Actuarial science offers proven approaches and processes for assessing and mitigating financial risks. The Actuarial Financial Planner (AFP) advocated in this website utilizes basic actuarial and financial economics principles to help retirees:
- Quantify household spending liabilities
- Develop a sustainable spending budget process
- Develop a liability-driven investment (LDI) process for allocating household assets between risky and non-risky investments, and
- Establish a strong foundation for retirement planning.
And while we can’t guarantee that you will never have to reduce your future spending budget in retirement if you use the AFP annually and fully fund your Floor Portfolio with non-risky assets, we believe that you will be able to sleep better at night knowing your essential spending in retirement is relatively safe.
After some background discussion, we will discuss four ways the AFP can help you mitigate financial risks in retirement.
Background
Actuaries help financial systems balance their assets and liabilities by making best-estimate (or conservative) assumptions about the future. For personal financial systems (households), the assumptions used to balance household assets with household spending liabilities include expectations with respect to:
- lifetime planning periods,
- timing of future planned expenses,
- increases in future planned expenses,
- timing and amounts of future lump sum or streams of income payments, and
- returns on invested assets.
If assumptions or expectations are wrong (financial risks), we must be prepared to make adjustments in our spending or somehow increase our assets. And, unfortunately, a lot can potentially go wrong with personal financial assumptions. For example,
- We may live longer than our expected lifetime planning period
- Our long-term care or other medical expenses may be more costly than we assumed
- Our future taxes may be more than assumed,
- Our spouse may die or we may divorce,
- Our premiums for various types of insurance may increase faster than expected
- Our future Social Security benefits may be reduced (or not fully indexed with inflation)
- Higher than assumed Inflation may make some or all our planned expenses higher than assumed,
- Our investments may experience periods of low or negative returns
- We may suffer uninsured losses or be victim of fraud,
- We, or other members of our family, may experience emergencies requiring unexpected expenses
The events described above will generally either increase planned spending liabilities relative to assets or decrease assets relative to spending liabilities. In either case, we will have to reduce our planned spending, increase our assets (e.g., by part-time employment?) or we will have to temporarily dip into our rainy-day funds to keep spending liabilities in balance with our assets.
In the current economic environment, we are looking at the distinct possibilities of higher-than-expected levels of inflation, rising interest rates, negative returns on investments and reductions in future Social Security benefits. These possibilities are definitely enough to give a retiree a bad case of agita and cause him or her lose some sleep.
So, what is a retiree to do today to mitigate financial risks and sleep better at night?
#1 Periodically Adjust Spending Budget to Reflect Actual Experience
Instead of using a static spending approach (like the 4% Rule) which will subject you to greater sequence of returns risk, we suggest performing a periodic “actuarial valuation” (at least once per year) to reflect actual experience and adjust your spending budget accordingly. By using a dynamic approach like the AFP, spending may vary from year to year, but it can be smoothed to some degree and your sequence of returns risk will be mitigated. Further, as discussed below, if discretionary spending is adjusted first, it may not be necessary to adjust essential expense spending.
#2 Use a Floor Portfolio to Fund Essential Expenses
The second way to mitigate financial risks in retirement is to find the proper balance between investment in non-risky and risky assets. Here at How Much Can I Afford to Spend in Retirement, we encourage retired households to consider establishing two separate investment buckets to fund their total spending in retirement:
- A Floor Portfolio comprised of relatively safe (non-risky) investments and assets used primarily to fund Essential Expenses, and
- An Upside Portfolio comprised of more risky investments used primarily to fund Discretionary Expenses.
This liability-driven investment (LDI) strategy attempts to match relatively safe household assets with more critical household spending liabilities for the purpose of protecting the assets that fund essential expenses, while using an Upside Portfolio to grow assets that may be used to fund more discretionary expenses. This LDI risk mitigation strategy has been variously described in personal finance literature as:
- a Safety-First approach,
- immunization of essential expenses, or
- funding needs vs. funding wants.
In our opinion, if you are not using a similar LDI strategy, you may be assuming too much (or too little) risk in your personal retirement plan. And, while you may need to reduce expenses in the future if the assumptions used in the AFP turn out to be too optimistic, it is likely that such reductions will involve discretionary expenses and not essential expenses.
While it is important to fully fund one’s Floor Portfolio with non-risky assets, it is also important to have adequate funding of one’s Upside Portfolio. Investments in both non-risky and risky assets enable households to balance their needs to protect and grow their assets, and discretionary spending from the Upside Portfolio can be more flexible than essential expense spending.
#3 Use Conservative Assumptions
The third way to mitigate personal financial risks is to use conservative assumptions. If your expectations about assumptions used in the AFP change, you can input different “override” assumptions. For example, see our post of March 20, 2022 for override inflation assumptions that may be used in lieu of the current default inflation assumption of 2% per annum. This action will change the amounts shown in the Actuarial Balance Sheet by increasing the present values of essential and discretionary expenses. This, in turn, may cause you to consider changes to your financial plan to rebalance your assets and your liabilities under the override assumption. So, decreases in your spending budget can occur “by evolution” over time as experience emerges, or they can occur “by revolution” by changing assumptions.
#4 Spend Less
The fourth way to mitigate personal financial risks is to spend less than your current year spending budget and increase the size of your Rainy-Day Fund. You are not required to actually spend all of your current year spending budget every year. Your Rainy-Day Fund can be used in future years to smooth spending volatility resulting from unfavorable experience.
Conclusion
Successfully achieving your financial goals in retirement is a risky business. Financial risks occur when actual future experience differs from expectations (assumptions). And while it is impossible to completely eliminate all risks in retirement, some risks can be mitigated through purchase of insurance or by other means. Households must find the proper balance between protecting their assets, growing their assets and carefully spending their assets. We believe that using the AFP and the actuarial processes recommended in this website can help retirees mitigate their risks, worry less about their financial future and sleep better at night.
