Since we are retired actuaries and not financial advisors, we don’t advocate any particular investment strategy in this blog. For example, we don’t tell you how much of your assets should currently be invested in life annuities, bonds, cash equivalents, real estate or equities (particularly in these somewhat turbulent times for investing). We do, however, provide several tabs in our Actuarial Budget Calculators (ABCs) that you (or your financial advisor) may find useful in developing your investment strategy. This post will discuss these tabs and how they might be used.
Inspiration for this post is a fine article in the November, 2018 issue of the Journal of Financial Planning entitled, “Annuitized Income and Optimal Equity Allocation” by David M. Blanchett and Michael Finke. The authors indicate that the goal of their article is to “estimate the actual optimal asset allocation to stocks and bonds following the purchase of an annuity.” The authors conclude that, “when a retiree buys an income annuity, they should optimally take more investment risk with the remainder of their investment portfolio. Even risk-averse retirees should hold a significant allocation to equities if they have a large percentage of total wealth held in guaranteed income assets.” The authors employ a balance sheet approach similar to the actuarial balance sheet approach recommended in this website to determine asset allocation percentages, which leads us to discuss how you can use the PV Calcs tab in our ABC workbooks to perform the investment allocation calculations discussed by the authors.
PV Calcs Tab
The first section of the PV Calcs Tab shows the present value of input assets based on input assumptions. The results of this section can be used to develop the percentage of your total assets allocated to equities. To do this, you will first need to divide your total accumulated savings into component asset categories, but the values of streams of payments like Social Security, pension and annuities (which the authors refer to as “guaranteed income assets”) and the present value of total assets are calculated in this tab. So, for example, if you have accumulated savings of $1,000,000 that is invested 50% in equities and 50% in bonds and “guaranteed income” from Social Security and a pension with a combined present value of $1,200,000, your effective current allocation to equities is only about 23% ($500,000/$2,200,000) of your total assets.
If, in the example above, you decided to spend $200,000 of your bond investments on an annuity (with an assumed present value of $200,000), your effective allocation of your total assets to equities would remain at about 23% even though your accumulated savings would now have a 62.5% allocation to equities ($500,000/$800,000). And while it is important to be aware of this increase in equity allocation in the accumulated savings portion of your total assets, the authors’ real point is that this transfer from bonds to annuities (and the resulting gain from “mortality credits” associated with life annuities) should actually be accompanied by a higher than 23% allocation to equities for the total assets (and therefore even a higher than 62.5% allocation to equities in accumulated savings in this example.) Note again that this is the authors’ conclusion, not ours. We simply point out that this tab in our workbooks can be used to calculate the percentage of your total assets currently allocated to equities.
Budget by Expense Type Tab
The authors note that a decision of how much of one’s assets to allocate to equities will depend to some degree on the expected levels of a retiree’s essential and non-essential expenses and tolerance for risk. The Budget by Expense Tab available in our ABC for Single Retirees can be used to quantify the assets needed to cover essential expenses vs. non-essential expenses. Separate assumptions can be used in this tab for assumed future increases for non-health and health related expenses. To the extent that this tab shows that most of a retiree’s assets will be devoted to funding future essential expenses, one could make an argument that the retiree may be better served by investing in “safer” investments.
5-Year Projection Tab
In the 5-Year Projection Tab available in the ABC for Single Retirees, we give you an opportunity to stress test your current spending plan and investment strategy. Thus, you can estimate the effect on your recurring spending budget of a significant decrease (or increase) in returns on equities and your total investment returns over the next five years. This will enable you to test your tolerance for investment risk.
Conclusion
The authors have written an important article regarding the optimal allocation of a retiree’s (or retired couple’s) total assets to equities and how that allocation may change when bonds are used to purchase life annuities. We encourage you to read it. And while we avoid giving investment advice (or even the appearance of giving investment advice) like the plague, we believe our workbooks can be useful tools in helping others develop investment strategies. As discussed in our Overview tab, individuals who use our ABC for Retired Couples workbook but who want to utilize the Budget by Expense and 5-Year Projection tabs discussed above can use our ABC for Single Retirees with appropriate inputs.
