We Have Two New Actuarial Budget Calculator (ABC) Workbooks for Couples

Our website is all about using basic actuarial principles to help you (or your financial advisor) develop a reasonable spending budget designed to meet your personal financial objectives.  The first actuarial principle of personal financial planning (and budget development) involves balancing your assets with your spending liabilities.  Our readers are quite familiar with the Basic Actuarial Equation shown below, where assets are the items on the left-hand side of the equation and spending liabilities are the items on the right-hand side of the equation.

Accumulated Savings

+

PV Income from Other Sources

=

PV Future Non-Recurring Expenses

+

PV Future Recurring Annual Spending Budgets

Note that if you are comfortable performing the present value calculations and math required by the Basic Actuarial Equation, you may not need to use our Excel workbooks at all.  The ABC workbooks that we make available on our website have been designed to simplify these present value and math calculations, but may not be as robust in all situations as the results that can be obtained from directly applying the basic principle to your specific fact situation.   

Our previous ABCs for Retirees and Pre-Retirees involved using a single Lifetime Planning Period (LPP) to estimate the present values of income from other sources and the present value of certain future non-recurring expenses and recurring annual spending budgets.  This single LPP assumption made the calculations easier, but not as accurate, as the calculations required for a couple.  We discussed the complications involved in couple’s budgeting in our post of July 4, 2017.  After that post, we decided to create separate workbooks for retired couples and pre-retired couples.  The new workbooks are the result of that decision. 

Instead of using one LPP for a couple, the new ABC couple’s workbooks use four LPPs:  one for each person in the couple, one for the LPP while either person is expected to be alive and one for the LPP while both persons are expected to be alive.  These four LPPs may be obtained from the “Planning Horizon” section of the Actuaries Longevity Illustrator.  In addition to these additional LPPs, the new Couple’s workbooks require entry of the percentage decrease in the couple’s desired recurring spending budget upon the first death within the couple.

The new workbooks are titled, “ABC for Retiree Couples” and “ABC for Pre-Retiree Couples.” The original single LPP workbooks still reside in our website (with the new workbooks) in our “Spreadsheets” section and have been relabeled as “ABC for Single Retirees” and “ABC for Single Pre-Retirees.”

As part of the process of developing the new couple’s workbooks and renaming the old workbooks, we have updated the overview tab material describing each workbook.   We encourage you to read this material to obtain a better understanding of the workbooks.

We wanted to make these new workbooks available to you in time for your 2018 calendar year budgeting, and we encourage you to “kick the tires” on them.  We hope you will like the changes.  If you like the workbooks, please recommend them to other “intelligent numbers people.”  If you think they can be improved, please pass along your recommended changes to us as we are always interested in your feedback.

Happy Budgeting from all of us at How Much Can I Afford to Spend.

In Search of the Optimal Retirement Planning Strategy

In his October 18 post What Is The Optimal Shape of Retirement Planning—Curve, Triangle or Rectangle? Michael Kitces did an excellent job of summarizing the evolution of retirement planning strategies and discussing the benefits and limitations of the three different strategies identified in his post.  The inspiration for Mr. Kitces’ post is a fine article by Patrick Collins and Francois Gadenne entitled The Shapes of Retirement Planning—Are You a Curve, a Triangle, or a Rectangle?  In our post today, we will briefly highlight some of the discussion in these articles and encourage you to read these thought-provoking pieces.

Collins/Gadenne Article

In their article, Messrs. Collins and Gadenne employ three very clever geometric metaphors to describe the three general types of retirement planning strategies currently used by financial advisors.  They encourage advisors to consider employing the more holistic household balance sheet approach, the rectangle shape, that considers all of a household’s present and future assets and spending liabilities to determine a funded status or a current spending budget.  According to these gentlemen, “This article is a call to advisors to expand beyond asset allocation pie charts and Sharpe ratio values to diagnose feasibility of goal funding and monitor the plan’s performance by helping clients ask and answer the following questions:

• Do I have enough to do what I’d like?
• How likely is it that my plan will remain sustainable under future economic environments?
• What is my capacity to meet the unknown or unexpected?”

