In our last post, we introduced our new Actuarial Financial Planner (AFP) workbooks for Single Retirees and Retired Couples. Several of our readers had questions about the new workbooks, so we decided to address these questions with an example in this post. We will also take this opportunity to discuss a related topic--investment in bonds vs. purchasing lifetime annuities.
Most of the questions readers had about the new workbooks involved how to use the percentage inputs in column J in the Inputs section to categorize certain types of assets as either Upside assets or Floor assets, (or some percentage combination of the two) and similarly how to categorize their liabilities (future expenses) as either Essential or Discretionary. Generally, readers had an easier time categorizing their future spending liabilities, but they struggled a little bit more categorizing some of their assets, so we will focus in this post on selecting the “Upside percentage” for some of your assets.
As discussed in our post of October 6, 2021, non-risky assets that are used to fund Essential Expenses from the Floor Portfolio “bucket” generally include:
- Social Security benefits
- Pension benefits payable for life
- Fixed dollar or indexed lifetime annuity payments
- Some bonds, or
- Cash
We admit that determining how non-risky or how guaranteed certain assets like bonds, home equity, family loan repayments, values of one’s business, etc. can be tricky, and may depend on your tolerance for risk and your assumptions about the risks and potential reward inherent in those assets. The AFP asks you to input an Upside percentage for risky assets or non-lifetime streams of payments and assumes that the complementary percentage belongs in the non-risky Floor Portfolio bucket. Different people may legitimately assign different Upside percentages to similar assets, just as different people may assign different Essential percentages to different spending liabilities.
When determining the Upside percentage for a particular asset, we tend to ask the question, “How safe (or how guaranteed) is the asset or stream of payments?” For example, we don’t consider part-time employment to be guaranteed, so we would input an Upside percentage of 100% for a projected stream of part-time employment income. And while bonds as an asset class tend to be less risky than equities, they do not provide lifetime payment guarantees. Further, there are many different types of bond investments (gov’t bonds, corporate bonds, junk bonds, bond ladders, bond funds, etc.) with varying levels of risk. Therefore, we tend to assign higher levels of risk (and an Upside percentage of perhaps 25% for example) to individual corporate bonds than we do to lifetime annuity payments.
Example
So,
let’s take a look at Dave and Sue’s financial status and see how they
completed the Upside percentage inputs for selected assets in the new
AFR for Retired Couples workbook. The screen shot below shows how they
completed the Input section of the new AFP workbook
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Dave is age 65 and Sue is age 60. Sue expects to work in part-time employment for the next five years, but may not if they can afford for her to retire earlier. Therefore, they designate this asset as 100% Upside in cell J (18).
They have accumulated savings of $1,000,000 invested 50% in equities and 50% in individual (mostly high quality corporate) bonds. They believe their bond investments are reasonably safe and therefore they have inputted an Upside percentage of 50% in cell J (25) for this item, but if they had used our adjustment of individual corporate bonds discussed above, they would have inputted an Upside percentage of 62.5% for their accumulated savings ([$500,000 X 100% + $500,000 X 25%] / $1,000,000).
Their son owes them approximately $25,000 for money they loaned him to help him buy a house. They think it is quite possible that this loan may not be repaid, and they have inputted an Upside percentage of 80% for this asset in cell J (26).
Their retirement plan anticipates downsizing their housing in about 15 years and they anticipate being able to take out $400,000 of equity at that time. While the housing market in their neighborhood has been fairly stable, they still assign an Upside percentage to this item of 75% in cell (27).
Under current Social Security law, Sue’s Social Security benefit will increase upon Dave’s death. They have calculated the present value of this survivor benefit in row 28 and have inputted 0% Upside in cell J (28).
The screen shot below shows the AFP results
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Based on their inputted assets, spending liabilities, upside percentages, essential expense percentages and assumptions, the AFR shows that the present value of their total assets exceeds the present value of their total spending liabilities by $131,699, but the present value of their floor assets are $27,265 less than the present value of their essential expenses. They decide that even though their essential expenses aren’t fully funded, they are comfortable with the levels of spending risk and investment risk they are assuming. They will continue to monitor their financial status in future years and hope to increase the amount of their rainy-day reserve fund as a possible buffer against future higher expected inflation, possible future decreases in Social Security or other risks they face in retirement. They will also explore the possibility of deferring commencement of Sue’s Social Security benefit as a way to strengthen the funding of their Floor Portfolio.
Investment in bonds vs. lifetime income annuities
As noted above, since lifetime income annuities provide income for life, they are generally less risky than most types of bonds, and because of the risk sharing premium enjoyed by annuity purchasers, they generally provide more income for the dollar. As noted in our post of July 5, 2021, recent research has shown that including lifetime income annuities in your Floor Portfolio can support increased spending. If you want to read more academic research on this subject, we suggest you read Dr. Wade Pfau’s article, “Why Bond Funds Don’t Belong in Retirement Portfolios.”
And finally, let’s look at what happens if Dave and Sue from our example buy single premium life annuities with some of the money they currently are investing in bonds. Based on annuity purchase rates as of November 10, 2021 from Immediateannuities.com, Dave determined he could purchase a monthly benefit for life of $740 per month for a premium of $150,000 and Sue could purchase a monthly benefit for life of $622 per month for a premium of $150,000.
If they re-run the AFP with these fixed-dollar life annuity amounts and $300,000 less in individual bonds, their Rainy-Day Fund would increase by $39,469 to $171,168 and their Floor Portfolio would also increase by $39,469 to $1,728,170 and would then be $12,204 greater than the present value of their essential expenses.
Summary
The amount you can spend in retirement is a function of the assets you accumulate (including Social Security and income from other sources). Managing your finances in retirement requires carefully protecting, growing and spending those assets. And, while classifying your assets as risky or non-risky (or some intermediate percentage) and your expenses as Essential vs. Discretionary may be irritating initially, we believe it will help you to better determine:
- If your desired spending plan is sustainable, and
- If you are taking on too much (or too little) investment risk with your assets and your current investments
You have to decide how willing you are to risk your current standard of living in order to achieve a higher standard. We believe this AFP spreadsheet can help you better manage your finances in retirement if you use it with open, honest eyes and are willing to live with the possibility of having to reduce your discretionary expenses at some point in the future.
