OK, Retirees, What’s Your Plan for Dealing with the Upcoming Bear Stock Market?

This post is a follow-up to our previous post in which we defended the Actuarial Approach and our deterministic spreadsheets against those who tout the supposed superiority of stochastic models for purposes of financial planning.  In this post we will “drill down” on our concern that results of stochastic models may actual encourage a “set-it-and-forget-it” complacency that could result in either significant over-spending or under-spending as time goes by.  To illustrate this point, we are going to ask you to consider a real-life problem—what is your plan for dealing with the upcoming bear stock market?  We will discuss what the upcoming bear stock market might look like and walk through an example that shows how a hypothetical individual can use the Actuarial Approach and the Actuarial Budget Benchmark (ABB) to help develop a plan for this contingency.  We encourage you to consider performing a similar exercise to help with your planning. 

Upcoming Bear Market

At some point in the future, we are going to experience another bear market.  We don’t know when it will occur, but we feel pretty safe in predicting that it will happen.  As first discussed in our post of June 12, 2015, Greg Morris in StockCharts.com included lots of scary analysis about bear and bull markets in his article, “Bear Markets! Are They a Thing of the Past?”  Using the statistics gleaned from his analysis, Mr. Morris concluded, “if the average bear market lasts about 26 months and it takes an average of 56 months to get back to where it started, that translates into a little over 5 years of going nowhere.”  Note that Mr. Morris’ “going nowhere” conclusion assumes that no withdrawals are being made from the investment portfolio, so it may take a bit longer than five years for a retiree who is withdrawing funds from his or her portfolio during this period to recover from an “average” bear market.  

In addition to not knowing when the next bear market will occur, we have no idea how bearish it might actually be.  But, we are actuaries (retired) and actuaries make assumptions.  Since this a “what if” planning exercise, we are just going to assume 2018/2019 investment equity performance approximately the same as experienced in 2008/2009 in combination with Mr. Morris’ 5-year period of “going nowhere.”  Therefore, we are going to assume equity returns for planning purposes in the example below as follows:

• 2018:  -40%
• 2019:  -15%
• 2020:   15%
• 2021:   25%
• 2022:   36%

You should feel free to develop your bear market response plan using different assumptions you believe to be reasonable for your “what if” analysis.  

Example

Mary is a 65-year old single retiree.  She has accumulated savings of $500,000 and is receiving a monthly Social Security benefit of $1,800.  She has reserved $75,000 as the present value of her expected long-term care expenses and $25,000 for unexpected expenses.  She has no reserve for desired amounts to be left to heirs upon her demise and she has no specific Rainy-Day reserve set aside to mitigate future investment losses.  Using our current recommended assumptions (4% discount rate, 2% inflation, 2% desired future budget increases and a 31-year Lifetime Planning Period) and our Actuarial Budget Calculator (ABC) for single retirees, Mary develops an actuarial spending budget for her recurring expenses for 2018 (Actuarial Budget Benchmark or ABB) of $38,608.

Using historical experience (unadjusted for the current relatively high Shiller CAPE index) and a stochastic model, Mary’s financial advisor determines that if Mary invests 50% of her assets in equities and 50% in fixed income securities she has a 90% probability of being able to spend $40,000 per annum in real dollars for the rest of her life. 
Mary likes this and decides that her spending budget for recurring expenses for 2018 will be $40,000.  She determines that this amount is about $5,000 higher than her recurring spending budget for essential expenses ($35,000).  

Mary compares her spending budget of $40,000 with her ABB of $38,608 and determines that she is comfortable with the 4% difference.  She figures that her investment strategy should justify spending a little bit more than the low-investment risk strategy used to develop the ABB.  In future years, her plan is to increase her previous year spending budget by the actual rate of inflation for the previous year to obtain her new year’s spending budget, but she will continue to monitor the relationship between the resulting spending budget and the ABB to see that she doesn’t stray too far off of the actuarially balanced track. 