While we have not developed a full understanding of the planning strategy they proposed, it is clear to us that it has a lot in common with our rectangularly-shaped Actuarial Approach, as both approaches employ balance sheet comparisons of an individual’s or household’s assets and spending liabilities.

Michael Kitces Post

In his post, Mr. Kitces deftly summarizes the three Collins/Gadenne geometric metaphors and his understanding of the benefits and limitations of employing each type of retirement planning strategy.  In response to his question “What is the optimal shape of retirement planning?” Mr. Kitces concludes that the best approach for retirement planning may involve incorporating elements from all three shapes.

Our Take

We support the Collins/Gadenne endorsement of what we consider to be the use of basic actuarial principles in the personal financial planning process.  We believe employing these principles will not only better meet the needs of clients of financial advisors, but also reduce financial advisor fiduciary liability.  At the same time, however, we also support Mr. Kitces’ conclusion that an optimal consulting approach may very well involve elements from different approaches.  It is exactly for this reason that we suggested in our Advisor Perspective article (originally entitled “Give Your Clients Another Data Point Each Year to Help Them Make Better Financial Decisions”) that financial advisors supplement their client consulting (i.e., not necessarily replace what they are doing) with calculation and explanation of the client’s Actuarial Budget Benchmark (ABB).

Mr. Kitces is critical of the sensitivity of the rectangle approach to the use of different discount rate assumptions to determine present values of assets and spending liabilities.  He indicates:

• that there is little agreement on the appropriate discount rate to use,
• “nothing on the household balance sheet directly conveys the greater risk that is inherent in assuming a higher discount rate”, and
• “two advisors using the same rectangle approach may still come up with substantively different conclusions and recommendations about whether the prospective retiree is on track!”

It is exactly for these reasons that we advocate using basic financial economic principles and annuity based pricing assumptions to develop the client’s ABB.  Use of these assumptions provides a mark-to-market comparison of the client’s assets and liabilities under the Actuarial Approach and significantly mitigates the concerns raised by Mr. Kitces.

Are There Better Spending Budget Calculators Out There Than Our Actuarial Budget Calculators?

We occasionally hear that the Excel workbooks that we make available in our website to help individuals and couples perform the present value calculations required by the Basic Actuarial Equation, are inferior to other free retirement calculators available on the Internet.  Depending on what you are specifically looking to accomplish, this can be a valid comment.  Our Excel Actuarial Budget Calculator (ABC) workbooks are clearly not the most sophisticated or sexiest personal planning spreadsheets around and are not designed to replace all the tasks generally performed by a financial advisor.  Readers interested in kicking the tires on other retirement calculators may find Mr. Darrow Kirkpatrick’s website that rates “The Best Retirement Calculators” to be of interest.  In full disclosure, our ABCs do not make the author’s curated list, and we have not compared our spreadsheets with all the calculators on Mr. Kirkpatrick’s list.

Despite being omitted from Mr. Kirkpatrick’s list, we believe that using our ABC spreadsheets with our recommended assumptions (or using the Basic Actuarial Equation directly) can provide you (or if you are a financial advisor, your clients) with important data points to help with personal financial planning.  Since we have not compared our spreadsheets with every other calculator in the universe, we can’t say for sure that our spreadsheets are better than every other free calculator available on the Internet for every conceivable purpose.  In this post, we will outline some of the common criticisms of our spreadsheets and respond to them, as well as discuss some of the things our spreadsheets can do that we don’t generally see in other calculators, and other reasons why we prefer our approach.

Common Criticisms of the ABC Spreadsheets and Responses

Deterministic Assumptions.  The most common criticism of our spreadsheets we hear is that they utilize a deterministic (or average) investment return assumption that ignores the individual’s actual or desired asset mix.  Many retirement calculators incorporate Monte Carlo modeling and require input of the individual’s asset allocation information.  This enables these calculators to provide a measure of volatility of the proposed asset mix and a probability of success of meeting specific retirement goals based on the assumptions used for the model.

