that you can use to calculate what we call your “Actuarial Budget Benchmark (ABB).”  Your ABB is a “market value” calculation of your current spending budget using assumptions approximately consistent with current insurance company pricing of life annuities and provides you with a relatively low-investment risk “data-point” to be used in your financial planning and budget setting process.  You don’t have to use these recommended assumptions to develop your spending budget, but we encourage you to do the calculations with the recommended assumptions annually to compare your spending budget (however you develop it) with the ABB.

In this post, we will focus on one of the assumptions you need to make to calculate your spending budget:  your lifetime planning period (LPP).   LPP is a nice way of saying how many more years of life you plan to fund with your assets.   Notice that we did not say that this is the number of years of life you expect to live.   We purposely want to make a distinction between your life expectancy and your LPP.

For ABB calculation purposes, we recommend that you use the LPP (or LPPs for couples) based on the 25% chance of survival for a non-smoking male or female (as appropriate) with “excellent health” from the “Planning Horizon” section of the Actuaries Longevity Illustrator.  So, for a 65-year old male in excellent health, this would be an LPP of 29 years, implying an age of death, for planning purposes, of 94.   By comparison, the 75% probability of survival is 15 years (age at death of 80) and the 50% probability of survival is 23 years (age at death 88).   While this male’s life expectancy (the 50% survival probability) is 23 years, there is still a relatively large range of when death is more likely to occur than not (ages 80 to 94). 

If you are not fully insuring your retirement through the use of annuity contracts, it is just prudent to plan for a longer-than-average lifetime.  We view this as part of the extra cost associated with self-insuring one’s retirement.  The insurance companies, of course, argue that the risk-pooling associated with their lifetime income products avoids this extra cost (i.e., where individuals who die early can subsidize those who live longer). They sometimes refer to this risk-pooling survival benefit as a “mortality credit.”

In addition to being more prudent to use the 25% probability of survival LPP rather than the 50% probability (life expectancy), using this LPP avoids future actuarial losses and declining spending budgets as you age if all other assumptions are realized (until about your late 80s).  This potential decline in spending budget is illustrated in the graph below originally from our post of December 3, 2014.

click to enlarge

Using Other LPP Assumptions to Develop Your Spending Budget

As discussed above, you should feel free to develop your spending budget using assumptions you believe are more appropriate than the ones we recommend to determine your ABB.  Not everyone is in “excellent” health.  Your current health or family history may cause you to believe that your LPP is shorter than the LPP we recommend for ABB purposes.   You should be aware, however, that most individuals tend to underestimate their life expectancy.  So, feel free to use the “average” or “poor” general health choices from the Actuaries Longevity Illustrator if you believe these choices would be more appropriate for your personal situation.  However, for the reasons noted above, we recommend that you still use the resulting 25% probability of survival LPP for budget setting purposes.

Assumptions for Evaluating Alternative Investment or Spending Strategies

You can use the Basic Actuarial Equation and our workbooks to give you additional “data points” in your evaluations of alternative investment or spending strategies by running possible scenarios and seeing which ones produce a larger current spending budget.   When evaluating immediate or deferred annuity purchases, lump sum or annuity options from defined benefit plans or Social Security deferral strategies, we recommend that you also use the 25% probability of survival LPPs rather than your life expectancy for your calculations.   Since these types of strategies generally favor the long-lived, we find that your ABB (which uses an LPP based on “excellent health”) will generally increase if you should decide to use some of your accumulated savings to purchase an annuity or defer commencement of your Social Security, but if your budget calculation is based on an LPP for someone in “poor” health, this may not be the case.

In addition, we recommend that you use a low-investment-risk discount rate for purposes of making these types of comparisons.  See our post of July 23, 2017 entitled “What is an Appropriate Discount Rate for Personal Financial Planning” for discussion of why we believe it is important to properly consider expected risks when comparing alternative strategies.   In general, investment in risky assets will carry higher risks than investment in annuities.   And while stochastic modeling can provide a measure of this risk (in the form of a probability of success), the comparisons are highly dependent on the reasonableness of the assumptions selected for modeling investment returns and variances.  Therefore, we recommend that if stochastic modeling is used to make such comparisons, they be supplemented by comparisons, based on the basic principles of financial economics, using a low-investment-risk discount rate.