Because Mary has a little bit of “non-essential” spending room (but not as much as she might like) in her spending budget, Mary decides to do some scenario testing to kick the tires on her spending plan.  While her financial advisor has indicated that her investment/spending strategy has a 90% probability of success, she wonders how her new plan would fare in a bear market similar to that experienced in the U.S. in 2008/2009.  Since she is only 50% invested in equities, she assumes 2% returns on her fixed income securities and annual rebalancing and (using the assumed equity returns shown above) develops the following “actual” investment returns for modeling the next five years:

• 2018:   -19.0%
• 2019:    -6.5%
• 2020:     8.5%
• 2021:    13.5%
• 2022:    19.0%

Mary then goes to the 5-year Projection Tab of our ABC for single retirees’ workbook.  She models three alternative spending plans under the above investment return assumptions (and assuming annual inflation of 2%):

• Spending Plan Alternative #1:  Spending budget starts at $40,000 and is increased each year by inflation 
• Spending Plan Alternative #2:  Spending budget equal to the ABB each year
• Spending Plan Alternative #3:  Spending budget starts at $40,000 and is increased by inflation each year but result not greater than 110% of the ABB and not less than 90% of the ABB (our recommended smoothing algorithm discussed in our post of January 2, 2017).

The table below shows the results of Mary’s efforts.  Percentages show annual spending plan amounts as a percentage of the calculated Actuarial Budget Benchmark (ABB) amounts.  For simplicity purposes, the 5-year projection tab assumes that assumptions used to determine ABB amounts are unchanged throughout the projection period and the individual’s lifetime planning period (LPP) is reduced by one in each future year. 

(click to enlarge)

Mary notices that while the spending plan alternative #1 is at no risk of depleting her savings, she doesn’t like the fact that spending under this plan is 20% or more higher than the actuarially balanced spending levels (ABB) for some years during the projection period, and therefore somewhat off the actuarially balanced track.  On the other hand, she also notices that spending plan #2 (spending the ABB and always on track) could involve undesirable fluctuations and some years where her spending budget is actually less than her essential expense estimate of $35,000 (and she would like to avoid cutting essential expenses if possible).  She is comfortable with the alternative #3 spending plan as a compromise solution and notes that this plan could also work in situations where experience is more favorable than assumed and she might be able to increase spending, whereas this is not a subject that has come up with her financial advisor.  Therefore, Mary tentatively determines that she will follow spending plan #3 in the future and is pleased that this plan appears to weather a bear market storm that is comparable to the one experienced in 2008/2009. 

Of course, these aren’t the only alternative strategies that Mary can explore as a result of her “what if” analysis.  In addition to examining different spending strategies, she can also look at different investment strategies, such as changing her investment mix or buying annuities.  She may also want to explore spending strategies that do not anticipate increasing with inflation each year, reflecting diminished spending desires as she ages (such as front-loading travel expenses, for example), or alternatives that involve using her long-term care reserves to mitigate short term investment fluctuations.  

The primary point of this example (and post) wasn’t necessarily to argue that one alternative spending plan is better than another (or to scare you about the future), but rather to illustrate how using the Actuarial Approach and the ABB (together with whatever other approach you are currently using) can help you develop a plan of action (strategy) to deal with a range of future scenarios.  

Developing a Financial Plan using a Stochastic Model

The stochastic model used by Mary’s financial advisor tells Mary that if she invests her assets in a certain way, she has a 90% probability of being able to spend $40,000 per year for the rest of her life.  It doesn’t really give her a plan of action if her assets decrease by 30% in one year (or increase by 30%).   The model results imply that, irrespective of actual investment experience, Mary should stay the course with respect to her investment strategy and keep spending $40,000 per year come hell or high water (and not worry about the 10% failure probability).  Thus, it is more of an “implied plan.”  We believe this is a potential shortcoming for many stochastic models.  Michael Kitces addressed this shortcoming in his post of December 7, 2015, “Is Financial Planning Software Incapable of Formulating an Actual Financial Plan,” when he said, 

“virtually no financial plan today actually constitutes a real “plan” for anything. After all, the whole point of planning is to formulate the strategy of how to handle a range of possible future scenarios. If A happens, then we’ll do B. If C happens, we’ll do D instead.

Yet financial plans today, and the financial planning software that supports the process, is incapable of illustrating such scenarios and the appropriate responses! Answering a simple planning question like “how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track” cannot be easily answered with any financial planning software available today!”

Conclusion

The Actuarial Approach and ABB can help you develop a real plan and provide you with data points to help you answer questions such as, “how much do the markets have to decline before I need to cut spending and how much would I need to adjust my spending to get back on [the actuarially balanced] track.”  We encourage you to use our spreadsheets to develop these data points.  As discussed in our post of November 26, 2017, we also encourage you to periodically model deviations from assumed experience (not just assumed investment returns) so that you can better plan for situations where actual experience may punch you in the mouth.  Given the current economic environment, however, it may not be a bad idea for you to start your deviation modeling by stress testing your plan (or implied plan) for a possible bear stock market.  By suggesting that you go through this exercise, we aren’t trying to scare you--We want you to be confident that your spending and investment strategy/plan will hold up if and when stock markets go south.

