As discussed most recently in our post of July 27, 2022, annuity purchase rates for single premium immediate life annuities have become more favorable over the past five months. As a result, you may be considering purchase of a single premium life annuity in the near future to strengthen the Floor Portfolio you use to fund your Essential Expenses. In this post, we will once again discuss how changes in your
- Present value of Essential Expenses,
- Present value of Non-Financial Floor Portfolio assets, or
- Accumulated savings
can affect the optimal investment mix in your financial asset portfolio (accumulated savings) under the Safety-First investment strategy.
To illustrate, we will use our example couple, named Karen and Roger, and the allocation formula discussed in our posts of February 9, 2022 and June 6, 2022. To remind you, our hypothetical couple’s actuarial balance sheet developed under the Actuarial Financial Planner (AFP) at the beginning of the year showed the following amounts:
- PV Essential Expenses of $1,900,000,
- PV-Non-Financial Floor Portfolio Assets (Social Security, pensions, etc.) of $1,500,000 and
- Accumulated Savings of $1,000,000.
And we indicated that the couple should use the formula shown below to determine the investment allocation of their financial assets (accumulated savings) following the Safety-First investment strategy. Since we have not seen this formula discussed elsewhere in personal financial literature, we are going to humbly call this formula the “Steiner Investment AllocationFormula.”
In our post of February 9, 2022, we applied the above formula and the actuarial balance sheet data above to develop a 40% non-risky/60% risky allocation for our hypothetical couple.
In our post of June 6, 2022, we applied the above formula to assumed reduced accumulated savings of $880,000 to develop a revised 45.5% non-risky/54.5 risky allocation. This allocation kept non-risky assets used to fund future Essential Expenses unchanged, and there was no “rebalancing.”
In this post, we are going to increase the couple’s PV Non-Financial Floor Portfolio Assets by having them take $200,000 of their accumulated savings and use that amount to buy a hypothetical immediate single premium life annuity. The couple’s PV Essential Expenses is assumed to remain unchanged at $1,900,000 and we are going to assume the couple’s accumulated savings is $800,000 (The beginning of year amount of $1,000,000 in the February 9 post minus the $200,000 annuity premium).
Karen is age 65. According to ImmediateAnnuity.com as of 8/13/2022, $200,000 of premium can purchase an immediate life annuity for her of $1,182 per month or $14,184 per annum. If we input this amount as an immediate annuity in the AFP for Karen, we get a present value using default assumptions of $245,226, or 22.6% ($45,226) greater than the $200,000 purchase price. As discussed in previous posts, this difference results primarily from the longer lifetime planning periods used in the AFP default assumptions.
Applying the above Steiner Investment Allocation Formula to this revised set of facts, we get a revised allocation of 19.35% non-risky and 80.65% risky. Thus, of the $800,000 accumulated savings, $154,774 would be allocated to Karen and Roger’s non-risky investments and the remainder of $645,226 would be allocated to risky investments. Readers will note that in addition to increasing Karen and Roger’s spending budget, purchase of an annuity for Karen today would also increase the amount they can invest in risky assets.
Reclassifying Essential Expenses
Note that the percentage allocation between risky and non-risky investments is simply a guideline for investment. Also note that we are actuaries and not financial or investment advisors. As can be seen from the Steiner Investment Allocation formula above, a critical element of the decision of how much to invest in risky vs. non-risky investments depends on self-classification of expenses that are essential to you vs. discretionary. If you want to be more aggressive in your investing, you can reduce your estimates of your essential spending. If you do so, you are taking on more risk and increasing the expenses you may need to reduce in the future if your risky assets earn less than you expect. You can view the essential expense selection process and the resulting present values as another way of determining your tolerance for risk and your investment preferences.
Summary
Changes in your present value of essential expenses, your present value of non-financial floor plan assets or your accumulated savings can affect how you allocate your accumulated savings between risky and non-risky investments. We encourage you to apply the Steiner Investment Allocation Formula to make sure your total investment risk in retirement aligns with your spending goals.