By comparison, the recommended assumptions used to calculate the Actuarial Budget Benchmark (ABB), using either our spreadsheets or the Basic Actuarial Equation, are consistent with the financial economics principle that the cost of retirement (in this instance) is not a function of individual’s asset mix, but rather is determined by the “defeasance cost” of the individual’s spending liability.  For this purpose, we recommend assumptions approximately consistent with those used to price immediate life annuities (annuity based pricing).  And while we don’t provide users with probabilities of success (or failure), we stress that the Actuarial Approach requires periodic adjustments, at least annually, to keep spending plans on track to meet retirement goals.

Since our focus is determining how much one can afford to spend each year, and not how to invest one’s assets, and we subscribe to the financial economics theory that spending levels should not necessarily be a function of how assets are invested, our spreadsheets are indeed silent with respect to asset mix.  We understand that this may be heretical to some financial advisors.   For this reason, we suggest that financial advisors or others may wish to consider supplementing whatever they are currently doing with the Actuarial Budget Benchmark (ABB) to provide clients with a relatively low risk “data point” to help them with their spending decisions as discussed in our post of May 10, 2017.   It is also important to note here that we don’t advocate any specific investment strategy, and while we use annuity based pricing to determine the cost of retirement, we don’t necessarily advocate investment in annuities.

Pre-tax Calculations.  Our spreadsheets develop a pre-tax spending budget that considers taxes to be just another expense to be covered by the spending budget.   This bothers some people who point out that assets have potentially different tax treatment when they are distributed, and this difference should be considered in an “accurate” model.  For pre-retirement planning, it will be necessary for individuals to manually reflect adjust their target spending after retirement to reflect these differences.  We don’t see this as a big issue.

Longevity and Social Security Information.  We ask users to gather relevant data on expected lifetime planning periods (LPP) from the Actuaries Longevity Illustrator (http://www.longevityillustrator.org/) and expected Social Security benefits from the Social Security Quick Calculator (https://www.ssa.gov/oact/quickcalc/), rather than building these calculations into the spreadsheet.  Unfortunately, it is just not practical to build these calculations into our spreadsheets.

Positive Aspects of Our Spreadsheets That We Don’t Generally Find in Other Calculators:

• Our spreadsheets are reasonably transparent and user-friendly and don’t involve black-box assumptions relative to asset returns
• We have a 5 Year Projection tab that enables users to model different experience with respect to investment returns and actual spending
• Our ABC for Retirees has a Budget by Expense Type tab that enables the user to make different assumptions for various types of expenses
• Our spreadsheet permits users to shape spending by making different assumptions about future increases in spending budgets or by treating certain expenses as “non-recurring” vs. “recurring”
• Our spreadsheets are Excel spreadsheets which you download so that information you input safely resides on your computer, not on the web, and
• We utilize basic actuarial principles

Conclusion

Are our ABC spreadsheets the best free retirement calculators available on the internet?  Probably not for everyone and not for every purpose, but we believe they are quite robust and can be useful tools for those we call “Intelligent Numbers People” (INPs).  If our readers have suggestions for improving our spreadsheets please forward them to us.  We are currently in the process of developing an ABC for Retired Couples that will more accurately calculate spending budgets for couples.  We hope to have this spreadsheet available in the next few months in time for 2018 calendar year budgeting, although it is unlikely to have all the tabs included in our ABC for Retirees workbook.

We note that some of the perceived limitations of our spreadsheets don’t necessarily apply if you are not using our spreadsheets but are using the Basic Actuarial Equation instead.  If you are using the Basic Actuarial Equation, you can use Monte Carlo modeling and you can make your calculations as complicated and sophisticated as you desire.  It is important to keep in mind, however, that it may not be worth your time and considerable effort to develop a more sophisticated model just to determine a spending budget that you may consult only once a year.

Nice Review of The Actuarial Approach in The Globe and Mail

Thanks to Ian McGugan, reporter with The Globe and Mail’s Report on Business, for his complementary review of the Actuarial Approach in his article of October 3, 2017.  And even though we tend to be a little too U.S. centric in our posts, it is important to note that the Actuarial Approach will work just fine for our nice neighbors up north.

