Congratulations. You made it through 2020!
In our ongoing effort to turn you all into actuaries, this post will recommend that you perform an “actuarial valuation” based on your personal data as of January 1, 2021. As part of this process, we will also encourage you to prepare an “actuarial report” to document your thought-process and any planning decisions you make for this year.
The purposes of this annual valuation exercise are to:
- Review how well you did in 2020
- Develop 2021 spending budget “data points” for your 2021 calendar year spending budget (or spending/savings budget for pre-retirees)
- Review your current asset allocation
- Perform “what if” scenario testing, if you haven’t done so recently
- Document the assumptions, data and adjustments used to determine your 2021 spending budget, and
- Collect and save information that may be useful for your future actuarial valuations
The first step in the actuarial valuation process is to gather all your relevant personal financial data as of January 1, 2021 and the actuarial report you prepared for last year.
We encourage you to involve your spouse, if you have one, in this process.
Measuring How You Did in 2020
We hope that you saved your data as of January 1, 2020 and documentation of your 2020 spending budget calculations. With this data you should be able to determine how you did in 2020, by approximating the items in the following equation:
BOY 2021 Accumulated Savings | = | BOY 2020 Accumulated Savings | + | 2020 Investment Income | + | 2020 Income from Other Sources | – | 2020 Amount Spent |
Solving for these amounts and comparing them with amounts expected, based on your 2020 calculations, will enable you to determine your total actuarial gain/(loss), by subtracting Expected 2021 BOY Accumulated Savings from Actual BOY 2021 Accumulated Savings. If your actual 2021 BOY Accumulated Savings is greater than your Expected BOY 2021 Accumulated Savings, you experienced an “actuarial gain” for 2020.
Similarly, you can determine your gain/(loss) by source by comparing actual amounts experienced in 2020 with expected values (based on the 2020 actuarial valuation) for the following items:
- investment income
- income from other sources
- spending
Despite losing over 30% between February 12 and March 16, the S&P index finished 2020 about 16.3% above the beginning of year index. As a result of Covid-19 restrictions, many retirees spent less during 2020 than they budgeted. For those significantly invested in equities, these investment and spending gains will generally translate into a higher Actuarial Budget Benchmark (ABB) for recurring expenses for 2021 than your 2020 ABB increased by inflation (or desired increase used in your calculation last year, if different from inflation), all things being equal. We will discuss below steps you might want to consider to “smooth” the effect of these gains on your 2021 spending budget.
For pre-retirees, an investment gain will generally translate into a higher projected first year of retirement recurring spending budget than last year.
Developing 2021 Recurring Spending Budget “Data Points”
As discussed in our post of April 20, 2017, the process of deciding on your recurring 2021 spending budget involves considering a number of “data points.” These data points may include, but are certainly not limited to, the following:
- Your 2020 recurring Spending Budget increased with inflation or some other percentage increase
- Your 2021 recurring Spending Budget recommended by your financial advisor or someone else
- Your 2021 Actuarial Budget Benchmark (ABB) for recurring expenses
- Your desire to avoid significant fluctuations in spending
- Your desire to be conservative or aggressive
- Your scenario testing (discussed in our post of November 26, 2017)
- Non-recurring spending anticipated for 2021, etc.
For the first item above, we recommend using the same increase announced for Social Security cost of living increases (in the U.S.) for 2021 of 1.3%. If you develop your recurring spending budget based on desired future increases of inflation minus 1%, however, your preliminary 2021 recurring Spending Budget “data point” would be your 2020 recurring spending budget increased by 0.3% (1.3% ‒ 1.0%).
Before using the relevant Actuarial Budget Calculator (ABC) this year, you may wish to read our post of December 9, 2019 for some ABC calculation tips.
As discussed in many of our previous posts, we encourage you to develop your Actuarial Budget Benchmark (ABB) as another data point in your budget setting process. The ABB is a recurring spending budget developed using basic financial economic principles by comparing the market value of your assets with the approximate market value of your spending liabilities (i.e., the theoretical cost of purchasing currently available inflation-indexed insurance annuity contracts to cover your future spending). This calculation is accomplished in our ABC spreadsheets by using the default assumptions. The purpose of the ABB is to gauge how conservative or aggressive your current spending strategy is. Armed with this benchmark, you can choose the level of recurring spending with which you are comfortable and, just as important, you can monitor how aggressive your recurring spending is each year by annually comparing it with your annually revised ABB. Default assumptions used to develop your 2020 ABB are summarized in the overview tab of our ABC workbooks and have been changed from last year as discussed in our post of August 16, 2020.
