Got “Lumps” in Your Sources of Income or Your Expenses? Smooth Them Out with the Actuarial Approach

Ever notice when you are reading about the best way to spend down your invested assets in retirement how most retirement researchers or retirement experts will demonstrate how well their Systematic Withdrawal Plan (SWP) works by assuming:

• Sources of retirement income will commence at the same time and will generally only involve Social Security and withdrawals under the SWP 
• Any other sources of income will commence at the same time, will be paid for life and will generally increase with inflation 
• Expenses in retirement will be smooth from year to year and will generally increase with inflation 
• Individuals or couples will develop their annual spending budget by summing their retirement income sources (sum of the sources) each year and will spend exactly this amount every year, and 
• The family unit’s goal is to have a recurring spending budget (and actual spending) that remains constant in Real Dollars for as long as they live.
  

For many individuals and couples, these just aren’t realistic assumptions, and application of the expert’s SWP can lead to undesired consequences under more real-world situations.  Amazingly, however, these potential problems don’t seem to stop the retirement researchers from continuing to tout the 4% Rule, the Required Minimum Distribution (RMD) Rule, some variation of these rules or some other rule of thumb SWP as the best way to spend down your assets.  We have previously discussed the potential shortcomings associated with SWPs and “sum-of-the-sources” budgeting if sources of income aren’t “smooth” throughout retirement (most recently in our post of April 9, 2017).  This post will focus on the problems associated with using SWPs that can also occur if expenses in retirement are expected to be “lumpy,” and how the Actuarial Approach can be used to smooth out such lumpy expenses, just as it works to smooth out lumpy sources of income.

How do lumpy expenses affect your annual recurring spending budget?

It is just kind of silly to assume that your expenses are going to remain constant in Real Dollars from year to year.  At some point during your retirement, you or your spouse is going to decide that your house needs a new roof, the kitchen needs to be remodeled, you need one or more new cars, etc.  As the old saying goes, “Expenses Happen.”  And these larger expenses are unlikely to fit into your recurring annual expense budget.  This is why we suggest that you establish reserves for unexpected expenses and other non-recurring expenses (in addition to your reserves for Long-Term Care and bequest motives, and general Rainy Day Funds to dip into if your investments perform poorly).  To the extent that these expenses are covered by reserves for this purpose, there may be no effect on your annual recurring spending budget (although you may have to build the reserves up again for the next unexpected expense, and this could reduce your annual recurring spending budget).

Sometimes these larger expenses, such as home improvements, can be considered as investments that increase (or do not decrease) the total value of your assets.  In this event, the diminution of your accumulated savings may be totally or partially offset by the increase in your home value, and depending on how you plan to use your home to finance your retirement, you may not have to experience a reduction in your annual recurring spending budget by incurring this type of expense.

Other expenses, for which you have established no reserves or that don’t increase the value of some other asset you own, are just large expenses, and you will have to decide whether they are “recurring” or “non-recurring.”  If you can’t (or don’t want to) absorb them entirely in this year’s recurring spending budget), then your assets will be reduced and your next year’s recurring spending budget may be reduced, just as it may be with any asset loss.
You may expect to incur some temporary, but not permanently, expenses over several years.  For example, you may have temporary family loans/support, plans to travel over a defined period of time or remaining mortgage payments when you retire.  As illustrated in the example below, you may wish to establish non-recurring expense reserves for these types of expenses, rather than have them significantly affect short-term and long-term annual recurring spending budgets.

Finally, research has shown that retirees tend to spend less in Real Dollar terms as they age.  If you are comfortable with developing a more “front-loaded” spending budget, you can use the Actuarial Approach to “smoothly” reflect this reality.

Example

Let’s assume we have a retired 65-year old female with:

• $500,000 in accumulated savings 
• a Social Security benefit of $20,000 per annum payable immediately 
• four years left on her home mortgage at $24,000 per annum that she does not want to pay-off early.
  

For calculation simplicity, let’s also assume that she inputs $0 for

• bequest motive, 
• PV Long-Term care costs 
• PV unexpected expenses
  

She desires to have constant Real Dollar recurring spending in retirement.  However, she establishes a reserve to pay off her current mortgage of $96,602.

