At the beginning of each new calendar year, we encourage our retired readers to perform an actuarial valuation of their household assets and spending liabilities to see whether changes should be made in the spending and investment components of their financial plans, especially if they haven’t done so recently. This year, we will use an example and the Actuarial Financial Planner (AFP) to illustrate the five easy steps we recommend for performing this annual actuarial valuation.
2022 was a tough year for retirees. In addition to poorer-than-assumed investment return experience, we also experienced higher-than-assumed rates of price inflation. The combined effect on most retiree’s household balance sheets was to significantly reduce the size of household assets and Rainy-Day Funds (the balancing item between household assets and household spending liabilities). Going forward for 2023, retired households will need to decide what actions, if any, should they plan on to address these reductions.
Easy 5-Step actuarial valuation process
As discussed in our post of October 27, 2022 and our Advisor Perspectives article of November 7, 2022, here is a summary of our recommended annual actuarial valuation process:
Step 1. Plan your spending in retirement. Be honest with yourself about your expected and unexpected recurring and non-recurring expenses for 2023 (or later years if they are expected to start later than 2023), and future expected annual increases to these expenses. If you don’t have long-term care insurance, you may need to budget for a future stay in a nursing home and/or assisted care facility or assume that such expenses will be covered by sale of a household asset, such as your home.
Step 2. Check your spending plan for feasibility by entering your spending plan from Step 1 and your assets and assumptions about the future into the AFP. Default assumptions in the AFP may be used or overridden if desired.
Step 3. Consider matching the present value of your planned essential expense spending with the present value of your non-risky investments. This step may involve increasing investment in non-risky investments, for example by delaying commencement of your Social Security benefits or by purchase of a lifetime annuity.
Step 4. Maintain your Rainy-Day Fund at a comfortable level. This step involves managing your spending and investments so that the present value of your retirement assets exceeds the present value of your expected spending. You may also wish to stress-test your plan by vary assumptions about the future or exploring “what if” scenarios.
Step 5. Revisit the above steps at least annually to reflect changes in your spending plan, retirement assets or in the assumptions used to calculate present values.
Example
As of January 1, 2022, Bill and Betty were age 68 and 65, respectively. They were fully retired and had the following retirement assets:
- Bill’s Social Security benefit of $22,000 per annum payable immediately
- Betty’s Social Security benefit of $30,000 per annum assumed to commence at age 70
- Betty’s lifetime fixed pension benefit of $15,000 per annum payable immediately
- Accumulated savings of $1,200,000 (approximately 62% of which invested in risky investments and 38% invested in non-risky investments, and
- A jointly owned home valued at $500,000 with no mortgage
Bill and Betty’s desired spending included the following:
- Annual recurring essential expenses of $50,000 expected to increase in the future with inflation
- Annual recurring essential expenses (medical-related expenses) of $15,000 expected to increase with inflation plus 1%,
- Annual recurring discretionary expenses of $15,000 expected to remain constant in nominal dollars in the future, and
- Annual non-recurring discretionary expenses (travel) of $20,000 increasing with inflation, but only expected for the next 15 years.
Bill and Betty’s 2022 assumptions about the future included the following:
- 3% per annum investment return on non-risky assets/investments (default as of January 1, 2022)
- 6% per annum investment return on risky assets/investments (default)
- 2% per annum rate of inflation (default)
- Lifetime planning periods in accordance with 25% probability of survival for non-smokers in excellent health from the Actuaries Longevity Illustrator (default)
- Percentage reduction in recurring spending upon the first death within the couple: 33%, and
- long-term care expenses and other unexpected expenses covered by the value of their home
The exhibit below shows Bill and Betty’s Actuarial Balance Sheet as of January 1, 2022
Exhibit 1—Bill and Betty’s Actuarial Balance Sheet as of January 1, 2022
PV Social Security benefits | $1,087,630 | PV recurring essential expenses | $1,847,976 |
PV fixed lifetime benefits | $309,007 | PV non-recurring essential expenses | $0 |
PV other non-risky investments/assets | $456,000 | ||
Total PV of non-risky investments/assets | $1,852,637 | Total PV essential expenses | $1,847,976 |
PV risky investments/assets | $744,000 | PV recurring discretionary expenses | $237,679 |
PV non-recurring discretionary expenses | $232,361 | ||
Total PV risky investment/assets | $744,000 | Total PV discretionary Expenses | $470,040 |
Rainy-Day Fund | $278,621 | ||
Total Assets | $2,596,637 | Total Liabilities | $2,596,637 |
Funded Status | 112.02% |
2021 had been a favorable year for Bill and Betty and therefore, as of the beginning of 2022, their Rainy-Day Fund was fairly large, and they felt good about their financial situation. So good in fact, that they spent about 10% more than their 2022 spending budget of $100,000. Much of their increased spending during 2022 was attributable to higher-than-expected inflation.