Do Stochastic Models Necessarily Do A Better Job of Helping You Determine How Much You Can Safely Spend This Year?

The impetus for this post was another thought-provoking post from our friend Dirk Cotton over at The Retirement Cafe entitled, “The ‘Future’ of Retirement Planning” in which he states, “Determining how much you can safely spend this year requires a good model of the future.”  Since we are “How Much Can I Afford to Spend in Retirement,” several of our readers wanted to know what we thought about Dirk’s post.   In particular, they wanted to know whether we agreed with his implication that models that use Monte Carlo stochastic assumptions (simulations) are “much better” than models (like our simple Actuarial Budget Calculators) that use deterministic assumptions (or what Dirk calls spreadsheet models).   In this post, we will discuss where we agree with Dirk and where we agree to disagree.  

Where We Agree

We totally agree with Dirk that: 

• “determining how much you can safely spend this year [and making other personal financial decisions] requires a good model of the future”, 
• A model is not a plan.  A plan is an intention or decision about what to do based on the results from a model, 
• “Of course, you can plan when outcomes are uncertain…”, 
• A good model should not ignore sequence of return risk, and
• A stochastic model that uses expected rates of investment return for various asset classes but adjusts for investment risk is a better model for determining safe spending levels than a deterministic model that simply utilizes expected rates of return without adjusting for investment risk, all other things being equal.

Where We Agree to Disagree

While we agree that it is important to employ a “good model” of the future when developing a retirement plan, we are not convinced that it is absolutely necessary to use a model that employs simulations.  Therefore, we will push back in this post on Dirk’s recommendation that “If you're using an online calculator, make sure it incorporates simulation”.

In our opinion, a “good model” for determining how much you can safely spend in the current year, or for making other personal financial decisions, is one that:

• Does a reasonably good job of forecasting future experience,
• Adequately addresses your retirement risks, and
• Helps you to make informed financial decisions with some degree of confidence.  

We believe that such a model should:

• Consider your personal financial situation and goals,
• Be relatively transparent,
• Allow you to do “what-if” scenario testing,
• Reflect all current assets and expected amounts and timing of future assets• Reflect all expected amounts and timing of current and future expected expenses,
• Employ reasonable, or relatively conservative, assumptions with respect to:
  o   Future investment returns
  o   Future increases in expected expenses (including before and after the first death within a couple)
  o   Your (and your spouse’s) future lifetime, and
  o   Other relevant future experience
• Develop a total spending budget for the current year, not just an amount to be withdrawn from invested assets/accumulated savings

Our point in describing the criteria for a good personal financial model is that there are quite a few conditions to satisfy to be considered “good.”  So, even if a model uses stochastic assumptions that are reasonable, this will not guarantee that such a model is necessarily a “good model” if it fails to satisfy some of the other criteria above.

Actuarial Approach with Recommended Assumptions (Actuarial Budget Benchmark)

We believe that the generalized individual actuarial model (The Actuarial Balance Equation) used in our Actuarial Budget Calculators combined with our recommended assumptions (to develop what we call the Actuarial Budget Benchmark (ABB)) will satisfy most of the above criteria to be considered a “good model” for developing retirement plans and spending budgets.

Just like most pension plan actuarial valuations, our simple Actuarial Budget Calculators (ABCs) use deterministic, not stochastic investment return assumptions.  When using these Excel workbooks, we recommend using assumptions consistent with assumptions used by insurance companies to price inflation-adjusted annuities to develop a market value (or market-priced) valuation of future spending liabilities.  While equities and other risky investments may be expected to generate higher returns than such low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more investment risk.  Following basic financial economics principles, the “risk-adjusted” expected returns on these more-risky investments should be approximately the same as expected returns on low-risk investments available in the market.   Thus, in applying these principles, we believe that using these low-investment risk assumptions are reasonable for the purpose of determining how much you can safely spend, and the use of stochastic modeling is not an absolute requirement for a “good model”.  

For a more detailed defense of our simple spreadsheet model, see our post of October 8, 2017, and for more discussion of the implications of using basic financial economic principles to determine the cost of retirement and thoughts from Dr. Moshe Milevsky on this subject, see our post of July 10, 2017.

