One of the most important considerations in your retirement plan is how to invest your assets. As part of our Recommended Retirement Planning Process, we suggest that you consider implementing a Liability Driven Investment (LDI) strategy where:
- investments in low-risk assets (the Floor Portfolio) are anticipated to be sufficient to fund spending on future essential expenses and
- investments in risky assets (the Upside Portfolio) are used to fund spending on future discretionary expenses.
Note that when we refer to investment of your assets, we mean all your retirement assets (including Social Security, pensions and annuity benefits), not just your accumulated savings.
We understand that some of your assets, like Social Security and pensions, may not be as liquid as your accumulated savings or other of your more “investible” assets, but they
- do have value
- generally provide relatively low-risk payments for life
- can be expected to provide income to meet some of your future spending liabilities, and therefore
- should logically be considered when deciding how much risk to assume in your more investible assets.
For example, in our post of November 27, 2018, we discussed research that suggested that purchasing life annuities with a portion of one’s accumulated savings could enable you to increase the level of risk with respect to the remaining assets.
In this post we will show how our Recommended Retirement Planning Process and our ABC workbooks can be used to help you make better investment decisions and increase your comfort level with the amount of risk you are assuming. Impetus for this post is a Forbes article written by fellow Fellow of the Society of Actuaries, Steve Vernon, entitled, “When Investing During Retirement, Don’t Make This Mistake.” We will build on the example introduced by Mr. Vernon in his article.
Steve Vernon’s article
As implied by the title of his article, Mr. Vernon believes it is a mistake for retirees (or their financial advisors) to select the investment mix of their investible assets without considering other sources of income that may be available. We agree. He illustrates his point with an example couple, Jack and Mary. As actuaries, we love it when articles contain numerical examples as it gives us a chance to compare the author’s results with results from our workbooks. Jack and Mary’s data is as follows:
- They are both retired and age 65
- They have $400,000 in accumulated savings
- They estimate their total annual retirement income is $49,670 (76% from Social Security and the remainder from their accumulated savings)
- They have no other sources of income
Since we know that Mr. Vernon is a big fan of using the IRS RMD approach to deploy savings to “generate retirement income” and the theoretical RMD withdrawal factor at age 65 (assuming RMDs actually applied at age 65) is 2.96%, we will assume that Jack and Mary will withdraw $11,921 to go along with their combined Social Security benefits for the year totaling $37,830. For our calculations below, we will assume that they both are eligible to receive the same annual Social Security benefit of $18,915.
Results for Jack and Mary under the Actuarial Budget Calculator (ABC)
The screen shot below shows the Input/Results tab for the Actuarial Budget Calculator (Retired Couple) for Jack and Mary based on their data and ABC default assumptions. Instead of developing a spending budget for the current year of $49,670, the total maximum sustainable spending budget produced by our ABC is slightly higher at $50,028 (0.7% higher). For all intents and purposes, however, the results are about the same as produced by Mr. Vernon.
(click to enlarge)
While it is likely that Jack and Mary may have several non-recurring expenses that don’t belong in their annual recurring expenses budget, we have assumed no such expenses to make the calculations comparable. And while Mr. Vernon considers establishing reserves for such expenses as “refinements” to his approach, distinguishing between recurring and non-recurring expenses is simply part of the Actuarial Approach for producing a more robust spending budget.
After completing the calculations for the Input and Results tab, Jack and Mary proceed to the Asset Reserves by Expense Type Tab.
After examining their expected expenses, they enter the amounts shown below for their expected recurring expenses. They also enter the expected annual increase percentage for these expenses.
(click to enlarge)
This tab shows Jack and Mary that the estimated floor portfolio to fund their estimated future recurring essential expenses is about $1,141,137 (83% of their total assets) and the upside portfolio to fund their estimated future recurring discretionary expenses (including a rainy-day fund of $41,530) is about $233,038 (17% of their total assets). They understand that they may be able to afford to spend a little more aggressively from their upside portfolio. Based on these calculations, however, they believe they can safely invest about 58% ($233,038/$400,000) of their accumulated savings in equities or other more-risky investments.
Jack and Mary understand that the results of this tab are simply data points that they can use to help them make better investment decisions. For example, they may decide that the potential rewards of investing in equities may justify assuming even more investment risk. But, they also understand that such a decision could potentially jeopardize their future essential expense budgets.
Note that under the Floor and Upside Portfolio investment strategy, Jack and Mary’s optimal investment strategy depends on the percentage of their future spending they consider to be essential vs. the percentage they consider to be discretionary. If most of their future expected expenses are considered by them to be “essential”, then they may not feel as comfortable devoting as much of their assets to equities as they would like.
Building a Floor Portfolio
Many of our posts over the last two years have suggested building a Floor Portfolio as the foundation for a sound investment strategy. For example, our post of July 9, 2019 entitled “Ok Retirees, Now May be a Good Time to Shore Up Your Floor Portfolio” suggested that shoring up your Floor Portfolio might make sense in light of the inevitable upcoming bear market in stocks. And yes, like Mr. Vernon, we also suggested deferring Social Security as one way that you could do this.
Summary
We agree with Mr. Vernon that a good investment strategy in retirement should consider “investments” in low-risk assets such as Social Security and annuities. We also agree with Mr. Vernon that “retirees and their advisors will need to devise smart strategies that will make them feel comfortable with the amount of investment risk they assume in retirement.” For those retirees and their advisors who are looking for smart strategies to do this, we suggest that they check out our Actuarial Approach and Recommended Financial Planning Process.