Using the Actuarial Budget Calculator and our recommended assumptions, she determines her annual recurring spending budget for this year to be $37,408.  If all her assumptions about the future are realized, this will be her Real Dollar recurring spending budget for her first year of retirement and for the rest of her life.  If she actually spends this amount plus the $24,000 of mortgage payments from her non-recurring fund, she will spend a total of $61,408.  By comparison, if she used the 4% Rule and didn’t set up a separate mortgage payment reserve, her total spending for her first year would be limited to $40,000, and would be expected to remain at this Real Dollar level throughout her retirement.  In her first year of retirement, however, her non-mortgage spending would only be about $16,000, compared with non-mortgage real dollar spending of $40,000 after her mortgage is paid off.

Conclusion

If you live in the real world where sources of income and expenses may not always follow the simplifying assumptions made by retirement researchers, we encourage you (or your financial advisor) to use the Actuarial Approach to develop a more reasonable recurring spending budget.  Even if your situation is consistent with the assumptions above, we still encourage you to become familiar with and apply our Actuarial Budget Calculators.

What is an Appropriate Discount Rate for Personal Financial Planning?

In our previous post, we got excited because several financial advisors appeared to be endorsing the use of basic actuarial principles in personal financial planning.  So, we were more than a little bit surprised and pleased when Michael Kitces decided to discuss discount rates, the time value of money and present values in his July 19, 2017 post Choosing An Appropriate Discount Rate For Retirement Planning Strategies, as these concepts are fundamentals of actuarial science and key elements of the Actuarial Approach recommended in this website.  And while we want to encourage financial advisors and others to think more like actuaries, we feel compelled, in this post, to push-back on Mr. Kitces’ advice regarding selection of an appropriate discount rate.

While Mr. Kitces primarily focuses his discussion on selection of a discount rate for the specific purposes of comparing immediate commencement of Social Security vs. delayed commencement’ and electing a pension vs. a lump sum, we believe selection of an appropriate discount rate is critical for many personal financial decisions.  For example, in addition to the two items discussed by Mr. Kitces, we recommend using the Actuarial Approach for items including, but not limited to:

• Determining assets needed to support aspirational spending (desired spending) 
• Developing a spending budget based on actual assets 
• Developing a savings strategy prior to retirement 
• Determining timing of retirement 
• Deciding whether to take a part-time job 
• Deciding whether to purchase an annuity contract
  

Mr. Kitces’ post tells us how to select the appropriate discount rate.  He says, “the discount rate should be the expected return of the portfolio.”  He goes on to say, “Notably, this means that investors who are more aggressive and have higher expected returns will use a higher discount rate.”  And finally, he notes, “Of course, it’s still important to choose a realistic rate of return for the portfolio as a discount rate.”

Unfortunately, while Mr. Kitces’ advice seems relatively straightforward, we are left to our own devices to define his important terms, “expected return” and “realistic rate of return.” You might infer from his post that if you realistically believe you can earn a 6% real rate of return on your equities, then you should be using the 6% real rate as your discount rate in your personal financial planning.  And while historical asset class returns give us a sense of what we might expect in the future from various asset mixes, there are no guarantees that these historical returns will continue in the future, and higher expected investment returns generally do not come without additional risk.  We believe that consideration of this additional investment risk is an important part of the “appropriate discount rate” determination that should not be ignored.  Mr. Kitces’ advice is potentially inconsistent with the basic financial economic principle that the value of a future stream of payments should be determined by finding a portfolio of assets that matches the benefit stream in amount, timing and probability of payment.

To calculate your Actuarial Budget Benchmark (ABB), we advocate assuming a discount rate that is roughly consistent with the discount rates inherent in current annuity pricing (currently a 4% nominal, or approximately 2% real, discount rate).  This provides you with, for example, a benchmark spending budget based on the assumption that your investable assets are invested in relatively low risk-investments (i.e., you could effectively settle your spending liabilities by purchasing annuities).  We most recently discussed the rationale for this assumption recommendation in our post of July 10, 2017, where we referenced the column What Does Retirement Really Cost? by Dr. Moshe Milesvky, which included these comments on this subject:

"As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column.  Any other answer involves extra risk, possibly invisible to the naked eye.

Don’t get me wrong.  There is nothing wrong with investing aggressively and holding stocks — I have said many times that my portfolio is pretty much 100% equity.  And I absolutely do not “price” my retirement income plans at the long-term expected return from stocks.

