Thanks to one of our readers, Ian Holliday of the U.K., for letting us know that Karsten, a blogger at Early Retirement Now (with the nickname “Big ERN”) has made available a Google spreadsheet entitled EarlyRetirementNow Actuarial SWR Toolbox. His new actuarial spreadsheet is very similar conceptually to the Actuarial Budget Calculators for single retirees and retired couples that we make available in this website. He utilizes the Basic Actuarial Balance Equation and calculates the present values of assets and spending liabilities (using deterministic assumptions—no simulations) to develop a recurring expense spending budget “data point.”
In this post, we will discuss Karsten’s new actuarial tool and the problems he perceives with using this tool rather than using his Safe Withdrawal Rate (SWR) Google Sheet (with simulations) to develop a spending budget in retirement.
In his recent post, “How to Calculate Your Safe Withdrawal Rate without using Simulations—SWR Series Part 33,” Karsten walks us through an example of how to use his new Actuarial Safe Withdrawal Rate (SWR) toolbox (with no simulations) and discusses the problems with using it vs. his recommended SWR Google Sheet (with simulations). He concludes that, “There are at least two problems with this [actuarial] approach.” He also says, “I would not recommend relying exclusively on this [actuarial] approach and you’ll need to rely on simulations after all. As discussed below, while we like Karsten’s new actuarial tool, we believe the perceived problems associated with using the actuarial approach can be addressed. We don’t find the spending budgets produced by Karsten’s SWR toolbox (with simulations) to be safer or better than those produced by the actuarial approach. Therefore, we disagree with his conclusion that “you’ll need to rely on simulations after all.”
His New Actuarial Tool is Robust
We were able to pretty much duplicate the results of his example based on his hypothetical data and economic assumptions. Using our default lifetime planning period assumptions and assuming a 33% reduction in spending budget after the first death within the couple, we developed an annual spending budget for the couple of $63,816 vs. his actuarial budget of $62,900. Had we taken the time to input his lifetime planning period assumptions and a 0% reduction in spending budget after the first death, we probably would have come even closer. So, we have every reason to believe that Karsten’s actuarial tool is functioning well.
“Safe Withdrawal Rate” (SWR) Budgets with Historical Return Simulations
We note that Karsten develops what he calls a “Safe Withdrawal Rate” budget with his recommended SWR Google Sheet (with simulations). In our opinion, we find the budgets developed with this tool to be neither “safe” nor strictly speaking a “withdrawal rate.” Looking at historical returns and picking the worst yielding N-year period and assuming the same results occur in the future does not make your assumptions “safe.” The future is the future, and future results for the next N years can be worse than the worst N-year period historical results. Just because we expect higher returns from risky investments does not guarantee that returns on risky assets will exceed returns on less risky investments. It should be noted, however, that we don’t consider the Actuarial Budget Benchmark (ABB) developed using our workbooks and recommended assumptions to be “safe” either if you are investing in risky assets (more on this below).
Instead of a withdrawal rate, Karsten’s budget it is more of a recurring expense spending budget and does not necessarily determine the amount to be withdrawn from accumulated savings. For example, the annual consumption amount determined in his post example using his actuarial spreadsheet is $62,900. And while this amount may be 4.19% of the couple’s portfolio, this is not the amount anticipated to be withdrawn from their portfolio during the year. If the recurring expense budget of $62,900 is spent during the year, $80,900, or 5.39% of the couple’s beginning of year portfolio value is anticipated to be withdrawn from the portfolio. This amount is the recurring spending budget of $62,900 plus the couple’s mortgage payments of $21,600 minus the proceeds from his immediate life annuity $3,600.
Perceived Problem #1 with Actuarial Approach—The Discount Rate
Karsten correctly points out that assuming different discount rates can produce different current year spending budgets under the actuarial approach. We don’t see this as a fatal flaw, as Karsten implies. What he fails to note is that the actuarial valuation process is a self-correcting process. If you are too optimistic with your assumptions early in your retirement, your actuarially determined real spending budget will decrease in the future as experience less favorable than your assumptions emerges. Also, if you are too pessimistic with your assumptions early in your retirement, your actuarially determined real spending budget will increase in the future as experience more favorable than your assumptions emerges.
We recommend using lifetime planning period and economic assumptions (including the discount rate) approximately consistent with assumptions used to price inflation-adjusted life annuities. This market price (or cost) for purchasing lifetime income is used to determine the market value of spending liabilities (and assets) under our recommended approach, and is consistent with basic financial economics principles. So, if assets are invested in risky investments and earn higher rates of return in the future than discount rates assumed for the less risky inflation-adjusted annuity investments, future spending budgets can be increased as the higher returns emerge (but not before). Rather than basing our assumptions on historical returns (or some other arbitrary basis), we base our assumptions (including, yes, our current 3.5% discount rate) on actual current insurance market information. Essentially, we assume risk-adjusted returns on other more-risky investments in one’s portfolio will also be 3.5% per annum.