As noted in our post of June 23, 2020, it may be reasonable to assume less conservative assumptions and/or lower future expense increases to develop the Actuarial Reserves necessary to fund future Discretionary Expenses (and therefore, higher corresponding spending budgets attributable to discretionary spending).
As discussed above, if you invested significantly in equities in 2020 and underspent your 2020 spending budget, it is likely that you experienced some gains last year. In order to avoid undesirable fluctuations in recurring spending, you may wish to consider some or all of the following actions:
- Adding to your Rainy-Day Fund
- Increasing 2020 non-essential non-recurring expenses (for example by doubling up your 2021 vacation expenses as discussed in our post of August 24, 2020), or
- Using the Smoothed Actuarial Budget Benchmark (illustrated in our post of November 6, 2018).
Based on the data points discussed above (and possibly others), you can finalize your 2021 total spending budget. Your total spending budget for 2021 is equal to the sum of the amount you plan to spend during 2021 on non-recurring expenses plus your 2021 recurring spending budget. And while we use the terms “final” and “finalize,” you can always revise your final 2021 spending budget during the year by performing a mid-year actuarial valuation if economic conditions or your personal situation change significantly during the year. This might make sense, for example, if you experience negative investment returns during 2021 or you experience significant unplanned non-recurring expenses during the year.
Reviewing Your Current Asset Allocation
As discussed in many of our posts, we encourage retirees to consider how much of their assets they may want to allocate to relatively low-risk investments in the “floor portfolio” anticipated to fund their essential expenses. We encourage retirees and near retirees to use the new “Asset Reserves by Expense Type” tab in our ABC workbooks for this purpose.
“What if” Scenario Testing
As discussed in our post of November 26, 2017, we believe it is important to periodically model potential deviations from assumed future experience. For example, we believe it is important for married couples to model what would happen if one of partners were to die during 2021.
Documenting Your 2021 Actuarial Valuation
Actuaries generally document their work in what is called an “actuarial report.” We encourage you to document your work in sufficient detail that you can figure out next year what you did to develop your 2021 spending budget. This process can be as simple as printing out the “Input and Results” tab and other relevant tabs of the ABC workbook you used and writing notes on the printed tabs. Or you may save the workbook with your notes in a file on your computer.
Maintaining an Historical Record
In addition to documenting your work in developing your 2021 spending budget, we encourage you to maintain an historical record of your spending budget calculations. This historical information will provide you with additional “data points” that you can use to refine future spending budget determinations. We provide a sample spreadsheet Historical Values of Actuarial Measurements for this purpose that resides in our “Spreadsheets” section. We encourage you to complete the items in the spreadsheet through the beginning of the 2021 year.
We aren’t trying to make you do a bunch of unnecessary busywork, so feel free ignore items in this spreadsheet you don’t feel like maintaining. Also feel free to customize this spreadsheet to make it better fit your personal situation. We started the spreadsheet with 2017 information, but if you have information for earlier years, feel free to add that earlier information to your personal spreadsheet.
As discussed in our post of November 27, 2018, you may wish to calculate how much of your total retirement assets are invested in equities or other risky assets to measure how much investment risk you are assuming in your investment strategy. We have included this ratio in this year’s version of the historical spreadsheet.
Conclusion
We recommend that you take some time in the near future to think about your personal financial situation and do a little planning. If you invested in equities during 2020 and you underspent your 2020 spending budget, you may have experienced an actuarial gain during 2020. What actions should you take in 2021 in response?
We recommend that you document your budget calculation thought process in an actuarial report that you can revisit at this time next year. We also recommend that you maintain this information so that you can use it to make better spending decisions and better assumptions in future actuarial valuations.
As noted in our post of December 20, 2018, we encourage you to involve your spouse (if you have one) in your year-end review and planning process. It just makes good sense for both of you to be on the same page when it comes to your household spending.
If you haven’t done so already, now may also be a good time to make sure your estate planning is up to date.
Let’s hope that 2021 is a happier new year, and that you find some truly fun things on which to spend (while at the same time staying healthy).
Best wishes, Ken and Bobbie
