One of the three basic principles of the Actuarial Approach to personal financial planning is periodically stress-testing of significant assumptions made in your plan to assess the risks that these assumptions may not be realized in the future and to determine if you want, or need, to take actions that may mitigate these risks. In this post, which is a follow-up to our post of March 16, 2021, we once again look at the importance of future inflation and resulting future expected increases in expenses in retirement.
In our post of March 16, 2021, we looked at the possible impact on spending budgets for a hypothetical couple assuming future investment returns and inflation increased by the same percentage, leaving real rates of return (the difference between nominal interest rates and inflation rates) unchanged. Historically, investment returns on non-risky assets like government Treasuries have generally exceeded rates of inflation, but currently this is not the case. In this post we will look at the impact on a different hypothetical couple’s plan assuming future inflation is greater than the low-risk investment return assumption, resulting in a negative real rate of return assumption for Floor Portfolio funding.
Inflation Stress Testing Example
Martin and Janet have retired but have not made decisions about when they will commence their Social Security benefits. They believe they have sufficient home equity to fund their long-term care costs and therefore they have excluded their home equity from their assets and long-term care costs from their spending liabilities.
Using the Actuarial Financial Planner, Martin and Janet enter their data as shown in the screenshot below
 |
| (click to enlarge) |
Assuming
- immediate commencement at age 65 of Martin’s Social Security benefit,
- commencement at age 66 of Janet’s estimated Social Security benefit at that age and
- using the default assumptions (3% annual investment return for Floor Portfolio assets, 6% annual investment return for Upside Portfolio assets and 2% inflation),
they balanced both
- their Floor Portfolio assets and Essential Spending liabilities and
- their total assets and total spending liabilities if they invested no more than 35% of their accumulated savings in equities.
Their current year spending budget under the default assumptions (base case) and input expenses was $94,000.
Total Recurring Essential | $51,000 |
Total Recurring Discretionary | 15,000 |
Total Non-Recurring | 28,000 |
Total Current Year Spending Budget | $94,000 |
Martin and Janet can live with that budget but they are worried about how future inflation and associated price increases may affect their spending. So, instead of assuming inflation of 2% per annum, they would like to see the results of assuming inflation of 4% per annum, but with no increase in the assumed investment returns on Floor Portfolio assets of 3% per annum or on Upside Portfolio assets of 6%. Therefore, under this scenario, Floor Portfolio assets would be assumed to earn a -1% (3% - 4%) real rate of return and Upside Portfolio assets would be assumed to earn a 2% real rate of return (6% - 4%) over their remaining lifetimes.
They decided to rerun the Actuarial Financial Planner by increasing their assumed future increases in planned expenses (both recurring and non-recurring) by 2% per annum, but not more than 4% per annum. They do this by clicking on the Default box for Expected Rate of Inflation in cell D46 in the Inputs & Results tab of the spreadsheet, selecting Override and entering 4% in cell F46 (and making similar changes to assumed increases in future expenses).
Making these changes in assumptions throws off the balance they had achieved in the base case between Floor Portfolio assets and Essential liabilities and between total assets and total spending liabilities. In order to achieve balance of these items under the revised assumptions without changing the timing of their Social Security benefit commencements, they played with changes to the input items that might achieve balance. They came up with the following package of changes to achieve their desired balance:
- Reduce annual recurring discretionary spending from $15,000 to $3,000
- Reduce planned vacation spending from $10,000 to $5,000
- Reduce maximum investment of accumulated savings in risky investments from 35% to 12%
These changes would reduce their current year spending budget by $17,000.
Instead of making these changes, Martin and Janet wondered whether they could achieve balance less painfully under these assumptions for the future by deferring commencement of their Social Security benefits until each of them reached age 70.
After estimating their expected Social Security benefits assuming 4% annual cost of living increases and actuarial adjustments for deferral, they discovered that they would still need to reduce their annual recurring spending by $5,000 and slightly reduce their maximum percentage investment in equities. The table below summarizes their current year spending budget under the different scenarios.
Martin and Janet’s Current Year Spending Budget
Under Alternative Inflation Assumptions
Current Year Spending Budget | Default Assumptions and 2% Inflation (Base Case) | Default Assumptions/ 4% inflation and no change in Soc. Sec. claiming | Default Assumptions/4% inflation and Soc. Sec. Deferral until age 70 |
Recurring Essential | $ 51,000 | $ 51,000 | $ 51,000 |
Recurring Discretionary | 15,000 | 3,000 | 10,000 |
Non-Recurring | 28,000 | 23,000 | 28,000 |
Total | $ 94,000 | $ 77,000 | $ 89,000 |
This example shows that the assumed relationship between future investment returns and assumed inflation is both an important factor in retirement planning and that inflation is a significant risk. It also shows that since Social Security is indexed to inflation, deferring commencement can significantly mitigate inflation risk (even more so than under the default assumptions). In the next section, we will provide our thoughts on reasonable assumptions for planning purposes.
What Can We Reasonably Expect for Future Investment Returns and Inflation?
The short answer to the question posed in this section is we don’t know. Current returns on low-risk government Treasuries are significantly less than current rates of inflation. Will this trend continue in the future? In the 2021 OASDI Trustees report (Table V.B.2), the Social Security actuaries and Trustees assume in their intermediate assumptions that rates of returns on the special Treasuries in which Social Security assets are invested will be less than assumed rates of inflation for the next 5 years, but then real rates of return are assumed to ultimately increase to 2.3% in years 2035 and later. By comparison, our default assumptions assume a constant real rate of return on non-risky investments over the household lifetime planning period of 1% per annum.
To add to this uncertainty, the Federal Reserve appears to be getting ready to raise interest rates. Moves by the Fed to raise interest rates may have adverse effects on stock prices. And, of course as we have written in past posts, future reductions in Social Security benefits are certainly possible.
While we believe that a 1% real rate of investment return on non-risky investments is reasonably conservative when combined with 25% probabilities of survival, you should feel free to select more conservative assumptions (or future reductions in Social Security benefits) if you are so inclined. Remember that the actuarial process will automatically adjust your spending budget for actual experience as it emerges, so if future experience is less favorable than assumed, you may need to reduce future spending and if it is more favorable than assumed, you may be able to increase your spending in the future.
Summary
In our last post, we encouraged you to plan to spend if you believe your plan is reasonably conservative. We encourage you to stress test your plan with relatively higher levels of assumed future inflation relative to the assumed investment return on non-risky investments to determine whether your spending plan is truly conservative. The example discussed above discusses how can use the Actuarial Financial Planner for this purpose.