The concept of “you can spend it now or you (or your heirs) can spend it later” discussed in the first paragraph of this section actually applies to any rational spending approach (including Karsten’s SWR (with simulations approach). Therefore, when he indicates his recommended recurring Safe spending budget for this couple is approximately $67,500 and “much higher” than the $62,900 budget developed by the actuarial approach, his “safe” approach is actually less conservative (and therefore less safe) than the Actuarial Approach, because it “pre-recognizes” the higher expected returns associated with the risky (70% equity/30% fixed) investment strategy assumed in the example. His approach is actually increasing the couple’s risk for future spending cuts relative to the Actuarial Approach, all things being equal.
Perceived Problem #2 with Actuarial Approach: Return Volatility and Sequence Risk
Karsten correctly notes that a mark to market calculation of the Actuarial Budget Benchmark (ABB) from year to year will fluctuate with actual investment performance. Of course, results from year to year may be smoothed under the Actuarial Approach (and we have a tab for that) just as Karsten acknowledges that his approach is not a “set and forget approach, and “it’s not so much IF we have to change our retirement budget, but more a matter of HOW MUCH we have to change our budget over time and for HOW LONG we might have to tighten the belt if our portfolio underperforms.” At least under the Actuarial Approach, we do provide you with a market-based data point to help you with this “how much and for how long” question. We are not clear, however, how Karsten wants you to handle this problem when future experience is either too favorable or too poor under his recommended approach.
Perceived Problem #3 with Actuarial Approach—No Asset Allocation Guidance. While Karsten does not devote a separate section in his post to this issue, he does indicate that the actuarial approach “gives me no guidance for my asset allocation. Quite the opposite, you might feel compelled to go for the highest risk asset allocation because it has the highest expected return and thus the highest discount rate which will likely generate the highest consumption target.” As with the previous two perceived problems, we disagree with Karsten on this one too. As discussed in many of our recent posts, we believe the Asset Reserve by Expense Type tab of our workbooks can provide valuable information with respect to the establishment and maintenance of “floor” and “upside” portfolios. In the example used in Karsten’s post, we wouldn’t be surprised if his couple reached the conclusion that a 70% equity/30% bond portfolio might not be consistent with their goal of funding future essential expenses with less risky investments.
How Aggressive do you want to be with your Spending Budget and Investment Strategy in Retirement?
Karsten takes great pride in the fact that his aggressive investment strategy and safe withdrawal rate with historical return simulation approach produces a higher spending budget than the conservative actuarial approach using insurance market life annuity pricing assumptions. Not surprisingly, as actuaries, we are skeptical of the level of safety claimed for his approach. In our opinion, Karsten’s approach is similar in concept to the strategy of refinancing your home and investing the loan proceeds in risky assets because you expect, based on historical returns, to earn a higher rate of return on those risky assets than the rate used to determine the cost of refinancing. When making such a financial decision, we believe you should properly consider the risks involved and not simply rely on higher return expectations.
Summary
Spending down your assets in retirement is a risky proposition. We are skeptical whenever we hear claims that certain approaches are safe (or safer) if they involve significant investment in risky assets. Similarly, we are also skeptical whenever we hear that certain approaches can increase spending budgets with no increase in risk.
We don’t know what future investment returns will be. We do have a pretty good sense of the discount rates insurance companies are charging to provide lifetime income (annuities). We don’t tell you how much you should spend each year in retirement or how to invest your assets. We provide you with a tool that you can use to determine approximately how much you could spend if you invested your assets in relatively low-risk investments. If you use the actuarial approach and you believe that your investments will earn more than the discount rates used to price inflation-adjusted annuities, you can either wait for the more favorable returns to emerge to increase your spending budget or you can be more aggressive and pre-recognize the favorable expected returns. The choice is yours. If you decide to pursue the more aggressive strategy and you use something like Karsten’s budgeting tool with simulations, we recommend that you also annually calculate your Actuarial Budget Benchmark (ABB) as an additional budget “data point” to quantify just how aggressive your spending strategy is and to keep it on track when actual future experience inevitably deviates from assumed experience.
We congratulate Big ERN on his new actuarial toolbox. We like it. We are going to have to disagree with him, however, when he implies that his Google sheet (with simulations) tool will produce either a better or safer data point than the actuarial approach for budgeting in retirement.
