Our primary mission here at How Much Can I Afford to Spend is to provide you with several actuarial tools and processes that you can use to make better personal financial decisions. And even though we are actuaries, we are no better than you are about predicting the future. Therefore, we will not be offended if you override our default assumptions with assumptions you believe to be more appropriate.
In this post, we will discuss two recent articles that you might find interesting, and we will once again provide you with a few data points that we hope will help you determine how conservative (or optimistic) our default assumptions (or your override assumptions) may be.
We recently received feedback from one of our readers who pointed out that Larry Kotlikoff recently reduced the real rate of investment return (the difference between assumed annual investment return and assumed annual future inflation) from 1% per annum to 0% for Maxifi, the financial planning program he markets. And while we use a 2% real rate for our default assumptions, we counter that relatively optimistic assumption to some degree by using pretty conservative lifetime planning periods (LPPs) based on 25% probability of survival of healthy non-smokers, not life expectancies based on 50% probability of survival.
In his Forbes article of May 9, 2020, Mr. Kotlikoff discusses his recommended real rate of return assumption by saying:
“But stocks are risky, particularly now. Once you adjust for their risk, they are yielding precisely zero after inflation. And, yes, the safe long-term TIPS (Treasury Inflation Protected Securities) rate may go back up. But it may also fall further. Hence, John and Sue have decided to plan prudently and assume they'll earn what they can actually now safely earn on their assets — zero percent, not 1 percent real, which they were previously assuming.”We generally agree with Mr. Kotlikoff on most things (he is a very bright guy), so he could be right. On the other hand, while current interest rates are indeed very low, we are picking assumptions for a 25-30-year period in the future and the actuarial process is self-adjusting, so future spending budgets will be automatically reduced if assumptions employed today are too optimistic (and vice versa if assumptions are too conservative).
In a related Washington Post article of May 14, 2020, Mr. Allan Sloan discusses assumptions used by the Social Security Actuaries in their annual valuation of the OASDI system to determine the present value of a $1,500 monthly benefit for an average age 65-year old male and female. Using our Present Value Calculator workbook, we were able to fairly closely duplicate the present values in Mr. Sloan’s article. Our present values, using the SSA actuaries’ assumptions, were slightly different because our workbook assumes beginning of year payments rather than monthly payments.
Because our default lifetime planning periods are considerably longer than the lifetime planning periods assumed by the Social Security actuaries, our ABCs develop much higher present values for expected Social Security benefit payments. For example, under our default assumptions, we developed a present value of a $1,500 per month benefit for a 65-year old male (including future expected cost of living increases) to be $402,480 vs. the $266,105 amount in Mr. Sloan’s article, an increase of $136,375 or about 51% higher.
It should be noted that assumptions used by the Social Security actuaries are for pricing the Social Security program, and involve mortality projections for the general population of the U.S. These assumptions are not intended to be used for personal financial planning for individuals or couples who generally plan to live longer than projected life expectancies of the general U.S. population.
In addition to showing the present values of a $1,500 monthly Social Security benefit under different assumptions, the table below also shows the account balance that would be required to generate annual real income of $1,500 per month under several common drawdown approaches. The columns show assumptions (when applicable) for the following planning approaches:
- The IRS Required Minimum Distribution (RMD) rules under proposed assumptions assuming RMD factors applied at age 65
- The 4% Rule
- The 3.5% Rule (same as 4% Rule except using 3.5%)
- The Social Security assumptions discussed above from the 2020 OASDI Trustees Report
- The Cost of Retirement Income (CORI) from BlackRock on May 17, and
- Default assumptions and results from our ABC for Single Retirees workbook
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The present values of Social Security developed in Mr. Sloan’s article (and shown above) are lower than the present values developed using our default assumptions and are also much lower than would be required to generate a monthly income of $1,500 increasing with inflation each year under the rule of thumb approaches (or the BlackRock CORI) shown in the table. Based on these comparisons, we believe the present value amounts discussed in Mr. Sloan’s article probably understate the value of Social Security for planning purposes.
And while our default assumptions generate a larger expected Social Security present value “asset” than developed using Social Security assumptions, our default assumptions also assume that future spending budgets (liabilities) will be required for longer periods. The net effect of using our default assumptions is to produce much lower (more conservative) current spending budgets and higher present values of essential expenses than would be produced if you overrode our default assumptions with the Social Security assumptions.
It should be noted, however, that all of the estimates of the present value of monthly $1,500 lifetime Social Security benefits in the table above also assume that the monthly benefit and cost of living increases anticipated under current Social Security law will continue to be paid for life and will not be reduced in the future. Given the program’s projected financial status, this is another assumption that planners will need to consider when trying to decide whether their retirement plan is based on conservative or optimistic assumptions.
Summary
For planning purposes, we believe Mr. Sloan has probably understated the value of Social Security benefits for most individuals in his article. The only question we have is “by how much?” And while the Social Security actuaries’ assumptions about the future are probably too optimistic for your planning purposes, Mr. Kotlikoff believes that prudent planners should be assuming 0% real rates of investment return.
We want to be as transparent as we can about the assumptions we refer to as the “default assumptions” used in our workbooks. All things being equal, using assumptions more optimistic than the default assumptions (higher real rates of investment return and/or shorter lifetime planning periods) will
- increase your calculated current recurring spending budget,
- increase the present value of your future essential expenses/Floor Portfolio, and
- increase your risk of having to reduce your spending budget in the future.
- decrease your calculated current recurring spending budget,
- decrease the present value of your future essential expenses/Floor Portfolio, and
- decrease your risk of having to reduce your spending budget in the future.
