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.
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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.
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.
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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.
When you propose something different, you can expect that not everyone is going to fully appreciate or understand your position. We at How Much Can I Afford to Spend advocate using basic actuarial and financial economic principles to help individuals (and their financial advisors) develop reasonable spending budgets and make better personal financial decisions. Because we are actuaries and not financial advisors or academics and because what we advocate differs somewhat from approaches advocated by industry “experts” or described in articles contained in well-established personal financial planning literature, we experience a fair amount of misunderstanding of what we propose. Most of this misunderstanding comes in the form of individuals erroneously describing what we are advocating and the associated deficiencies of what they think we are advocating. We have found that the majority of these misperceptions have come from individuals who:
- Have never read the explanations of the Actuarial Approach provided in our website,
- Have never tried to apply the basic principles endorsed,
- Have different agendas to pursue or
- Some combination of the above items.
In this post, we will respond to some of the more common misperceptions we hear about the Actuarial Approach, and we will encourage individuals and their financial advisors to try to ignore these misperceptions, try to be a little more open-minded about this new approach and actually try to apply the basic actuarial principles endorsed by us as a supplement to what they are currently doing. To repeat the tagline from Alka Seltzer commercials from the early 1970s; we believe you should, “Try it, you’ll like it.”
Misperception #1—We advocate conservative investments.
Not true. We don’t advocate any specific investment strategy. Yes, we do recommend using assumptions consistent with annuity-based pricing to develop your Actuarial Budget Benchmark (ABB), but we believe determining the cost of your spending liabilities for this purpose is a separate issue from the issue of how best to invest your assets to accomplish your financial goals. 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).
There are plenty of good reasons why you may or may not want to invest all or part of your assets in liability-driven investments (like annuities) or in more risky assets (like equities). We aren’t going to list those reasons here. We leave the decision of how best to invest your assets to meet your financial goals up to you with possible assistance from your financial advisor.
We acknowledge that the basic financial economics principle that the cost of future spending liabilities may be determined independently of the client’s investment mix is almost heretical within the financial advisor community. This community frequently concludes that client spending may be increased, within limits, by increasing the client’s investment risk; a result generally obtained by assuming historical real rates of return and variances will continue in the future. We counter this general conclusion by pointing to the problems created by public pension plan actuaries who similarly assumed plan contributions could be reduced simply by increasing investment risk, and to recent Actuarial Standards Board considerations requiring actuaries to disclose a low-investment risk liability in actuarial reports for public pension plans as a way to quantify the extra risk assumed by the plan sponsor (and taxpayers) resulting from the plan’s investment policy (similar in concept to what we advocate with our ABB calculation).
Misperception #2—We advocate conservative spending.
Not true. We don’t tell you how much you should spend each year. The amount you spend each year is your business (or your and your spouse’s business). We tell you how much you can afford to spend this year to meet your financial goals based on your financial situation and the assumptions you make about the future. If you use our recommended assumptions to calculate your ABB, you are calculating a current year spending budget based on a relatively low investment-risk strategy. Yes, this approach should produce a reasonably conservative spending budget. But, you don’t have to spend your ABB. 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.
In our posts, we have discussed many ways that you can spend more aggressively by front-loading your spending. Several ways to do this without increasing your investment risk include:
- Assuming declining future real dollar future spending budgets,
- Assuming decreases in the spending budget upon the first death within a couple, or
- Treating some expenses (such as travel expenses) as non-recurring and thus not spreading them over your entire expected longevity planning period.
Misperception #3—We advocate using a deterministic assumption model rather than a stochastic model
Partly untrue. While the simple Excel workbooks that we make available on our website to facilitate the present value calculations required under the general asset/liability matching model we advocate use deterministic assumptions, this doesn’t mean that our general individual model (the Basic Actuarial Equation) can’t accommodate stochastic modeling. Since we provide you with an ABB based on basic financial economics principles and don’t claim to provide you with the maximum amount of income that can be provided at a specified probability of success based on assumptions with respect to expected returns and variances associated with various types of investments, we don’t feel a need to complicate our simple models with unnecessary stochastic modeling. Unlike black-box stochastic models, our models are relatively transparent when deterministic assumptions are used, and unlike stochastic models, our process anticipates periodic future valuations to adjust for future experience that will inevitably differ from assumed experience.
Misperception #4—We advocate using only the Actuarial Approach to determine a reasonable spending budget
Not true. As discussed in our post of April 20, 2017 and as discussed above, we recommend that you consider your ABB as another “data point” to be used in making your spending decisions. Thus, we recommend that you use this calculation in combination with, and not in lieu of, other budgeting approaches you may be using that you find to be helpful.
Misperception #5—The Actuarial Approach is either too simple, not as sophisticated as Monte Carlo modeling and therefore inferior or it is too complicated for average individuals to use.
Partly untrue. As discussed above, quite a few people tend to conflate the Excel workbooks that we provide to facilitate the present value calculations required under the Basic Actuarial Equation with the more general process we refer to as The Actuarial Approach. The Actuarial Approach involves using three basic actuarial principles:
- Use of a generalized individual model that compares assets with liabilities (The Basic Actuarial Equation),
- Annual valuations to keep spending on track to meet financial goals, and
- Modeling of deviations in assumed experience to assess risk and assist financial planning
When taken together, these principles are much more powerful personal financial budgeting tools and concepts than our simple Excel spreadsheets.
We will admit that the calculations required by the Actuarial Approach may unfortunately be beyond the comprehension of many individuals today. That is why we have targeted Intelligent Numbers People (INP) in our communications.
Conclusion
No one (not even actuaries or financial advisors) knows what your investments will earn in the future and no one knows how long you (or your spouse) will live. In fact, what we do know is that whatever assumptions we make about the future will be wrong, and future adjustments to spending plans will likely be required. These unknowns make spending budgeting a difficult task. Many stochastic models use historical experience to forecast future investment performance, and many clients rely on these models (and their questionably precise probability of success calculations) to make complex financial decisions regarding investments and spending. We have concerns about stochastic models that promise higher levels of spending without properly quantifying the additional risk. We also have concerns about blindly relying on the results of these models, particularly over extended periods of time without adjustment. And while no one knows what future investments will earn, we do know how much insurance companies are currently charging to provide income for life based on life annuity quotes. We believe that this “known” market pricing information can be useful in developing a low-investment-risk Actuarial Budget Benchmark that you can use in combination with the other approaches you are using to make better financial decisions.
Unlike others who may encourage you to use a specific budgeting approach, we have no financial stake in the decision you make. We won’t benefit financially if you decide to buy annuities or invest in equities or use the Actuarial Approach. We receive no direct or indirect income from advertising or hits to our site. Despite having to occasionally address these misperceptions and live with the baffling lack of support from our own profession, we remain passionate about recommending the same basic actuarial principles that we applied in our work as actuaries to help INPs make better financial decisions.
We encourage you to try to keep an open mind with respect to using the Actuarial Approach and give it a try rather than rejecting it out of hand simply because of misperceptions you may have heard or read about it.
