This post will take a closer look at the Sum of Retirement Income Generators (SORIG) approach and compare it with the Actuarial Approach advocated in this website, which focuses instead on how much of your total assets you can afford to spend each year in retirement.
SORIG Approach
Under this approach, lifetime income streams are summed to determine an annual spending budget. For this purpose, assets that are not payable in a lifetime income stream (such as invested assets) are converted to an equivalent lifetime stream using a Strategic Withdrawal Plan (SWP). Examples of SWPs that may be used for this purpose include the 4% Rule or the IRS Required Minimum Distribution (RMD) approach. For purposes of the comparison chart below, we will assume that conversion of a person’s invested assets into a lifetime payment stream will be accomplished using the IRS RMD approach.
As discussed in our previous post, developing a spending budget by converting an invested asset portfolio into lifetime income (using either a static or dynamic approach) and adding the result to other income can produce undesirable spending budget results in many real-world situations. Income may start and stop at different times during retirement and may not be payable in real dollars throughout retirement. We call these sources of income “lumpy income.” Further, expenses may also start and stop at different times during retirement and may increase or decrease in real dollars in the future. We call these types of expenses “lumpy expenses.” In situations where either lumpy income sources or lumpy expenses exist, the SORIG approach may not produce a reasonable or desirable spending budget from year to year.
Proponents of the SORIG approach argue that these lumpy income/lumpy expense problems can be addressed with specific modifications to the approach. A classic example of one of these modifications is the deferral of Social Security commencement strategy. An individual who wants to retire at age 65, for example, but commence Social Security benefits at age 70, has a lumpy source of income problem if she desires to keep her spending relatively constant in real dollars throughout her retirement. SORIG proponents suggest solving this problem by establishing a “Social Security Bridge” fund from her invested assets to pay her during the deferral period. Some SORIG proponents have even suggested that employers or the government help people establish Social Security Bridge funds to enable them to defer their Social Security benefit.
But this is just one example of a situation where someone (or a couple) may have a lumpy source of income problem. See our previous post for a list of possible lumpy sources of income. Can we reasonably expect employers or the government to provide specific assistance for those other situations?
Of course, the more SORIG is modified to address its short-comings with respect to lumpy assets and lumpy expenses, the more complicated it becomes. And all these modifications can defeat the whole premise that SORIG is a simple approach that most individuals and couples can easily use.
Actuarial Approach
The Actuarial Approach advocated in this website uses present values (PV) to develop a sustainable spending plan in retirement. Similar to the approaches used by actuaries to determine pension plan contribution requirements and measure the financial status of Social Security, it calculates a spending budget by employing deterministic assumptions that equates family assets (the left-hand side of the Actuarial Balance Equation below) with family spending liabilities. By using this basic actuarial principle (time value of money or present values), the Actuarial Approach automatically reflects the timing of lumpy sources of assets and lumpy expenses in the spending budget calculations.
Annual valuations determine a current year spending budget consisting of a non-recurring expense spending budget and a recurring expense spending budget. If all assumptions are realized and budget amounts are spent, future calculated spending budgets will emerge as expected. When future experience inevitably differs from assumed experience, the process is self-correcting. Our workbooks enable users to perform these present value calculations and provide tabs for users to measure the impact on their future spending budgets of possible deviations from assumed experience.
SORIG proponents (and proponents of other “simple” approaches, including many other actuaries) argue that the Actuarial Approach is too complicated because it involves present value calculations and people generally lack the skills needed (i.e., aren’t smart enough) to understand present values. On the other end of the spectrum, some financial advisers argue that the Actuarial Approach is not complicated enough, because it uses deterministic assumptions and does not produce probabilities of achieving certain lifetime spending goals.
We believe that many people are, in fact, proficient enough to understand present values and the Actuarial Approach. They may not be able to calculate present values, but many people understand the time value of money concept that a dollar payable next year is worth less than a dollar payable today. We also believe that our workbooks provide the tools that make present value calculations accessible to individuals and couples who are looking for a more robust solution to their lumpy source of income or lumpy expense problems.
Comparison of SORIG Approach and Actuarial Approach
The table below summarizes the key differences between the SORIG Approach (in its most simple form) and the Actuarial Approach. As discussed above, the SORIG approach can be modified to address some of its shortcomings.
The above chart shows the primary advantages of using the Actuarial Approach over the SORIG approach. Many of these advantages flow from how the two different approaches treat withdrawals from invested assets. The SORIG approach converts invested assets into a hypothetical lifetime payment stream through the use of a Strategic Withdrawal Plan, while the Actuarial Approach subtracts anticipated payments from other sources from the current year spending budget to determine the current year amount withdrawn. This different approach permits the Actuarial Approach to properly coordinate withdrawals from invested assets with lumpy sources of retirement income.
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The above Actuarial Balance Equation that we employ in our Actuarial Budget Calculators (ABCs) clearly demonstrates that the amount you (or your family) can spend in retirement (the right-hand side of the equation) is a function of the assets you own (the left-hand side of the equation). Therefore, in developing your spending plan for retirement, we believe you should simply focus on the portion of your total assets you can spend each year.
Summary
We see the basic problem of how much a person or couple can afford to spend in retirement as a classic actuarial problem that screams out for a classic actuarial solution. We continue to be baffled that many actuaries (including the major actuarial organizations) appear to believe that individuals just aren’t up to understanding present values, and therefore they should be provided with simpler, less robust solutions, like the SORIG approach. We disagree with our profession’s assessment of people’s ability to understand present value concepts, and we will continue our crusade to offer a more robust solution for intelligent individuals willing to do a little more number crunching to obtain the right answer for their personal situations.
