The Actuarial Financial Planner (AFP) is a useful tool to facilitate household decision-making in or near retirement. In this post we will discuss how the AFP (and possibly the Actuarial Budget Calculator for Single Retirees) can be used to determine if you are financially ready to retire. We include an example below to illustrate the process.
The following five items set forth our recommended “Ready-to-Retire” Checklist.
“Ready-to-Retire” Checklist
- Current Funded Status is greater than or equal to desired retirement threshold percentage (recommend 110%)
- Current present value of non-risky assets/investments is greater than or equal to present value of future essential expenses
- Current investment in risky assets is greater than or equal to present value of desired future discretionary expenses,
- Funded Status threshold for reducing future spending (or increasing assets) has been established (recommend 95%), and
- Possible future cash flow issues have been identified and planned for.
If all five above boxes can be checked, you should feel confident that you are financially ready to retire. Note however, that, consistent with checklist item 4, this does not mean that you will never have to reduce desired spending in retirement. The actuarial approach is a dynamic strategy that periodically compares household assets and household spending liabilities to see if spending adjustments may be necessary in the future as a result of
- deviations of actual from assumed experience,
- changes in assumptions about the future, or
- spending more or less than budgeted
The first three Checklist items are developed in the AFP. The fourth item is simply a confirmation of a household’s commitment to take actions to reduce spending or increase assets once the Funded Status developed in the AFP drops below an agreed upon threshold in the future. The fifth item can be checked using information from the ABC, if necessary, as discussed below.
We discuss this process below.
Using the AFP
The AFP requires as input:
- Age and gender information for the planning household (single retiree or retired couple)
- Asset and investment information, separately classified as non-risky and risky
- Desired or expected spending information, separately classified as recurring, non-recurring, essential and discretionary,
- Assumptions about expected future investment returns on non-risky investments, investment returns on risky investments, inflation and lifetime planning periods (using default or override assumptions) as well as expected future increases in future asset and expense streams, and
- Desired decrease in recurring expenses upon the first death within the married household
For purposes of testing your financial ability to retire, it is important to input spending in the AFP that reflects your spending goals in retirement—your needs, your wants and your desires. You should also anticipate unexpected expenses. The output from the AFP or ABC is only as good as the inputted spending plan (GIGO--garbage in, garbage out).
After inputting the necessary information described above, the AFP will output
- An Actuarial Balance Sheet that will compare the present value of your household assets with the present value of your household desired spending liabilities,
- Your current year spending budget, and
- The information for first four checklist items above.
Example
Bill and Betty are a hypothetical couple considering whether they both can afford to retire this year. Bill is currently age 67 and Betty is age 62. Neither would like to work in part-time employment after retirement. They have combined accumulated savings of $1,100,000 and they anticipate being able to take about $250,000 (present value) out of their home when they downsize, which they expect to occur in about 15 years. They also anticipate spending about $300,000 (present value) in long-term care when Bill is likely to have passed and there won’t be anyone around to help Betty if and when she becomes infirm. They have no long-term care insurance.
They both are eligible to receive Social Security benefits, but Betty has decided she will wait until age 70 to commence her benefits. They also have several other asset and recurring and non-recurring spending inputs shown in the screen shot below. They have decided to use the AFP default assumptions for testing whether they are financially ready to retire.
Bill and Betty’s AFP inputs and outputs are shown in the AFP screenshot below
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As shown above, Bill and Betty’s desired spending budget for 2023 if they were to retire is $99,000 and
- Their Funded Status based on their assets and inputted desired spending is 115.94%.
- The present value of the assets/investments they have classified as “non-risky” is about equal to the present value of expenses they have classified as essential, and
- The present value of the assets they have classified as risky exceeds the present value of their discretionary spending
- They agree that if their Funded Status falls below 95% in the future they will look into spending cuts and/or increases in assets (like part-time employment or renting out one of their rooms).
Therefore, based on these AFP results, they can check the first four boxes in the Ready to Retire checklist. To satisfy the fifth checklist requirement, they need to look at expected future cash flows under their spending plan. As noted in the “Limitations, Risks and Caveats” section of the AFP Overview, cash flow issues may emerge under the Actuarial Approach if significant amounts of income are deferred into the future. Deferral of income increases present values to be spent, but such higher spending may deplete accumulated before the deferred income is actually received. In Bill and Betty’s case, their plan relies on an influx of cash resulting from downsizing their home in about 15 years and also from deferral of Betty’s Social Security benefit. These income deferrals could create a cash flow problem for them. Of course, if this cash flow problem became an issue in the future, they could always decide to start Betty’s Social Security benefit earlier than age 70, sell their home earlier or they could look at some other ways to temporarily borrow money (for example using a home equity line of credit (HELOC)). To be safe, however, they decide to use the Actuarial Budget Calculator for Single Retirees to test for potential cash flow issues. This spreadsheet is slightly different from the AFP so they have to make a few adjustments described below to approximately duplicate the results they obtained in the AFP:
- They use slightly different assumptions (because the same investment return assumption applies to both non-risky and risky investments in the ABC and there is only one lifetime planning period used in the ABC)
- They input $350,000 for their Rainy-Day Fund which is ignored in the calculation of their recurring spending budget in the ABC
- Instead of inputting present value expectations for proceeds from downsizing and long-term care costs, they enter expected payments designed to produce about the same present values (which they check by using the PV Calcs tab)
The screen shot below shows the results
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This spreadsheet produces about the same initial spending budget, present value of assets and present value of non-recurring expenses as the AFP spreadsheet. The ABC also indicates that there shouldn’t be a cash flow problem if all assumptions are realized because there is no potential cash flow issue warning displayed, and this conclusion is also confirmed in the spreadsheet run-out tabs.
As an alternative to including expected proceeds from downsizing and long-term care costs in their AFP calculations, Bill and Betty could simply assume that Betty’s expected long-term care costs will be covered by their home equity.
Having gone through this exercise, Bill and Betty are comfortable that all five Ready to Retire checklist boxes can be checked, and if they want to retire at this time, they can do so with confidence that they are financially ready.
Summary
In addition to helping retirees decide when they can increase or should decrease spending on an ongoing basis and helping them develop an investment plan, the AFP can be used to help near-retirees decide when they can afford to retire. We recommend using the Ready to Retire Checklist for this purpose. Retirees who are more conservative in their planning can vary the threshold requirements in boxes 1 and 4, and can certainly invest more in non-risky investments than indicated in box 3 if they are so inclined. While we admit that it is a little tricky to check box 5 for potential cash flow issues using the ABC, this step may not even be required unless significant deferred income is anticipated under the household plan.
