In our post of September 25, 2019,
we encouraged you to take responsibility for your own retirement. In
this post, we will build on our previous post by encouraging you to
adopt and implement a strategic plan for your retirement.Like it or not, you (and/or your spouse) are the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of your family’s financial operations in retirement. You may have retained a financial advisor as your family’s consultant, but because of how you pay that person, you should be aware that he or she may have some inherent conflicts with your family’s financial interests. Therefore, you should understand that you, as your family’s CEO and CFO, are ultimately responsible when it comes to investing and spending your family’s assets during retirement.
Like the CEO and CFO of a corporation, developing and implementing a strategic plan will help you:
- establish internal controls – the mechanisms, rules, and procedures implemented by an entity to ensure the integrity of financial and accounting information, promote accountability and prevent fraud (https://www.investopedia.com/terms/i/internalcontrols.asp)
- evaluate your financial advisor recommendations (if applicable), and
- make better financial decisions
- Where you are now
- Where you could be in the future
- Where you want to be (goals)
- How do you get there (strategies and implementation), and
- Your progress in meeting your goals (assessment metrics)
Goals
Your strategic plan should align your spending budget and investment strategy with your spending goals. So the first step in developing your plan is to determine what your retirement spending goals may be. The following are fairly standard goals primarily related to recurring spending in retirement:
- Maximizing spending while living
- Not running out of accumulated savings
- Not becoming a burden on children or other family members
- Avoiding undesirable year-to-year volatility of essential spending
- Not leaving too much to heirs
- Being able to sleep better at night by erring on the “too conservative” rather than the “too aggressive” side of investing and spending
- Investment in new career opportunities
- Unexpected expenses
- Spending on hobbies
- Spending on mortgages
- Travelling and vacations
- Assisting family members with emergency expenses
- Home remodeling
- Having flexibility to spend on other discretionary items
- Purchase of new automobiles, etc.
In order to align your spending and implementation strategies with your spending goals, the strategic spending component of your strategic plan should consider all your assets and all your spending liabilities. It should provide you with an annual spending budget for both your non-recurring expenses and your recurring expenses, and it should involve processes that provide you with relevant information to help you adjust your spending plan to keep it you on track to meet your spending goals (to the extent practicable) when your assumptions about the future are not realized or your spending goals change.
A Strategic (or Sustainable) Withdrawal Plan (SWP) like the 4% Rule does not consider all your spending goals or all of your assets. Since it does not coordinate with other sources of assets or distinguish between recurring and non-recurring expenses, it generally will not provide a robust spending budget. Static (non-dynamic) SWPs, like the 4% Rule, provide no mechanism to keep spending on track in the future.
And while Monte Carlo (MC) models may be based on thousands of simulations about life expectancy or expected investment performance of various types of assets, many of these models do not consider all spending liabilities and do not distinguish between recurring and non-recurring expenses. MC models generally will not anticipate different rates of future increases for different types of expenses. In addition, MC models generally won’t tell you what action to take if future experience deviates from your assumptions. Telling you that you have a 95% probability of being able to spend $X per month for the rest of your life if future experience follows assumed experience does not tell you how much you can afford to spend next year (or in future years) unless your plan unrealistically anticipates relatively constant total (non-recurring plus recurring) spending of $X per month from year to year and future assumptions don’t significantly differ from assumed assumptions.
Aligning Investment Strategies with Spending Goals
In order to align the investment strategy used in your strategic plan with your spending goals, you need to determine how willing you are to risk your current standard of living for the opportunity to enjoy a higher standard of living. As discussed in many of our 2019 posts, this involves determining how much of your assets should be invested in low-risk investments to fund your essential expenses (your Floor Portfolio) and how much of your assets should be invested in higher-risk investments to fund your discretionary expenses (your Upside Portfolio). Since your assets are your only source of spending, you need to carefully balance the need to protect your assets with your need to grow your assets. By fully funding your Floor Portfolio, you will be able to sleep better at night, but a larger Upside Portfolio will provide you with flexibility to fund some of those desired non-recurring discretionary expenses (as discussed in our post of November 12, 2019).
The 4% Rule and most Monte Carlo models used by financial advisors were developed by academics and financial advisors, and frequently support decisions to invest considerable portions of a retiree’s assets in equities based, in part, on the assumption that future returns will be similar to historical returns. Depending on the assumptions used to model future investment experience, some Monte Carlo models can even imply that it is less risky to invest in equities than it is to purchase annuities. We acknowledge that Monte Carlo models can be more realistic than deterministic models like the Actuarial Approach when it comes to showing ranges of future experience, and MC models can and do provide outcome probabilities based on assumed experience, but we are not convinced that such models are superior to the Actuarial Approach for the purpose of determining a specific dollar amount spending budget, aligning spending strategies with spending goals, or adjusting the spending plan for deviations from assumed experience.
Conclusion
Many financial advisors, and surprisingly, even some actuaries, believe that Monte Carlo models are inherently superior to the Actuarial Approach advocated in this website for the purpose of developing and implementing a strategic spending plan in retirement. We disagree. Running 10,000 or more simulations doesn’t make a Monte Carlo model a better tool for developing a spending budget, particularly if you have or will have significant future non-recurring expenses. We also don’t buy the argument that Monte Carlo models are superior budgeting tools because they are more “sophisticated” or more “complicated” than the deterministic Actuarial Approach model.
MC approaches generally don’t provide guidance as to what actions should be taken when actual experience deviates from assumed experience. As noted in prior posts, pension plan actuaries and Social Security actuaries continue to use deterministic assumptions in calculations for their clients who are looking for specific dollar amount results, and not ranges or probabilities, even though they could easily use Monte Carlo stochastic approaches.
We believe the issue of whether the model used to develop a strategic spending plan uses stochastic assumptions or deterministic assumptions is a red-herring, and is far less important than the purpose of the calculation, the assumptions used for future experience, the adjustment processes anticipated ,and whether the model differentiates between recurring and non-recurring expenses as discussed in our post of October 8, 2019.
We also disagree with those who claim that the appropriate model or approach used to develop a plan for an individual or couple will depend on whether they have retained a financial advisor. This claim implies that individuals or couples who have retained a financial advisor should unquestionably rely on their financial advisor’s model and plan recommendations. And while we advocate retaining a qualified financial advisor if you believe you need one, we encourage you to properly discharge your CEO/CFO responsibilities irrespective of whether you have retained a financial advisor. This can involve either using the Actuarial Approach as an independent check on your consultant’s recommendations, or alternatively, asking your financial advisor to use the Actuarial Approach to produce another data point that can be compared with or integrated into your financial advisor’s recommended plan.
