One of the primary purposes of our website is to provide you with tools to help you achieve your spending goals in retirement. Typical spending goals include:
- Maximize spending while living
- Not run out of accumulated savings
- Avoid year to year spending volatility
- Have some certainty of being able to cover essential expenses
- Have spending flexibility
- Not leave too much to heirs
In this post, we will compare the risks and potential rewards of self-insuring your retirement vs. purchasing life annuities. Note that while the discussion below compares these two alternatives, there is nothing to stop you from combining these approaches in your personal financial planning. In fact, many retirement experts recommend utilizing both approaches rather than one or the other. For the self-insuring alternative, we will assume that you will be using the Actuarial Approach/ABB to develop your annual spending budget. While the Actuarial Approach is a dynamic spending approach and not a static approach, static and dynamic spending approaches, for the most part, share the same potential advantages and carry similar risks when compared with the annuity purchase strategy. See the appendix below for a discussion of static and dynamic spending approaches.
The Actuarial Approach
The Actuarial Approach is robust dynamic spending approach that can provide you with important data points to help you accomplish many of your spending objectives, but you should be aware that the current year spending budget produced by our workbooks is not guaranteed to last a lifetime. The Actuarial Approach utilizes relatively conservative assumptions about the future that may or may not be realized over time (and for any one-year period, will undoubtedly not be exactly realized). The current recommended (default) assumptions for developing spending budgets for ABB purposes include a 4% investment return assumption (2% real), 2% desired rate of future spending budget increases (equal to assumed inflation) and lifetime planning periods based on 25% chance of survival for healthy non-smokers from the Actuaries Longevity Illustrator. If you self-insure, use the Actuarial Approach/ABB to develop your annual spending budget and you don’t earn at least a 2% annual real rate of return (actually a little bit more than 2% real to cover the longevity losses that are expected to occur after about age 80 (as discussed on our post of January 21, 2018) , you will experience “actuarial losses” (reductions in assets or increases in spending liabilities resulting from unfavorable deviations from assumed experience or changes in assumptions) and these losses will reduce your future real dollar spending budgets below today’s current real dollar level, all things being equal. In fact, if you self-insure, use any spending strategy that anticipates spending your principal over time, and you don’t earn enough on your assets or live too long, you are either going to run out of assets (with static spending approaches) or you are going to suffer decreases in your spending budgets (with dynamic spending strategies).
The Actuarial Approach spreads actuarial gains and losses (from actual vs. assumed investment returns, actual vs. assumed spending, actual vs. assumed longevity, changes in assumptions) over your assumed remaining lifetime (LPP). As you get older, your LPP decreases. Therefore, your spending budget can become more volatile as you age unless you smooth the results or establish a Rainy-Day Fund. As noted above, however, one of the advantages of self-insuring is that you can always change your mind and purchase an annuity (assuming there is a market). And, as discussed in this post, you (or your heirs) might want to keep this option in mind as your cognitive facilities diminish.
If you truly can’t stomach the thought of purchasing an annuity (even if it may make financial sense to do so) and still want to be responsible for your investment/spending decisions but you want to be more conservative in developing your spending budget, you can override the default assumptions in our ABC calculators. For example, instead of assuming a 25% chance of survival LPP, you can assume a 10% chance and instead of assuming a 2% real rate of investment return, you can assume a 1% real rate of return. Alternatively, you can simply spend less or use the Maintain Your Principal approach, which is what many retirees do. The choice is yours, but be aware that there are no guarantees when you self-insure.
Conclusion
A key question to consider when it comes to self-insuring some or all of your retirement (to be asked using your best Clint Eastwood do-you-feel-lucky-voice) is “am I being too conservative with my assumptions about the future or am I being too aggressive?” The ABB, with its relatively low-risk annuity-based pricing assumptions, gives you an important data point to help you answer this question, but the only way to truly guarantee your retirement income is to purchase a life annuity.
Appendix--General Types of Spending Strategies
Static Spending Strategies. Under this family of spending strategies, the spending budget is determined at time of retirement and is typically increased each year thereafter by increases in measured inflation. The spending budget does not reflect actual experience (investment performance, spending, changes in expected longevity, etc.). Examples of this type of spending strategy include the 4% Rule, other safe withdrawal approaches and Monte Carlo models that produce low probabilities of ruin for a given level of real dollar spending. As a general rule, static spending strategies tend to be better than dynamic strategies at avoiding year-to-year fluctuations and providing some certainty of covering essential expenses, but can be poorer at achieving the other typical goals. Of course, advocates of these types of strategies note that technically they aren’t really “set and forget” type strategies and should be reviewed periodically to make sure individuals or couples are not spending too much or too little. Static spending strategies are generally more susceptible to sequence of return risk than dynamic spending strategies.
Dynamic Spending Strategies. Under this family of spending strategies, the spending budget is adjusted periodically (typically annually) to reflect actual experience (investment performance, spending, changes in expected longevity, etc.). Examples of this type of spending strategy include the Maintain Your Principal approach, the IRS RMD approach and the Actuarial/ABB approach. As a general rule, dynamic spending approaches tend to be better than static approaches at maximizing spending while living, not running out of accumulated savings, having spending flexibility and not leaving too much assets to heirs, but not quite as good at avoiding spending fluctuations or providing certainty that spending budgets will cover essential expenses. If course, advocates of dynamic approaches argue that spending volatility can be mitigated through smoothing techniques or through the use of Rainy-Day Funds.
