In our last post, we indicated that there are several levers in the AFP that more conservative users can employ to reflect their lower tolerance for potential future spending reductions, including:
- Using more conservative (than default) assumptions about the future to determine their household Funded Status,
- Building up a larger Funded Status over time, or
- Classifying more expenses as “essential.”
In this post, we will flip the coin and look at levers available for those with a higher tolerance for potential future spending reductions, or for those with insufficient assets to cover their spending liabilities using the default assumptions (and therefore, have little choice but to assume more risk).
We include an example.
As discussed in our previous post, using the AFP from year to year is a self-correcting process. Therefore, if actual future experience turns out to be more favorable than assumed, your funded status will increase and your future spending may be increased, but if actual future experience turns out to be less favorable than assumed, your funded status will decrease and your future spending will likely need to be decreased (unless you somehow increase your assets). Using the AFP for personal retirement financing is like financing the Social Security system—Based on the system’s current actuarial balance sheet, we will either need to increase revenues or decrease benefits to bring the program back into balance.
Using more aggressive assumptions in your financial plan will increase the likelihood (and magnitude) of possible future spending cuts, all things being equal. By providing the AFP tool for your use, we provide no guarantees (nor does anyone else) about your future spending, irrespective of assumptions about the future you may use.
Example
Let’s assume Bernie is a 65-year-old single male, with $400,000 of accumulated savings and a Social Security benefit that has already commenced of $20,000 per year. Bernie’s exceedingly simple spending goal is to spend $45,000 per year, and he estimates that his essential expenses are $30,000 per year and his desired discretionary expenses are $15,000 per year (all in real dollars). For simplicity sake, we will assume that he has no non-recurring spending goals or other sources of income (just like the simple assumptions users of the naive 4% Rule make, for example).
Using the default assumptions for the AFP for Single Retirees and approximately matching the present value of his non-risky assets/investments with the present value of his expected essential expenses, Bernie uses the AFP to develop the following actuarial balance sheet shown in Exhibit 1
Exhibit 1—Bernie’s actuarial balance sheet assuming default assumptions, $30,000 in annual recurring real-dollar essential expenses and $15,000 in annual recurring real-dollar discretionary expenses
PV Social Security benefits | $508,592 | PV recurring essential expenses | $762,888 |
PV fixed lifetime benefits | $0 | PV non-recurring essential expenses | $0 |
PV other non-risky investments/assets | $256,000 | ||
Total PV of non-risky investments/assets | $764,592 | Total PV essential expenses | $762,888 |
PV risky investments/assets | $144,000 | PV recurring discretionary expenses | $268,890 |
PV non-recurring discretionary expenses | $0 | ||
Total PV risky investment/assets | $144,000 | Total PV discretionary Expenses | $268,890 |
Rainy-Day Fund | ($123,186) | ||
Total Assets | $908,592 | Total Liabilities | $908,592 |
Funded Status | 88.06% |
Exhibit 1 shows that, under the default assumptions and investing about 64% of his accumulated savings in non-risky investments to match the present value of his essential expenses, Bernie’s Funded Status is only 88.06% and, in theory, he should either cut back on some of his discretionary spending and/or find additional assets to strengthen his balance sheet. Using the AFP, Bernie estimates that if he reduced his planned discretionary spending each year by $7,000 per year to about $8,000, his Funded Status would increase to approximately 100%.
But, Bernie, considers himself to be a risk-taker, and he doesn’t want to reduce his current spending. Instead of reducing his current discretionary expenses, Bernie decides to use more aggressive assumptions about the future and reduce his essential expenses from $30,000 per annum to $20,000, (the amount covered by his annual Social Security benefit). And instead of assuming a 7.5% annual investment return (4% real) on his risky investments and 3.5% annual inflation, he assumes a 9.5% annual return (6% real) on his risky investments and 3% per annum future inflation. He understands that he is increasing the likelihood that he may have to decrease his future discretionary spending by making these changes, but he is willing to take the additional risk.
The results of his revised more aggressive AFP are shown in Exhibit 2 below.
Exhibit 2—Bernie’s Actuarial Balance Sheet assuming more aggressive assumptions, $20,000 in annual real dollar essential expenses and $25,000 in annual real-dollar discretionary expenses.
PV Social Security benefits | $477,193 | PV recurring essential expenses | $477,193 |
PV fixed lifetime benefits | $0 | PV non-recurring essential expenses | $0 |
PV other non-risky investments/assets | $0 | ||
Total PV of non-risky investments/assets | $477,193 | Total PV essential expenses | $477,193 |
PV risky investments/assets | $400,000 | PV recurring discretionary expenses | $349,752 |
PV non-recurring discretionary expenses | $0 | ||
Total PV risky investment/assets | $400,000 | Total PV discretionary Expenses | $349,752 |
Rainy-Day Fund | $50,248 | ||
Total Assets | $877,193 | Total Liabilities | $877,193 |
Funded Status | 106.08% |
Exhibit 2 shows that if these revised assumptions are exactly realized every year in the future and Bernie maintains his spending at exactly the assumed level every year, his current funded status would be 106.08% and he wouldn’t have to cut back his spending in the future.
Bernie understands that he is assuming more income risk by taking this more aggressive approach. He uses the AFP to run some “what-if” analysis to see how much his spending may need to be reduced under different assumptions about the future. He is confident that under most reasonable future scenarios, he will not be required to reduce his essential expenses, and he is comfortable with reducing or eliminating most of his discretionary spending, if necessary, especially as he ages.
Summary
Some
of our readers have complained that our approach is too conservative.
They claim that, based on historical performance, investments in
equities can be expected to earn at least a 6% real rate of return or
more, on average, in the future. We have no problem if users of the AFP
want to use more aggressive assumptions for future returns on risky
investments, as long as they understand that they are increasing their
risk of having to cut back spending they have identified as
discretionary in the future. If these expenses that users are willing to
reduce are truly discretionary, it may not be too painful for them to
reduce them when necessary.