In fact, this sort of thinking is precisely the mistake that got the pension fund industry (and many of their actuaries) into big trouble.”

One of the potential problems with using expected rates of return without consideration of risk to develop a discount rate is that individuals (and pension plan clients) can be seduced into investing too aggressively.  As Mr. Kitces suggests, individuals who are more aggressive and have higher expected rates of return can therefore assume higher discount rates and can therefore develop higher spending budgets (or lower pension contributions).  Unfortunately, this desire to have a larger spending budget (or lower pension contributions) can easily lead to poor financial decisions.

Our Actuarial Budget Calculators permit you to enter your “expected return on your portfolio” if you want to develop your spending/savings budget using this assumption (or assumptions other than the ones recommended to develop your ABB).  We recommend, however, that if you do so, you also calculate your ABB with our recommended assumptions and compare it with your more aggressive (or conservative) spending budget to see just how much additional risk you are assuming.  We also suggest that you monitor this ratio over time to see if your spending strategy is becoming relatively more or less aggressive.

The ABB can help you develop an investment and spending strategy (and make other personal financial decisions) with which you are comfortable, based on:

• Your tolerance for future spending cuts 
• The proportion of your retirement spending covered by sources outside of your investment portfolio, and 
• The availability of reserves (such as Rainy Day funds, LTC reserves or flexible bequest motives, for example)
  

We do agree with Mr. Kitces that if you plan to always be invested in more conservative investments than annuity contracts, you might want to consider using a lower discount rate than those inherent in annuity contracts (or you might also want to consider investing in annuity contracts).

We have previously discussed the important personal financial decisions of whether to defer commencement of Social Security benefits (most recently in our post of November 14, 2016) and whether to elect a lump sum vs. pension (in our post of February 18, 2015).  As noted above, when making these decisions, we believe it is important to consider not only the expected return of an alternative strategy, but also the expected risk associated with the alternative strategy.  Applying basic financial economics principles, you should wind up in the current economic environment with an appropriate discount rate in the 3% - 4% (nominal) neighborhood for these comparisons.

Of course, Mr. Kitces knows that individuals should consider risks associated with alternative strategies, which is why he refers to the benefits of Monte Carlo modeling near the end of his post.  Fortunately, you can also get a good sense for the magnitude of these risks without using Monte Carlo modeling, just by using the Actuarial Approach and basic financial economics principles.

Happy present-valuing from the team at How Much You Can Afford to Spend!

McLean Asset Management Endorses Basic Actuarial Principles for Personal Financial Planning

We are thrilled to see that McLean Asset Management Corporation (MAMC) has endorsed the use of basic actuarial principles for personal financial planning.  In his July 14 Retirement Researcher blogpost, Dr. Alex Murguia said “We are really fond of the Funded Ratio because it allows us to provide a numerical picture of your retirement income plan.”  The calculations involved in determining MAMC’s “Funded Ratio” are, for all practical purposes, the same as those required by the Actuarial Approach recommended in this website.  So, if you like MAMC’s Funded Ratio concept, you (or your financial advisor) can use our workbooks to develop your own “numerical picture of your retirement income plan.”

The MAMC “Funded Ratio” is

_________________an individual’s (or couple’s) total assets_________________

total aspirational liabilities

(the present value of spending liabilities based on the individual’s spending goals)

(the present value of spending liabilities based on the individual’s spending goals)

This “Funded Ratio” is to help the individual determine:

• where he or she stands in meeting financial goals and 
• how much the individual’s assets would need to be to meet these goals.
  

This aspirational funded status measurement (or measure of financial wellness) is easily calculated using the Actuarial Approach with the assistance of our Actuarial Budget Calculator (ABC) workbooks.  Our Budget by Expense Type tab in the ABC for Retirees can also be used to estimate the present values of desired essential and non-essential expenses in retirement.

As discussed in our summary Actuarial Approach – Using Basic Actuarial Principles to Accomplish Your Financial Goals, the comparison of one’s assets and liabilities is a “bedrock” actuarial principle.

Principle #1—Comparison of Assets and Spending Liabilities

The Actuarial Approach can be used to:

• determine the assets needed to support aspirational spending liabilities (desired spending), 
• develop an annual spending budget based on the existing assets, and 
• help one make personal financial decisions.
  