Better Budgeting with the IRS RMD Table?

In his recent Advisor Perspectives article, Joe Tomlinson touts the benefits of using a “variable” or “dynamic” strategic withdrawal plan (SWP) like the “endowment SWP” rather than a “fixed” SWP like the 4% Rule.   According to Mr. Tomlinson, “The general superiority of variable over fixed withdrawals applies regardless of the type of [investment] sequence.”  Under an endowment SWP (for example, x% of each year’s accumulated savings), withdrawals may fluctuate from year to year based on actual investment performance or actual spending for the previous year, while under a fixed SWP, withdrawals are not based on actual investment performance or actual spending, and are generally just increased from one year to the next by inflation (with the hope that the money doesn’t run out).  There are, of course, many hybrid SWPs that combine elements of both approaches and/or smooth the individual’s withdrawals from year to year.

In addition to advocating variable SWPs over fixed SWPs to mitigate sequence of return risk, Mr. Tomlinson’s research demonstrates that the IRS Required Minimum Distribution (RMD) SWP improves retirement outcomes over a flat percentage endowment SWP.  He indicates that this is accomplished “in very approximate terms… by dividing savings by expected remaining life.” He notes, “One can attempt exact calculations using an appropriate actuarial table and assumed investment returns, or a simpler approach is to rely on the IRS requires [sic] minimum distribution (RMD) tables.”

The Actuarial Approach we recommend in this website, which is also a variable approach, uses the more “exact actuarial calculations” referred to by Mr. Tomlinson; that is, it uses the present value of the future lifetime planning period with desired annual future increases.  And while the IRS RMD SWP may be a tad simpler than the Actuarial Approach, we believe that doing the more exact actuarial calculations is definitely worthwhile and can improve retirement outcomes even more.  This is why our website tagline reads, “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”  The following paragraphs discuss why we believe you or your financial advisor may be making a mistake using the “simpler” IRS RMD SWP advocated by Mr. Tomlinson to determine your spending budget in retirement or to determine when you should retire or how much you should be saving for retirement.  Our reasons may be summarized as:

• 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
  

The IRS RMD SWP is quite conservative

The IRS didn’t design its Required Minimum Distribution table to be used as a spending budget tool for retirees.  The rules were designed to force retirees with pre-tax accumulations in qualified defined contribution plans and IRAs to take distributions from these plans so that the government could collect their income taxes.  And by the way, just because you are required under these rules to make minimum withdrawals, you aren’t required to spend the money when you do.   Determining how much you can afford to spend each year is an entirely different matter.

Because the required minimum distribution under the IRS RMD rules are determined assuming a 0% real discount rate and a very conservative mortality table, the distribution periods in the IRS tables produce lower withdrawals at every age than the more exact Actuarial Approach.

The following chart compares real dollar spending under:

• the IRS RMD rules vs. 
• the Actuarial Approach

We used the same person in Mr. Tomlinson’s straightforward example (female age 65 with $1,000,000 in accumulated savings and a Social Security benefit of $30,000 per year), and we assumed exact realization in the future of our current Actuarial Budget Benchmark recommended assumptions (4% investment return assumption, 2% inflation, 31-year lifetime planning period and 2% annual desired increases in future spending budgets).  We also ignored, as Mr. Tomlinson did, long-term care costs, unexpected expenses and bequest motives, and we assumed, as Mr. Tomlinson did, that the hypothetical person would spend exactly her spending budget each year (at the beginning of each year).   For ages prior to 70, we assumed a 3.5% per year annual rate of withdrawal under the IRS RMD SWP.

click to enlarge

The chart shows that the hypothetical female’s total spending budget is consistently higher in real dollar terms under the Actuarial Approach than under the IRS RMD approach. Yes, we understand that it is highly unlikely that the assumptions about the future that we made to develop this chart will be exactly realized every year for the next 25 years.   But, that is not the point here.  The point is to illustrate the clear relationship between the two lines, as both of these approaches are variable approaches and, absent any smoothing, these two lines will move up and down in tandem with actual investment performance.  Under these assumptions for the future, the hypothetical person’s accumulated savings at the end of her 89th year are $716,896 under the IRS RMD approach as compared with $243,171 under the Actuarial Approach.  Therefore, if one of her goals is to maximize retirement income and not leave significant bequests, as Mr. Tomlinson indicated, she would be much better off using the Actuarial Approach.  