Modeling Deviations from Assumed Future Experience

We here at How Much Can I Afford to Spend advocate the use of three basic actuarial principles to help you develop a reasonable spending budget and enhance your personal financial planning.  We refer to the combination of these basic principles as “The Actuarial Approach.”  As discussed in Misperception #5 of our five common misperceptions post of November 6, 2017, many people tend to confuse the Excel workbooks that we provide to facilitate the present value calculations required under the Basic Actuarial Equation with the more general Actuarial Approach/process.  

The Actuarial Approach/Process

• Principle #1--Matching Assets and Spending Liabilities 
• Principle #2—Annual valuations 
• Principle #3—Modeling deviations from assumed experience to mitigate risks
  

The first principle involves making assumptions about the future and matching your assets and your liabilities (calculated based on those assumptions) to help you develop a financial plan and a reasonable spending budget for the current year; the second involves periodically making adjustments in your plan and spending budget to reflect experience as it emerges, and the third involves preparing yourself in the event your assumptions about the future turn out to be wrong.  When taken together, this actuarial process provides a much more powerful personal financial planning tool than our simple Excel spreadsheets. 

This post will focus on applying the third principle—modeling deviations from assumed experience, a principle graphically described by boxing legend Mike Tyson when asked if he was concerned about Evander Holyfield and his fight plan.  Mike’s now famous response was, “Everyone has a plan until they get punched in the mouth.”  In this post, we will encourage you to “stress test” your financial plan with some “what if” analysis for the purpose of determining the potential negative implications of being wrong about the assumptions used in your plan, and the actions you may wish to consider now or in the future to mitigate these potential negative implications.

The Assumptions Used in Your Plan Will Be Wrong

As discussed in our post of September 22, 2015, “Retirement Planning in an Uncertain World—Part 2”, there are many possible reasons why forecasts made today will be wrong (deviate from expected results) in the future.  These reasons include:

• Differences between actual and assumed investment returns 
• Differences between actual and assumed longevity 
• Differences between actual and assumed spending 
• Differences between actual and assumed sources of income, and 
• Differences between actual and assumed rates of inflation
  

In fact, every assumption you make in developing your financial plan and current spending budget may turn out to be wrong to some degree.  And while we want you to sleep well at night, and we don’t want you to be overly-paranoid about the future, we do believe that a reasonable amount of risk assessment and risk mitigation can be helpful in facilitating achievement of your long-term financial goals.

Differences Between Actual and Assumed Longevity

Since our last post included an example of determining a spending budget for John and Mary, we are going to continue that example and start with stress testing their lifetime planning period (LPP) assumptions.  You should refer to this previous post for the calculation details.  As you may recall from that example, John and Mary went to the Actuaries Longevity Illustrator and the planning horizon section on the results page told them that the 25% chance (or probability) of survival was 29 years for John, 37 years for Mary, 37 years for “either alive” and 26 years for “both alive.”  Based on these and other recommended assumptions used for developing their Actuarial Budget Benchmark (ABB), they developed a current year spending budget of $77,893. 

The LPP assumptions they used for their plan may turn out to be about right, too long or too short for one or both of them.   To stress test the LPP assumptions for the potential impact of being too long, we recommend that John and Mary look at the estimated effect on their spending budget assuming one of the couple (in this example, John) dies immediately.   Because John elected a 50% Joint and Survivor form of annuity payment and because he has a $100,000 life insurance policy, Mary would receive $100,000 in proceeds from the insurance policy and would receive $1,300 per month under John’s pension upon John’s assumed demise.   Based on her age (60), she would also be eligible for a survivor’s benefit from Social Security equal to 71.5% of John’s ($2,000 per month) benefit, which would be payable until she elected to receive the benefit based on her own Social Security earnings.   For this purpose, Mary assumes that she will commence her benefit based on her earnings at age 70 and will receive her survivor’s benefit from John for 10 years.  She therefore goes to our Present Value Calculator V 1.1 to determine the present value of $17,160 ($1,430 per month) payable annually for 10 years and increasing by 2% per year.  She enters the resulting present value of $157,486 in C (7) of the ABC for Single Retiree workbook together with other relevant data and assumptions to estimate her spending budget assuming John’s immediate demise. 

