It seems that every other article we read these days in the retirement media involves someone’s thoughts about how best to withdraw funds from accumulated savings to supplement income from other sources such as Social Security, pensions and annuities in retirement. The most common withdrawal strategy for this purpose, of course, is “the 4% Rule”, but there are literally thousands of alternative withdrawal strategies (and more being developed every day). Advocates of these strategies stress that “converting” accumulated savings to “retirement income” is essential to ensuring that one’s annual retirement income (“I”) exceeds one’s annual expenses (“E”), or (“I > E”). In fact, several authors have proclaimed this “common-sense equation” to be, “The most important rule of personal finance — spend less than you earn.”
And, while we don’t particularly like the 4% Rule or other structured (or systematic) withdrawal plans (SWPs), we don’t have a problem with the general concept that, over time, retirement “income” should exceed household expenses. But, because neither household income sources nor household spending is generally linear from year to year, we advocate the use of present values to make this comparison between income and expenses more effective. Doing this makes the actuarial approach recommended in this website much more robust than other strategies and enables users of the Actuarial Financial Planner (AFP) to satisfy the common-sense equation above by using an actuarially determined withdrawal strategy. But, users don’t need to focus on the withdrawal strategy effectively used in the AFP, as it is automatically accomplished (and automatically adjusted) by maintaining the balance between household assets and household spending liabilities (the household Funded Status) over time.
In this post, we will discuss:
- The actuarial balance equation used in our more robust version of the I > E equation,
- The actuarially determined spending budget developed in the AFP,
- The “withdrawal strategy” effectively used in the AFP, and
- Why you don’t need to be terribly concerned about the withdrawal strategy effectively used in the AFP--Simply focus on your annual spending budget and annually-determined AFP Funded Status
Actuarial Balance Equation
The basic equation underlying the Actuarial Approach (and AFP Actuarial Balance Sheet) recommended in this website is:
Accum. Savings | + | PV Income from Other Sources | = | PV Essential Expenses | + | PV Discretionary Expenses | + | Rainy-Day Fund |
Where “PV” stands for present value, and both essential and discretionary expenses can be expanded into recurring or non-recurring components (or if desired, other categories of expenses).
Since current accumulated savings can be considered as the present value of future withdrawals from accumulated savings, this equation can be re-written (for those advocating more of a focus on “retirement income”) as
PV Future Withdrawals | + | PV Income from Other Sources | = | PV Essential Expenses | + | PV Discretionary Expenses | + | Rainy-Day Fund |
Or more simply,
PV Future Income > PV Future Expenses
And while use of this actuarial equation can result in potential cash-flow issues if household income is significantly deferred or anticipated household expenses are significantly front-loaded, it does a much better job of handling situations involving non-linear sources of income and/or expenses than the simple I > E version . Because many household expenses are non-recurring in nature, or decrease upon the first death within a couple, it is easy to see how expenses can be non-linear. There are however, many potential instances where income sources can also be non-linear. See our post of June 4, 2021 for a list of examples.
Actuarially Determined Spending Budget
The AFP develops an Actuarially Determined Spending Budget (ADSB) each year through an iterative process to solve the actuarial balance equation above. It is the spending budget that is expected to be supported by inputted household assets based on inputted household data, desired expenses and assumptions about the future (including assumptions about future increases in expenses and implied assumptions like lifetime sources of income will continue unchanged). In the AFP, the ADSB is called the Current Year Spending Budget. If all assumptions are realized in the future (and the Rainy-Day fund remains constant), the ADSB will increase from year to year with inputted increase assumptions for recurring and non-recurring expenses, increase with new non-recurring expenses and decrease when non-recurring expenses are expected to cease.
The Actuarial Approach “Withdrawal Strategy”
While we don’t generally think in terms of having a withdrawal strategy under the Actuarial Approach, for purposes of comparison with the many withdrawal strategies out there, the amount anticipated to be withdrawn annually from Accumulated Savings under the AFP is
The ADSB – Income from other sources (Social Security, pensions, annuities, etc.) expected during the year
Because both sources of income and expenses are frequently non-linear, amounts withdrawn from accumulated savings under the AFP may vary significantly from year to year and most likely will not equal 4% of the accumulated savings at initial retirement increased by inflation (or amounts produced under any other systematic withdrawal strategy).
Why You Don’t Need to be Concerned with the Withdrawal Strategy in the AFP—Simply Focus on Your Spending Budget and AFP Funded Status
While the withdrawal strategy inherent in the AFP may be of interest to some, we don’t believe it is necessary to calculate or project withdrawal amounts from year to year, as these amounts are not as important for planning purposes as the ADSB and the ratio of household assets to household spending liabilities (both for essential spending and for total spending). The AFP Funded Status metric automatically reflects the actuarial determined spending budget and withdrawals from savings discussed above. Planning under the AFP can best be described as follows:
If assumptions, future income streams and future expense streams inputted into the AFP are exactly realized in the future and household spending exactly follows the AFP spending budget each year, your current household assets are expected to be sufficient to cover X% [Funded Status] of your projected spending liabilities in retirement. Of course, it is unlikely that future experience will exactly follow assumed experience and/or your expectations about future experience may change. If so, your Funded Status will change from year to year. In general, experience more favorable than assumed (or spending less than your budget) will increase your Funded Status, and experience less favorable than assumed (or spending more than your budget) will decrease your Funded Status. If your Funded Status falls below 95% now or in the future, you should consider reducing your spending budget (or increasing your assets) to bring your Funded Status up to 95%. If your Funded Status is or becomes more than 120%, you may consider increasing your spending budget.
Summary
Comparing financial assets and liabilities is what actuaries do to determine the status of a financial system. Generally, this comparison is done using basic actuarial principles, including the calculation of present values. In her recent post, financial blogger Allison Schrager deftly summarized the actuarial process as follows:
“It does not take much to make a Pension Geek happy. We just like to value liabilities (using a market discount rate, of course) and compare them to assets. We are happier when they match. But if they don’t match (almost always a shortfall), we get concerned.”
We believe Allison was referring to the Social Security system in her post, but the same description can easily apply to actuarial principles applied to personal financial planning. We encourage you to release your inner Pension Geek when performing your retirement planning.