The chart also shows that for much of her expected period of retirement, her spending is expected to increase in real dollar terms under the IRS RMD approach as she ages under the assumptions selected.  Such increases in real dollar spending may also not be consistent with her retirement goals.  She may desire a more level (or even front-loaded) expected spending pattern.

SWPs frequently do not coordinate well with other sources of retirement income

Retirement spending goals generally involve how much you can afford to spend, not how to “tap” your accumulated savings.  SWPs in general and the IRS RMD approach specifically are concerned only with how to tap your accumulated savings and not the bigger picture of your total spending.   As we have discussed many times, (most recently in our post of August 8, 2017), SWPs may not work very well if you have other sources of income that aren’t paid for the entire duration of retirement (like part-time employment or QLACs) or are not paid in a manner consistent with your desired future increases in spending budgets (like fixed dollar pension benefits or life annuity payments).   For couples, other sources of income may commence or cease at different times.  In these instances, you may not be able to develop a reasonable spending budget by simply adding other sources of income for the year to the SWP amount for that year.  To smooth out these discontinuities and produce a more reasonable spending budget, the Actuarial Approach takes the present value of income from other sources and spreads it over the individual’s (or couple’s) future lifetime using the same spreading factor (and same desired increases) used to spread your accumulated savings.  Therefore, if you like how the Actuarial Approach spreads your accumulated savings, you will love how it spreads the present value of your income from other sources to develop a more reasonable spending budget.

SWPs like the IRS RMD approach don’t consider your non-recurring expenses and they don’t anticipate different rates of increases for different types of expenses.
Retirement experts constantly bombard us with admonitions to be sure to worry about increasing health-care costs, unexpected expenses and long-term care costs when we do our retirement planning.  Despite these admonitions, SWPs like the IRS RMD approach generally focus only on your recurring spending in retirement and not these non-recurring expense items.  By comparison, these items are addressed directly using the Actuarial Approach.

SWPs generally don’t permit “budget shaping” to meet individual spending goals

As discussed in our previous two posts, the Actuarial Approach can be used to shape your spending budget to better meet your spending needs in retirement.  For example, you can “front-load” your travel expenses by treating them as non-recurring, or you can plan on decreasing spending budgets in real dollars as you age consistent with the “go-go, slow-go and no-go” phases of retirement noted by many retirement researchers.

SWPs don’t do a particularly good job of helping with pre-retirement planning

Unlike SWPs that focus on helping you tap your savings after retirement, the same basic principles used in the Actuarial Approach can help you plan for your retirement.  It can be used to develop a spending/savings budget consistent with your retirement goals and keep you on track as experience deviates from your assumptions.

Conclusion

While the IRS RMD SWP may be a better approach than the 4% Rule and other fixed SWPs for purposes of “tapping your savings”, neither of these SWPs can hold a candle to the Actuarial Approach in terms of helping you develop a reasonable spending budget and make other financial decisions.  Unfortunately, financial planning is relatively complex and not always adequately addressed by simple rule of thumb approaches.  We encourage you to utilize the basic actuarial principles inherent in the Actuarial Approach and do the number crunching necessary to obtain the right answer for you based on your specific situation and your specific financial goals.

We have no problem with Mr. Tomlinson’s suggestion that fund companies keep the IRS RMD rules in mind when developing managed payout options for their clients (particularly those with tax qualified accounts.  We firmly believe, however, that financial advisors can do a much better job for their clients by employing the more “exact actuarial calculations” inherent in the Actuarial Approach rather than by using IRS RMD tables.