Our Concerns with Monte Carlo (Stochastic) Modeling

Our concerns with Monte Carlo (stochastic) modeling may be summarized as follows:

• Stochastic Model results are highly dependent on assumptions made for expected returns and variances for various asset classes (which are frequently built into the model, based on historical experience)
• Stochastic Models are generally not transparent
• Stochastic Models may not reflect all assets and spending liabilities, and
• Stochastic Model results may not facilitate the making of good financial decisions (the primary purpose of using a model)

We discuss these concerns in more detail below. 

Model Assumptions.  Even if you are (or your financial advisor is) using a stochastic model that meets most of the above criteria to be considered to be a “good model,” you are pretty much forced into accepting the model designer’s “built-in” assumptions for expected future real investment returns and standard deviations for various classes of assets.  Therefore, the reasonableness of the results of such a model will be very dependent on the reasonableness of these built-in assumptions about the future.  You can accept these assumptions on faith, or you can question whether they are reasonable.   And unlike assumptions that can be relatively easily gleaned from current annuity market pricings, it may not be so easy to tell how reasonable these assumptions are.  You can, of course, compare them with historical results, but everyone knows that historical results don’t necessarily reflect current economic conditions and therefore are not necessarily great predictors of the future.  Alternatively, you can compare the model results of using such assumptions with the model results of using annuity-based (low-investment risk) pricing assumptions.   As discussed in our post of February 4, 2018, “Should Increasing Your Investment Risk Increase Your Current Spending Budget?,” we become concerned when we see models that suggest that you can increase current spending with little or no perceived additional risk by investing in riskier assets.  This is an indication to us that the investment return assumptions for equity investments (or other risky investments) built into a model may be too aggressive in the current market environment.

We understand that Monte Carlo modeling is fairly standard practice among financial advisors.  We also understand that most financial advisors make their living by increasing AUM (assets under management).  And while most financial advisors undoubtedly believe they are using reasonable assumptions for future investment returns and variances for various classes of assets in their models, it may be prudent for you to try to independently assess how reasonable these assumptions might be.  For example, you might want to ask your financial advisor how he or she has adjusted these assumptions for variations in the Shiller Cape 10 index (which at over 30 today would suggest lower than historical real expected rates of return in the future, all things being equal.)

Transparency and Reflection of All Assets and Spending Liabilities.  In general, stochastic models tend to be somewhat “black boxy” in nature.  Model results tend to be something like, “if you invest as follows, you will have a X% probability of being able to spend $Y per year in real dollars as long as you or your spouse is expected to live.  When using such a model, you will need to determine if all future expected expenses (such as medical expenses that are expected to increase faster than inflation, unexpected expenses, long-term care expenses, other non-recurring expenses, etc.) have been adequately reflected in the model.  

Using the Model to Make Decisions.  We like Dirk’s weather forecast analogy in his argument for using a model that develops probabilities.  If there is a 5% chance of rain today, you may decide not to bring an umbrella.  A good model is supposed to help you make more informed decisions.   Unfortunately, results of stochastic modeling tend to provide probabilities of success applicable to  long periods of time and may not facilitate good short-term decision making.  For example, a couple may become complacent after they are told that they have a 95% probability of being able to spend $X per year irrespective of actual future investment experience.  Unlike the Actuarial Approach, which encourages annual valuations, periodic scenario testing and annual thinking about the safe amount to spend (and Rainy- Day Funds to establish or use to mitigate fluctuations in spending), the results of a Monte Carlo model can encourage more of a “set-it-and-forget-it” type of behavior that could result in either significant over-spending or under-spending as time goes by. 

We are also concerned with Monte Carlo models that may lead users to invest too aggressively.   For example, if overly aggressive future real rates of investment return (or overly conservative standard deviations) are assumed for equities, some individuals who wish to increase their current spending levels may be persuaded to increase their equity holdings beyond their tolerance for risk.   

You Aren’t Required to Use Just One Model/Conclusion

There is no law that says that you have to use just one model in your retirement planning.  You should feel free to look at the results produced by several models.  We don’t think you should reject models just because they use deterministic assumptions if these models adequately address retirement risks.  We also think it is perfectly reasonable to be somewhat skeptical of models developed by model designers who have a financial stake in the decisions you may make as a result of using their model.  If you want to use a stochastic model, or your financial advisor uses a stochastic model, we encourage you to compare the results of that model with the results of our ABC model (developed by retired actuaries who have absolutely no financial stake in the decisions you make as a result of using our models) or other models.  If the different models produce significantly different results, you should try to figure out why.  This exercise will provide you with  more “data points” to help you make better informed financial/spending decisions, which is, after all, the primary purpose of modeling the future.