The Actuarial Financial Planner (AFP) advocated in this website is a relatively simple, deterministic actuarial model (i.e., it uses deterministic assumptions about the future to determine results). By comparison, many financial advisors use more complicated Monte Carlo models which involve the use of one or more stochastic assumptions. In this post, we will once again discuss why we believe the AFP is the more appropriate model for the purpose of ongoing (as opposed to one-time) financial planning in retirement.
This post is a follow-up to our post of December 25, 2022. We start by providing background on deterministic vs. stochastic models and then discuss one of the main purposes of financial planning--periodically rebalancing household assets and spending liabilities to keep spending on track during retirement. We conclude that the AFP better accomplishes this purpose than Monte Carlo models commonly used today.
Background
The American Academy of Actuaries recently released, “The Roles of the Actuary in the Selection and Application of Actuarial Models.” In that discussion paper, the authors state:
“The models that actuaries typically use in their work are classified as either deterministic or stochastic. They are simplified representations of possible outcomes relative to future contingent events. A “contingent event” is an event whose occurrence, timing, or severity is uncertain. Actuaries recognize that even though a deterministic model produces an outcome that appears to be predicted with certainty, this “certainty” is based upon assumptions that are themselves uncertain. Therefore, deterministic models have an “if-then” characteristic. That is, if the assumptions made in the deterministic model are realized in the real world and if the real world behaves exactly as predicted by the model, then the outcome of a deterministic model will occur. Clearly, these are big ‘ifs’ and even deterministic models are hypothetical and, at their best, can only be expected to produce outcomes reasonably within a range of possible future outcomes.”
We acknowledge that the assumptions used in the AFP are deterministic and are unlikely to be exactly realized in the future (just like the assumptions generally used by pension plan actuaries). This is why we encourage our readers to follow a dynamic approach involving periodic actuarial valuations of a retired household funded status. Our recommended process also involves periodic adjustments in household assets and/or spending liabilities to maintain a reasonable funded status on an ongoing basis when actual experience invariably deviates from assumed experience. We see this re-balancing of household assets and liabilities on an ongoing basis as one of the most important purposes of personal financial planning in retirement. The anticipated adjustment process (which we refer to as the Actuarial Approach) is a dynamic strategy as opposed to static, or one-and-done strategy, like the 4% Rule or static Monte Carlo approaches. Note, however, as discussed in our post of January 7, 2023, annual valuations of retired household funded status do not necessarily imply annual adjustments of household assets or spending liabilities, as households can consider actions to take when the measured funded status falls below or above pre-established action corridors while keeping their plan without adjustment if their funded status continues to fall inside the funded status corridor.
By comparison, there seems to be some confusion within the financial advisor community (and, undoubtedly, also amongst their clients) as to whether Monte Carlo models frequently used are static (one and done) or dynamic. Therefore, clients are frequently in the dark about actions they will need to take if experience is more or less favorable than assumed. For example, in the Kitces.com post of December 21, 2022, the author, Derek Tharp, notes:
“For instance, while a recent experimental survey found that financial advisors recommend the same probability-of-success thresholds when conducting one-time and ongoing financial planning projections, the reality is that risk levels associated with the same probability-of-success threshold are very different when considered in the context of a one-time plan versus part of an ongoing financial planning service provided to clients.”
Dr. Tharp correctly notes that the spending anticipated by a one-time plan will undoubtedly be significantly more conservative than the initial spending anticipated by an ongoing plan. He says:
“ [while] few advisors are running Monte Carlo simulations intended as truly one-time projections….it appears that this understanding of the distinction between Monte Carlo in a one-time-plan context and Monte Carlo in an ongoing planning context is not well appreciated.”
We agree with Dr. Tharp that there are very few households (or their financial advisors) who are comfortable with one-and-done, head-in-the-sand, planning approaches, but very few actually understand the real implications of having their financial advisor use a one-time planning model and conservative assumptions to generate a 90% probability of “success.”
What is the purpose of a financial planning model?
We believe that measuring the retire household balance sheet funded status and quantifying actions to take with respect to household assets or spending liabilities when the funded status becomes too small or too large is one of the primary purposes of a robust ongoing financial planning model.
As outlined in the American Academy of Actuaries (AAA) discussion paper noted above:
“Actuarial models vary considerably, and some models may be better than others for a particular project. When deciding what model to use or what model assumptions are most appropriate, actuaries typically consider factors including but not limited to the following:
- Whether the design of the model and the assumptions used are reasonable in light of the purpose of the analysis;
- Whether the model appropriately reflects fundamental principles of actuarial science;
- Whether the model is consistent with accepted actuarial practice;
- Whether the model can be used with available data; and
- Whether the model output is consistent with the actuary’s intended use of the model”
Conclusion
We
believe the AFP satisfies all of the above requirements set forth in
the AAA discussion paper (including the first bullet regarding using a
model and assumptions that are reasonable in light of the purpose of the
analysis). Therefore, we have no problem recommending its use for
ongoing financial planning in retirement.
