In this post, we will once again set forth and discuss the two basic equations that form the foundation of the AFP. Application of household demographic and financial data and reasonable assumptions to these two equations turns the AFP into a relatively simple but very robust planning tool for financial planners with retired or near-retired clients and for retired or near-retired DIYers.
Equation #1—The Basic Actuarial Balance Equation
The basic actuarial equation used in the AFP is
Accum. Savings | + | PV Income from Other Sources | = | PV Essential Expenses | + | PV Discretionary Expenses | + | Rainy-Day Fund |
where “PV” means present value, and PV Income from Other Sources includes streams of current and future income from Social Security, pensions, annuities, future proceeds from sales of assets not already reflected in accumulated savings, etc. Essential and Discretionary expenses generally include both recurring and non-recurring type expenses. This equation tells us that what we can afford to spend in retirement depends on the assets we possess (including non-financial assets like Social Security, pensions and annuities).
Input of
- household demographic and financial data,
- expected (or desired levels of) household expenses
- assumptions for future increases in expected expenses,
- assumptions for future increases in streams of future income,
- percentage of an inputted asset assumed to be a risky investment (vs. non-risky) and percentage of an inputted expense liability assumed to be essential (vs. discretionary),
- relevant expected asset rates of return/discount rates on risky and non-risky investments and expected lifetime planning periods, and
- percentage decrease of spending after first death within the couple (for couples only)
into this equation produces the AFP Actuarial Balance Sheet which compares the present value of household assets to the present value of household spending liabilities (separately comparing the PV of non-risky investments with the PV of essential expenses and the PV of risky assets with the PV of discretionary expenses) and generates a current year spending budget designed to increase in future years based on inputted increases if all assumptions about the future are realized. Default assumptions about the future are provided in the AFP but can be overridden if desired.
Since all assumptions about the future will invariably not be realized, the AFP anticipates that determination of the current year spending budget will be revisited periodically (at least annually) so that the household spending budget can be adjusted to reflect actual experience as it emerges. Thus, like any good retirement planning tool, the AFP will tell you when you need to consider changes to your spending to keep you on track to meet your spending goals in retirement.
Equation #2—Steiner Investment Allocation Equation for Retired (or Near-Retired) Households
This second equation helps you determine how household assets should be allocated between risky and non-risky investment.
This equation uses results summarized in the AFP Actuarial Balance Sheet to help you develop a Liability-Driven Investment (LDI) strategy that matches the PV of your non-risky assets (sometimes referred to as your Floor Portfolio) with the PV of your Essential Expense liability. The percentage allocation to non-risky investments developed in the above equation applies to your financial portfolio (or as referred to in the AFP, your accumulated savings.) Remaining accumulated savings may be invested in riskier assets (sometimes referred to as the Upside Portfolio). We discussed this equation in several posts, including most recently, our post of August 13, 2022. Using this equation is a more sensible (and simpler) LDI alternative to using one of many investment rules of thumb such as “100 – your age” or “60/40” allocations, because it considers the present value of the non-financial Floor Portfolio assets you own, which are presumed to be non-risky in nature.
Note that this equation is not recommended for pre-retirement investing. Also note that we are actuaries and not investment advisors. The AFP is based on basic actuarial and financial economic principles.
Readers interested in more complicated investment strategies may find this New Retirement article, entitled “28 Retirement Investing Tips from Today’s Financial Geniuses” to be of interest. It should be noted that many of these tips are not necessarily inconsistent with the AFP LDI approach described above and some of these tips clearly apply to pre-retirement periods.
Managing Risks with the AFP
One of the argued advantages of using a Monte Carlo model to determine how much can be spent each year is that, depending on a user’s risk tolerance, the user can select a spending level with a high probability of success (albeit based perhaps on overly optimistic assumptions about the future). As discussed in many of our prior posts, we are not overly impressed with using Monte Carlo modeling for planning in retirement (or the need for risk tolerance questionnaires for that matter). However, there are plenty of transparent levers that AFP users can pull to manage how conservative or how aggressive they may want their plan to be. Here are just a few:
- Use more conservative assumptions to fund essential expenses (see our post of June 30, 2022)
- Categorize more (or less) expenses as “essential.”
- Develop a larger (or smaller) Rainy-Day Fund
- Spend less (or more) in early years of retirement
- Undervalue (or overvalue) some household assets
- Overvalue (or undervalue) some household spending liabilities, and
- Periodic stress-testing of assumptions
Thus, more conservative retirees can choose to pull one or more of these levers rather than selecting a plan purported to have 97% probability of success (this year).
Summary
The AFP uses two relatively straightforward equations involving actuarial and financial economic principles and processes to help you balance your needs in retirement to grow your assets, protect your assets and prudently spend your assets. You can easily tweak these equations to increase or decrease the relative level of conservatism of your plan. It is important to note that the AFP does not address every conceivable financial planning problem that may be addressed by a certified financial planner, such as withdrawal strategies, tax minimization strategies, etc.
While generation of an actuarial balance sheet, annual spending budget and liability-driven investment strategy is a relatively simple matter using these equations, the plan produced by the AFP (with annual adjustments and periodic stress testing) is quite robust and, in our opinion, significantly better than similar plans produced by many financial advisors using Monte Carlo models and risk-tolerance questionnaires.
