The current default assumptions used in our four ABCs are:
- Discount Rate/investment return: 3.5% per annum (2% Real),
- Inflation: 1.5% per annum
- Lifetime Planning Period(s): From the Actuaries Longevity Illustrator (ALI) based on 25% probability of survival for a non-smoker in excellent health
All things being equal, decreasing your assumed Discount Rate/investment return translates into higher present values of future asset payments (like future Social Security or pension benefits), but it also increases the present value of future liability payments, such as future Recurring Expenses. Generally, assuming a lower Discount Rate will increase the cost of future expense budgets and the cost of funding your future Essential Expenses. This will be particularly true if the decrease in the interest assumption is not also accompanied by an equal decrease in the desired rate of future expenses (which is generally tied to the Inflation assumption).
In the sections that follow, we will discuss:
- Estimations of fixed interest rates built into current fixed dollar annuity purchase rates, which generally serve as a baseline to us for the default assumptions we use in the ABCs,
- Real interest rates (approximately equal to assumed investment return minus Inflation) suggested for pre-retirees and retirees by Dr. Wade Pfau for models (like ours) that use deterministic assumptions, and
- Investment implications in current economic environment.
The table below shows monthly life annuity quotes for males of different ages per $100,000 of premium in the second column from Immediateannuities.com as of April 10. Life expectancies shown in third column are 50% probabilities of survival from the Actuaries Longevity Illustrator for non-smoker males in excellent health. The fourth column shows our calculation of the fixed investment rate of return that would be earned if a person bought the annuity and died at his current age plus his life expectancy (in months). This investment return is net of insurance company expenses and profits. These rates are nominal rates and not real (net of assumed Inflation) rates.
Note that males who die prior to reaching their current life expectancy would “earn” less than the estimated percentage annual return, and males who die after reaching their current life expectancy would “earn” a higher rate of return. This potential for higher return for those who outlive their current life expectancy is known as “the mortality premium” and is one of the reasons why you still may want to consider buying a life annuity in the current environment, even though current expected returns are quite low, on average.
Monthly Life Annuity Quotes for Males per $100,000 Single Premium
| Current Age | Fixed Monthly Life Annuity | Life Expectancy in Months | Assumed Annual Rate of Investment Return |
| 55 | $ 399 | 396 | 3.0% |
| 60 | $ 436 | 336 | 2.9% |
| 65 | $ 489 | 276 | 2.7% |
| 70 | $ 561 | 216 | 2.2% |
| 75 | $ 692 | 156 | 1.2% |
| 80 | $ 887 | 108 | 0.9% |
The table shows that the calculated level annual rate of return for these life annuities decrease with increasing age, indicating that investment return assumptions used by life insurance company actuaries are not constant for each future year, but vary with the expected length of payout, consistent with an increasing Yield Curve. In addition to implying that perhaps we should consider lowering our current default Discount Rate/investment return assumption of 3.5%, this table also implies that older individuals who use our workbooks may wish to use even lower Discount Rates/investment returns, but not necessarily a lower assumed rate of Inflation or desired increase in future recurring budgets.
Real interest rates suggested by Dr. Wade Pfau for deterministic models
In his Forbes article of April 1, 2020, Dr. Wade Pfau presented several good arguments why retirement planners (both financial advisors and DIYers) may want to use different investment return assumptions in deterministic models for the pre-retirement accumulation phase and the post-retirement decumulation phase. He says,
“For example, a conservative individual might be willing to use the 25th percentile return during accumulation (calibrated to a 75 percent chance for success) but only the 10th percentile during retirement (90 percent chance). If the individual were comfortable with the arithmetic real return and volatility of 5.6 percent and 10.6 percent, this would suggest using a 3.7 percent compounded real return assumption in the spreadsheet for accumulation and a 2 percent compounded real return assumption in the spreadsheet for retirement.”
We don’t have a problem with Dr. Pfau’s bifurcated suggestion, and our ABCs for pre-retirees do permit input of separate pre-retirement and post-retirement investment return assumptions. We do, however, believe that the investment return assumption made for the period of retirement should be consistent with the cost of defeasing post-retirement spending liabilities with low-risk investments (the Floor Portfolio). In today’s economic environment, this may mean assuming an investment return less than 3.5% and somewhat less than a 2% real rate of return, depending on how conservative the longevity planning period assumption is and the age of the user.
Investment implications of current low-interest rate economic climate
We continue to support the Floor/Upside investment strategy as a risk-mitigation approach, even though investments in low-risk assets at this time appear to be quite expensive and/or are expected to generate low investment returns. Lower interest rates in the current environment favor deferring commencement of Social Security until age 70, pensions, existing life annuities and individual bonds that are already owned. Buying new life annuities or new individual bonds with relatively low expected returns at this time is a more difficult decision. As noted above, life annuities can generally generate higher returns than bonds for those who live longer as a result of the mortality premium. But fixed annuities involve committing a large sum of money up front and some individuals may simply decide that the best strategy for funding a Floor Portfolio at this time is to stick money in cash until more favorable bond or annuity returns emerge. As discussed many times in this blog, we are not investment managers, so we can’t and don’t give investment advice.
Summary
Decreases in the Federal Funds Rate to almost 0% have affected current Bond yields and consequently, investment return assumptions made by actuaries in pricing life annuities. However, we don’t plan to change our default assumptions at this time. Since the Actuarial Approach is a self-correcting process, it is not critical that assumptions be 100% accurate.
It can be argued that more conservative assumptions could be used in our models for retirees:
- for valuing future Essential Expenses,
- Floor Portfolio funding requirements and
- Floor Portfolio spending
- the assumptions used for pre-retirement accumulation periods,
- for valuing Discretionary Expenses,
- Upside Portfolio funding requirements and
- Upside Portfolio spending for retirees.
For the time being, we encourage you to think about the assumptions that may be best for your purposes. As part of this thought process, we encourage you to assess the risks in your retirement plan by modeling possible deviations from your assumptions as discussed in our post of November 26, 2017. If you are uncomfortable with some of these risks (for example you are worried that higher rates of Inflation may re-emerge), you may want to take steps to mitigate your risks by using more conservative assumptions or by building up a larger Rainy-Day Fund. At the end of the day, retirement planning is a relatively simple two-step process:
Step 1: Make your best estimate (or conservative assumptions) about the future
Step 2: Be prepared (and flexible) whenever the assumptions made in Step 1 prove to be incorrect.