We are pleased that MAMC has discovered the benefits of using basic actuarial principles in personal financial planning, and we encourage you to use these principles to make better financial decisions.  If you are a financial advisor who doesn’t work at MAMC, we encourage you to include these actuarial principles in your consulting toolkit to better meet the needs of your clients.

Now, That’s What I’m Talking About

We recently came across a great Think Advisor column written in 2011 by Dr. Moshe Milevsky that we would like to share with you in this post and encourage you to read.  The column is titled, What Does Retirement Really Cost?  Dr. Milevsky is a Professor of Finance at the Schulich School of Business at York University, Toronto, Canada, and we have discussed his writings in several prior posts.

The obvious reason that we like this particular column so much is because in it Dr. Milevsky advocates using the same basic financial economics principles (annuity based pricing of spending liabilities) that we advocate in our website to develop your Actuarial Budget Benchmark (ABB).  He says:

“As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column. Any other answer involves extra risk, possibly invisible to the naked eye. It is often obscured from view thanks to heroic assumptions hardwired into financial calculators.”

In this column, Dr. Milevsky cautions us to be suspicious about retirement plan strategies (such as those that may be developed using Monte Carlo modeling or safe withdrawal approaches) that appear to offer higher levels of spending at little or no perceived additional risk.

Note that Dr. Milevsky is (and we also are) not recommending that retirees actually go out and purchase annuities, only that they be used to price the cost of retirement.  Combining this pricing concept with basic actuarial principles yields your Actuarial Budget Benchmark (ABB), which provides an indication of potentially how aggressive or how conservative your current proposed spending plan may be.

As discussed in our post of June 27, you can use your ABB to help you develop an investment and spending strategy with which you are comfortable, based on:

• Your tolerance for future spending cuts 
• The proportion of your retirement spending covered by sources outside of your investment portfolio, and 
• The availability of reserves (such as Rainy Day funds, LTC reserves or flexible bequest motives, for example)
  

For someone with relatively high essential expenses and therefore a lower tolerance for future spending cuts, or who doesn’t have much other income from outside the portfolio or who doesn’t have much in the way of reserves, this may imply more conservative investment and/or spending strategies (i.e., lower ratios of proposed spending for the year to your ABB).  On the other hand, someone with relatively low essential expenses and a higher tolerance for future spending cuts, or someone who has significant amounts of income from outside the portfolio or has significant reserves may be comfortable with more aggressive investment and spending strategies (i.e., a higher ratio of proposed spending for the year to your ABB).

Nobody Knew Couples Budgeting Could be So Complicated

After we announced our new and improved ABC for retirees, Lori Fassman, (a fellow employee at The Wyatt Company in Boston and a singing goddess) asked us the simple question of how to use the ABC for Retirees spreadsheet to develop a spending budget or Actuarial Budget Benchmark (ABB) for a couple. This turned out to be a great question, and one that was also somewhat embarrassing to us, as we had clearly not given it sufficient thought.   So, this post will address budgeting for couples.  As we researched it, we felt a little like how our President felt about health care when he said, “Nobody knew [it] could be so complicated.”

What Makes Couples Budgeting So Complicated?

The short answer to the matter of couples budgeting is that applying the Basic Actuarial Equation is more complicated for couples than for individuals.

As we have discussed many times before, our approach to developing a spending budget in retirement is to apply the Basic Actuarial Equation, which balances the PV of total assets with the PV of total spending liabilities, of:

Accumulated Savings

+

PV Income from Other Sources

=

PV Future Non-Recurring Expenses

+

PV Future Recurring Annual Spending Budgets

The primary problem with the current version of the ABC for Retirees spreadsheet as it applies to couples is that it uses the same LPP to calculate

• PV of Income from Other Sources
  

 as it does for the

• PV of Future Recurring Annual Spending Budgets.
  

This is a problem because, if a couple’s Income from Other Sources (such as Social Security benefits, pension benefits, or life annuities) is expected to decrease or cease upon the death of one of the individuals, the left-hand side of the Basic Actuarial Equation (the assets) can be overstated by assuming the longer of the LPPs of each of the individuals in the couple.  Additionally, depending on the desired level of budget following the death of one individuals of the couple, the right-hand side of the equation (spending liabilities) may be understated.