The screen shot below shows the entries Mary makes into the ABC for Single Retirees to develop an estimated spending budget of $53,505, or about 69% of the $77,893 spending budget anticipated for the couple while both alive.  This amount is a little bit higher than their desire to have about a 33% decrease in spending upon the first death within the couple, so while Mary wouldn’t be overjoyed if John passed away this year, she is reasonably comfortable with the financial consequences. 

(click to enlarge)

John can also examine what effect on his budget would be if Mary were to pass away this year.  The important result of looking at the possibility of earlier than expected deaths is the effect such death could have on the spending budget of the survivor.   If, for example, John had not elected a 50% joint and survivor form of annuity and/or did not have a life insurance policy, John’s early demise could have a significantly negative effect on Mary’s spending budget.  If that were the case, the couple could mitigate this potential negative impact by deciding to either buy some life insurance protection for John or buy annuity income based on Mary’s life.

John and Mary could also look at the potential implications of living longer than the assumed LPPs they used for planning purposes by re-determining their spending budget assuming even longer LPPs.  For example, instead of using the 25% probability of survival from the Actuaries Longevity Illustrator, they could use the LPPs based on a 10% probability and re-determine the additional present values of the benefits payable to Mary after John’s revised age of demise.  In this case, the impact on their spending budget would be fairly minimal.

Additional stress testing of the longevity assumptions can also be accomplished by assuming different health assumptions for one or both of the couple, assuming one or both is a smoker or by assuming one or both is X number of years older or younger than their actual age. 

Differences Between Actual and Assumed Investment Return and Actual and Assumed Spending

We have provided 5-year projection tabs in our ABC’s for single retirees and post-retirees to enable you to model the approximate impact on your spending budget of deviations from these assumptions.  As discussed in the overview tabs of the ABCs for retired and pre-retired couples, if you are a couple, you can use the single versions of the ABC’s to approximately model these variations.  Stress testing these assumptions can provide helpful information for developing investment and spending strategies, such as the possibility of establishing a robust Rainy-Day Fund.  Given the current equity market, it may be prudent to model the impact on your spending budget of a significant correction in the equity markets in the near future. 

Differences Between Actual and Assumed Sources of Income

If a significant portion of your assets is expected to come from one or two sources, you may wish to stress test your assumptions about receiving this income.  For example, if you are not yet retired, a significant source of your expected income may be your future expected employment income or your Social Security benefit.  Sources of income may also be lost or diminished in the event of death or divorce.  Also, many individuals expect to tap into their home equity or other sources to fund their retirement expenses.  If the potential loss or diminishment of these sources of income significantly reduces your expected spending, you may wish to consider taking steps to better protect these sources of income through insurance, through alternative investment strategies or you may wish to adjust your spending strategy to be more conservative.

Differences Between Actual and Assumed Inflation

While rates of inflation have been at historical low levels in recent years, it is certainly possible that higher rates may emerge in the future.  You may wish to stress test this assumption as well to help you make choices between investments that may or may not be inflation sensitive.

Conclusion

This website encourages you to think like an actuary and use basic actuarial principles in addition to what you are currently doing when it comes to your own personal financial planning.  In addition to making assumptions about the future and periodically balancing your assets with your spending liabilities, we encourage you to periodically stress-test important planning assumptions you make so that you can possibly mitigate negative outcomes if actual future experience punches you in the mouth. 

Survivor Payments Anticipated After First Death Within the Couple

Almost immediately after releasing our new Actuarial Budget Calculators for couples, we began to receive questions on how to handle payments anticipated after the first death within the couple.  Such payments could occur, for example, if

• One or both of the couple have a joint and survivor form of life annuity, 
• One of the spouses is eligible for a larger monthly benefit from Social Security or Canada Pension Plan upon the first death within the couple, or 
• One of the spouses may receive a lump sum or annuity upon death from a life insurance policy.
  

At this time, we don’t plan to modify our simple spreadsheets to calculate the present value of these various types of survivor benefits.

