This post is a follow-up to our post of May 19, 2020, where we encouraged you to play with our ABC workbooks to become more comfortable with how your results can vary by employing different assumptions about the future. We hope that trying out a few “override assumptions” will give you a better sense for how conservative or optimistic your planning assumptions about the future might be. Subsequent to that post, we made changes to our default assumptions (see our post of August 16, 2020) to make them more consistent with current assumptions used for hypothetical inflation-indexed annuity pricing. The current default budgeting assumptions are:
- Annual investment return/discount rate: 3%
- Annual rate of inflation/desired future recurring budget increases: 2%
- Lifetime planning period(s): Planning horizon from Actuaries Longevity Illustrator, 25% probability of survival for non-smoker in excellent health
These three assumptions are essential for converting lump sum assets (like invested assets) into lifetime payment streams, and conversely, for converting lifetime payment streams (like social security and pension benefits) into lump sum present values. Note that the above three assumptions are not necessarily selected to be individually reasonable, but rather are designed to produce, in combination, a reasonable estimate of the price of an inflation-indexed annuity.
As discussed in our post of April 11, 2020 and our Recommended Financial Planning Process, some of our readers may wish to use the more conservative default assumptions for determining the present value of their future Essential Expenses and more aggressive assumptions for determining the present value of their future Discretionary Expenses.
In this post, we will first discuss recent research from Morningstar concerning lifetime planning period assumptions for retirement budgeting purposes and then discuss the impact of using more conservative planning assumptions like our default assumptions.
Morningstar Lifetime Planning Period Research
Recently, Dr. David Blanchett of Morningstar published an excellent report on selecting planning assumptions for longevity entitled, “Estimating the ‘End of’ Retirement.” We recommend you read this report (you may be required to sign up for a free copy), or you can read a discussion of the report in Greg Land’s ThinkAdvisor article of August 28. In summary, Dr. Blanchett’s conclusions for selection of reasonable lifetime planning periods are very consistent with our default lifetime planning assumptions for single individuals and couples. Dr. Blanchett says,
“Through simulations it is determined that adding five years to the life expectancy estimate for a single household, and eight years to the longest life expectancy of either member of a joint household (or to each member if separate end ages are used for spouses), at the assumed retirement age, is a reasonable approach to approximating the retirement period…”
The five year and eight-year amounts noted by Dr. Blanchett are reasonable rules of thumb and are approximately the differences in years between the 50% probabilities (life expectancy) and 25% probabilities of survival from the Actuaries Longevity Illustrator (ALI) that we recommend for the default assumptions in our workbooks (which he references in his report).
Dr. Blanchett’s lifetime planning period rule of thumb for single retirees are a little more conservative than using the 25% probability of survival at older ages, and may be more conservative for married couples if one spouse is considerable older than the other or the couple believes the spending budget may be reduced somewhat on the first death within the couple.
You may be interested, however, in
considering the “objective” adjustments to expected longevity summarized
in the first column of Exhibit 6 on page 15 of Dr. Blanchett’s report
when considering override assumptions to use in our ABC workbooks.
The Society of Actuaries and American Academy of Actuaries have very recently “updated” the Actuaries Longevity Illustrator after having done so just last October (see our post of October 20, 2019). The new ALI uses Social Security’s 2017 (updated from2016) back-end mortality tables and SOA’s MP-2019 (updated from MP-2018) rates of mortality improvement. The impact of this “update” was to decrease the whole number LPPs shown in the ALI at several ages by one year. For example, the 25% probability of survival for a 65-year old non-smoker male in excellent health was decreased from 29 years (as shown in Exhibit 2 of the Morningstar report) to 28 years in the updated version. We have updated our ABC workbooks to reflect this update.
It is important to note that the back-end mortality tables developed by Social Security used in the ALI do not reflect Covid-19 experience, which may further negatively impact expected longevity in the U.S.
Implications of using conservative planning assumptions
While making more conservative assumptions about the future will generally reduce current spending budgets, it can also increase the value of guaranteed lifetime payment streams such as Social Security, annuities and pension benefits relative to other types of investments. This can influence investment decisions to the extent investment in these guaranteed lifetime streams is an option. While it is important to know approximately how much lifetime income can be generated from a pot of invested assets when planning your retirement, it is equally important to know the approximate value of guaranteed lifetime payment streams that may be available to you [Note: these are two sides of the same retirement planning coin].
Let’s take a look at the value of some of these lifetime payments streams using our current “updated” default assumptions for a 67-year-old male and female. Costs for the annuity amounts were obtained recently from Immediateannuities.com. All of these present values can be obtained in the PV Calcs tabs of our updated ABC workbook for single retirees using default assumptions and assume annual beginning of year payments, which may overstate present values somewhat.
Present Values of Various Lifetime Payment Streams under Current Default Assumptions
Lifetime Payment | Current Cost | Present Value | Present Value |
Immediate Social Security benefit of $2,000 per month | n/a | $553,839 | $609,167 |
Deferred commencement until age 70 of immediate $2,000 per month benefit | n/a | $598,334 | $666,939 |
Fixed immediate life annuity of $500 per month | $97,847 (male) | $110,479 | $118,585 |
Fixed deferred life annuity of $1,200 per month commencing at age 85 (no pre-commencement death benefit) | $42,194 (male) | $61,157 | $80,611 |
Fixed immediate pension benefit of $2,000 per month | n/a | $441,916 | $474,339 |
Note that the Social Security present values assume continuation of current law and no future reductions in benefits. The Social Security present values do not include the value of any spousal or survivors’ benefits. Based on the current default assumptions, there is approximately a 9% increase in present value associated with deferring commencement of Social Security benefits from age 67 to age 70.
In addition to showing present values of currently available fixed dollar single life annuities, the above chart also shows the approximate price to purchase those annuities today (from Immediateannuities.com). In all cases, the present values of these payments under the default assumptions exceeds the estimated cost to currently purchase these lifetime payments.
Finally, we have included a fixed dollar pension benefit to illustrate the difference between fixed dollar payments and inflation-indexed payments (from Social Security). Even though the default inflation assumption is only 2% per year, the value of the inflation-indexed Social Security immediate annuity is over 25% greater than the value of the fixed immediate life annuity payments under the default assumptions.
Knowing the value of your pension under your planning assumptions can be important if you are offered a choice between taking your pension benefit as a lifetime annuity or receiving it in a lump sum.
Summary
Note that we are not investment advisors and are not pushing you to purchase annuity products or even defer commencement of your Social Security benefits. Our recommended financial planning process does encourage you to use more conservative assumptions (like the default assumptions) to determine the present value of your Essential Expenses and to consider funding your Floor Portfolio with relatively low-risk investments like those shown in the chart above.
As discussed by Dr. Blanchett in his Morningstar report, it is simply prudent to plan on living longer than your life expectancy. Using our default lifetime planning period assumptions is one robust way to do this, but you may wish to also consider certain “objective” adjustments to these default lifetime planning periods.