As of January 1, 2023, Bill and Betty are now age 69 and 66 respectively, and have the following assets:
- Bill’s Social Security benefit of $23,914 per annum payable immediately (an 8.7% increase vs. 2% assumed)
- Betty’s Social Security benefit of $31,971 per annum assumed to commence at age 70 (reflecting an 8.7% increase vs. 2% assumed)
- Betty’s lifetime fixed pension benefit of $15,000 per annum payable immediately
- Accumulated savings of $964,300 ($567,200 of which is invested in risky investments and $397,100 invested in non-risky investments. These amounts reflect approximately a -15% return and $35,000 withdrawal from risky assets and a -5% return and $38,000 withdrawal from non-risky assets, and
- A jointly owned home still valued at $500,000 with no mortgage
Since inflation increased their spending for 2022 and they expect inflation will be about 5% for 2023, they estimate their spending for 2023 will be as follows:
- Annual recurring essential expenses of $57,750 (15% greater than 2022 budget) expected to increase in the future with inflation
- Annual recurring essential expenses (medical expenses) of $17,325 expected to increase with inflation plus 1%,
- Annual recurring discretionary expenses of $15,000 expected to remain constant in nominal dollars in the future
- Annual non-recurring discretionary expenses (travel) of $23,100 increasing with inflation, but only payable for the next 14 years.
Bill and Betty choose to use the revised default assumptions (revised last June to include a 4.5% investment return assumption for non-risky investments, a 7.5% investment return assumption for risky investments and 3.5% inflation) for their 2023 budget and actuarial balance sheet determination. The exhibit below shows Bill and Betty’s resulting January 1, 2023 Actuarial Balance Sheet under these assumptions and their revised asset and spending liability information.
Exhibit 2—Bill and Betty’s Actuarial Balance Sheet as of January 1, 2023
PV Social Security benefits | $1,134,711 | PV recurring essential expenses | $1,930,695 |
PV fixed lifetime benefits | $255,328 | PV non-recurring essential expenses | $0 |
PV other non-risky investments/assets | $395,363 | ||
Total PV of non-risky investments/assets | $1,785,402 | Total PV essential expenses | $1,930,695 |
PV risky investments/assets | $568,937 | PV recurring discretionary expenses | $187,006 |
PV non-recurring discretionary expenses | $255,717 | ||
Total PV risky investment/assets | $568,937 | Total PV discretionary Expenses | $442,723 |
Rainy-Day Fund | $(19,078) | ||
Total Assets | $2,354,339 | Total Liabilities | $2,354,339 |
Funded Status | 99.20% |
The totals in the exhibits may not add due to rounding. Note that these exhibits may be developed independently by the reader using our Actuarial Financial Planner for married couples and inputting Bill and Betty’s data and assumptions outlined above. Better yet, we recommend that you go through this exercise with your own data and assumptions (i.e., the purpose of this post).
Exhibit 2 shows that Bill and Betty’s Rainy-Day Fund, based on revised assumptions and updated asset and expense data is almost $300,000 lower than it was as of the beginning of the year. The primary drivers of this result are decreased investment returns (approximately -20% for risky investments and approximately -5% for non-risky investments) and greater than expected price inflation. Exhibit 2 also shows that Bill and Betty’s accumulated savings investment mix no longer matches the present value of their essential expenses.
What actions should Bill and Betty take now?
The Actuarial Financial Planner (AFP) is a planning tool that provides data points to facilitate spending and investment decisions. At the beginning of the year, Betty and Bill enjoyed a relatively large Rainy-Day Fund and decided that they could spend more than their spending budget as a result. Higher than expected inflation helped them make this decision, but they no longer have a relatively large Rainy-Day Fund. In addition, the present value of their non-risky investments no longer matches the present value of their essential expenses. Actions they may wish to consider in 2023 include:
- Doing nothing. They can hope that 2022 was an aberration and that their investments will bounce back in 2023
- Increasing their investment in non-risky assets to match the present value of their essential expenses
- Watching their spending budget more closely and/or resolving to perform a mid-year actuarial valuation to make sure they are still on track
- Reducing discretionary spending
- Strengthening their balance sheet by purchasing one or more life annuities (see my Advisor Perspectives article of December 19, 2022),
- Using more aggressive assumptions with respect to the future,
- Reclassifying some of their essential expenses as discretionary expenses, and
- Increasing household assets to be used for retirement purposes
In order to help them decide what actions they may wish to take; it may also be worthwhile for Bill and Betty to stress-test their plan by considering:
- What if future inflation is higher (or lower) than the default assumption of 3.5% per annum?
- What if other assumptions are not as favorable as assumed?
- What if their Social Security benefits are reduced as part of Social Security reform?
- What if Bill or Betty dies earlier (or later) than assumed?
These contingencies can all be fairly easily modeled in the AFP.
Summary
Retirement planning is definitely easier when investment returns exceed expectations, inflation is low and your Rainy-Day Fund is growing (i.e., “fish are jumpin and the cotton is high” from the song “Summertime.”). Unfortunately, 2022 stopped the string of relatively easy planning years.
The first step in the planning process is to see where you stand financially. That is, how your assets compare with your spending liabilities and how big your Rainy-Fund is. The AFP can help you do this. It’s time for you (and your spouse) to sit down and crunch your numbers to see where you stand at the beginning of 2023 (the easier part). And, once you determine where you stand, then you can consider the actions you should take (the harder part).
Happy New Year and Happy Planning!