However, in this post, we will address how you can estimate the additional present values of these survivor payments using the Present Value Calculator spreadsheet, and then add the calculated present values to the “present value of other sources of income” input item in the ABC spreadsheets, to refine the calculation of your current spending budget.

We will use the following example of the retired couple of John and Mary and our ABC for Retired Couples to illustrate how this calculation could be done.

Example

Assume the following information for John and Mary:

• John is age 65 and Mary is age 60 and are both retired. 
• Neither of the couple has part-time employment income. 
• John has a monthly Social Security benefit of $2,000 that he is currently receiving and Mary anticipates receiving a Social Security benefit of $2,800 per month payable in future dollars when she reaches age 70. 
• John also has a pension benefit of $2,600 per month which is payable for his life with 50% of his benefit ($1,300 per month) payable to Mary after his death as long as she lives. 
• He also has a paid-up life insurance policy that will pay Mary $100,000 when he dies. 
• Mary has no lifetime income benefits other than her Social Security and she has no life insurance. 
• Because Mary has significant Social Security benefits on her own, she does not expect her Social Security benefit to change on John’s death. 
• They have accumulated savings of $500,000. 
• They also have equity in their home, but they have decided such equity will be used to cover any long-term care costs they may incur. 
• They assume unexpected expenses with a present value of $75,000 and expenses on final death of $100,000 in today’s dollars.
  

Assumptions:  John and Mary use the assumptions we recommend to calculate their Actuarial Budget Benchmark (ABB) to determine their 2018 recurring spending budget.  These assumptions include:

• 4% discount rate 
• 2% assumed rate of inflation 
• 2% annual increases in their future desired spending budget 
• 33% decrease in the spending budget upon the first death within the couple
  

They go to the Actuaries Longevity Illustrator and enter their birthdates, their genders, “no smoking” and “excellent general health” on the first page of this tool.  The planning horizon section on the results page tells them that the 25% chance (or probability) of survival is 29 years for John, 37 years for Mary, 37 years for “either alive” and 26 years for “both alive.”

To reflect the anticipated death benefits payable to Mary after John’s assumed death in the current year’s spending budget, they need to add the present value of the anticipated death benefits payable to Mary after John’s death in PV Other sources of income item C(26) of the ABC for Retired Couple workbook.  To obtain these present values, they go to our Present Value Calculator V. 1.1 spreadsheet and enter the following items:

For Mary’s expected pension benefits after John’s death (which based on the planning horizon assumptions is expected to occur after 29 years):

• $15,600 for “p” (which is twelve times the monthly amount Mary would receive: 12 X $1,300 per month) 
• 29 years of deferral for “t” 
• 8 years of payment for “n” (which is the difference between Mary’s assumed planning years until her demise of 37 minus John’s assumed planning years until his demise of 29) 
• 4% for “i” 
• 0% for “k.
  

This produces a present value of $35,025, as shown in I(15).

The present value of John’s life insurance policy is $32,065, and is determined by entering:

• $100,000 for “p” 
• 29 years for “t” 
• 0 years of payment 
• 4% for “t” 
• 0% for “k.
  

(click to enlarge)

The screen shot above shows the amounts that John and Mary enter into the Input portion of the Inputs & Results tab of the ABC for Retired Couples and the results. 

Note that the additional present value of $67,090 inserted in C(26) produces a 3.4% increase in John and Mary’s current spending budget (from $75,298 to $77,893).   This relatively small increase is a function of assuming relatively long lifetime planning periods for budget setting purposes.  The value of these benefits would, of course, be much greater if John were to die in the near future.  Also note that if John were entitled to benefits after Mary’s death, there would be no additional present value of such benefits, as under the planning assumptions, John is assumed to pre-decease Mary.

While we recommend assuming relatively long lifetime planning periods for budget development, it is also important to periodically determine the effect on spending budgets if assumptions about the future are not realized.  In John and Mary’s case, the earlier than expected death of either individual would probably not significantly negatively affect the budget of the surviving individual, but this is something that other couples should examine.

We will address the assessment of risks (that assumptions will not be realized in the future) in our next post.