The Actuarial Approach advocated in this website is a dynamic spending approach that anticipates periodic determinations (or valuations) of the retired household funded status and, if necessary, adjustments in the household spending plan to maintain a desired funded status level. Contrast our recommended approach with static approaches (like the 4% Rule or static Monte Carlo models) that anticipate a one-and-done determination of future household spending with presumably a relatively high probability of success.
In our last post, we provided an example of the actuarial approach for a couple (Bill and Betty), whose Actuarial Financial Planner (AFP) funded status decreased from 112% as of January 1, 2022 to 99% as of January 1, 2023. In that post, we left it up to Bill and Betty (and their personal tolerance for risk) to determine actions they might want to consider in light of this decrease. In this post, we propose an alternative automatic approach for Bill and Betty (and other households) to use to adjust their spending budget if their AFP funded status either becomes too low or too high now or in the future.
Proposed automatic adjustment approachStep 1: Adjust last year’s spending plan by
- excluding expenses no longer expected to be incurred,
- including new expected expenses, and
- increasing adjusted plan expenses for inflation.
Step 2: Run AFP this year with adjusted spending plan expenses from Step 1, revised assets (like Social Security with cola increase and updated portfolio balances), updated personal data and best-estimate assumptions.
Step 3: If AFP funded status developed in Step 2 is less than 95%, decrease discretionary spending budget for this year to achieve a 95% AFP funded status
Step 4: If AFP funded status is more than 120%, consider increasing discretionary spending budget for this year to achieve a 120% funded status.
Under this suggested automatic approach, Bill and Betty from our previous post would not have to reduce their budgeted discretionary expenses in response to the decrease in their AFP funded status during 2022. However, if they experience further losses (from overspending, poor investment returns, higher-than-expected inflation, etc.) in 2023 and their funded status as of January 1, 2024 drops below 95%, they will.
We suggest a 95% to 120% corridor for this automatic approach based on the assumption that most retired households will want to target an average ongoing funded status in excess of 100%. Note also, that the automatic approach does not actually require taking steps to decrease funded status if it exceeds 120%. It merely suggests that you may wish to consider increasing your discretionary expense spending to avoid underspending.
Depending on your tolerance for risk, you may choose different corridor limits than the ones suggested above. The purpose of using an automatic adjustment approach, however, is to introduce a level of discipline in the process while, at the same time, to introduce an element of smoothing of the spending budget from year to year.
Conclusion
Actuaries use models and dynamic processes to manage risks for financial systems. We believe the dynamic Actuarial Approach utilizing the AFP model advocated in this website is superior to static head-in-the-sand approaches like the 4% Rule and static Monte Carlo models for many reasons. It is a self-correcting approach that focuses on the retired household’s balance sheet and the funded status of that balance sheet from year to year. As shown in this post, simple corridors can be implemented around the desired household funded status to introduce a level of discipline in the process while at the same time providing for an element of smoothing of spending from year to year.