How to Handle Couples Budgeting

We will add better budgeting for couples to our list of items to address in the next version of the ABC for Retirees.  In the meantime, this post will discuss two possible approaches that you can use in the interim:

• a simple approximate approach and 
• a more complicated (but more accurate) actuarial approach.
  

Simple Approximate Approach

The Actuaries Longevity Illustrator, which we recommend using to determine LPPs (no smoking, excellent health, 25% probability of survival) provides four planning horizons (or LPPs) for a couple:

• Person #1 
• Person #2 
• Either Alive, and 
• Both Alive
  

If you don’t want to crunch the numbers required under the more complicated (but more accurate) approach described below, we suggest that you use the Either Alive period for the LPP in the spreadsheet.  In most instances, this will probably produce a result that is sufficiently accurate for budgeting purposes.

More Complicated Actuarial Approach

If you want a more accurate budget, we encourage you to go back to the basics and perform the present value calculations in the Basic Actuarial Equation.  For this purpose, you can either use the PV calculation functions in the ABC for Retirees spreadsheet or the Present Value Calculator spreadsheet.

The Basic Actuarial Equation above can be restructured to solve for the current year’s spending budget as follows:

Current year’s spending budget

=

Accumulated Savings + PV IFOS ‒ PV Future Non-Recurring Expenses                         PV of Future Years with Desired Increases

So, to determine current year’s spending budget, we need to determine:

• Accumulated Savings 
• PV Income from Other Sources (IFOS) 
• PV Future Non-Recurring Expenses, and 
• PV of Future Years with Desired Increases
  

Accumulated Savings and PV Future Non-Recurring Expenses for a couple are as determined for an individual, so they do not need to be specifically addressed here.

The first step in calculating a couple’s spending budget using the Basic Actuarial Equation is to calculate the PV of Income from Other Sources (IFOS), separately for each individual, based on the individual Person #1 and Person #2 LPPs, rather than one LPP for both and sum the results.  Remember that some benefits may continue or be reduced after the first expected death.

The second step is to calculate the PV of Future Years with Desired Increases for the couple. If you have followed us so far, this is where it just may get just a little too actuarial for you.

Depending on the desired budget after one of the couple dies as a percentage of the budget while they were both alive (Y%), the PV of Future Years with Desired Increases for the couple can be determined by applying the following formula:
 

PV of Future Years with Desired Increases (couple)

=

Y% of PV (Person #1 LPP)

+

Y% of PV (Person #2 LPP)

–

[2Y% -100%] of PV (Both Alive LPP)

Example Using More Complicated Actuarial Approach
So, for example, let’s say our couple consists of Jim, a 67-year-old male, and Mary, a 61-year-old female.  The Actuaries Longevity Illustrator tells us that the relevant LPPs for this couple, based on the recommended assumptions, are

• 27 years for Jim 
• 35 years for Mary 
• 36 years for Either Alive and 
• 24 years for Both Alive
  

The present values are at cell K18 of the Input and Results tab of the ABC for Retiree spreadsheet.  They are determined by entering the relevant LPPs in cell G25 of the ABC for Retiree spreadsheet with the current assumptions (4% discount rate, 2% inflation and 2% desired future increases).  In this example, they are:
 

Age	Sex	LPP	PV of Future Years with Desired Increases (from cell G25 of the Input and Results tab G25 of the ABC for Retiree spreadsheet)
67	Male	27	21.2172
61	Female	35	25.6462
n/a	n/a	24	19.3707

Let’s assume that this couple agrees that the target spending budget after one of them dies is 67% (.6667) of the spending budget while they are both alive

Their PV of Future Years with Desired Increases is calculated as follows:

     .6667 x (21.2172) + .6667 x (25.6462) - .3333 x (19.3707) = 24.7876
 
Don’t want to go through these calculations?  Fine, as discussed above in the simple approximate approach, we suggest that you use the “Either Alive” years for your LPP.  In this example, you would be using a PV of Future Years with Desired Increases of 26.1530 (based on the 36-year Either Alive period in this example), but remember that you might be overstating your PV Income from other Sources (IFOS) and possibly understating your spending budget somewhat, depending on actual benefits and the desired decrease in the couple spending budget after the first death.

Thanks again to Lori Fassman for bringing this to our attention.  If anyone else has questions about the workbook or suggestions for improvement, we are always happy to receive them.