In his August 7, 2023 Advisor Perspectives article, Larry Swedroe, head of financial and economic research for Buckingham Wealth Partners, discusses what he calls the seven great “challenges” to retirement plans today. According to Mr. Swedroe, these challenges are:
- historically high equity valuations;
- historically low bond yields;
- increasing longevity;
- the potential need for expensive long-term care;
- the failure of government to fully fund the Social Security and Medicare programs;
- the likelihood of slower economic growth due to the rising debt-to-GDP ratio; and
- the end (and even likely reversal) of favorable tailwinds for corporate profits (falling interest rates, profits growing faster than GDP, and falling tax rates).”
Six of Mr. Swedroe’s challenges involve the asset side of a retired household balance sheet while two of them (increased longevity and the potential need for expensive long-term care) primarily involve the spending liability side of the household balance sheet. These challenges (and others discussed below) translate into increased “risks” that the historical assumptions frequently used in retirement planning projections by many financial advisors in Monte Carlo models or in other static planning approaches (like the 4% Rule) may be too optimistic. Fortunately for retirees, these risks can be managed by using the basic actuarial principles and processes advocated in this website and discussed below.
Background
Actuaries help financial systems manage their financial risks. For personal financial systems (households), the assumptions used to measure household assets and spending liabilities for planning purposes include explicit expectations with respect to:
- lifetime planning periods,
- timing of future planned expenses (separated into recurring and non-recurring as well as essential and discretionary),
- increases in future planned expenses,
- timing and amounts of future lump sum or streams of income payments, and
- returns on invested assets.
In addition to these explicit assumptions, more implicit assumptions may include:
- No future changes in Social Security law or in other sources of income,
- No future marital dissolution or early death of a spouse, and
- No spending in excess of budgeted spending
If planning assumptions or expectations about the future are wrong (and they will be), we must be prepared to make adjustments in our spending or somehow increase our assets to keep our finances in balance. And, unfortunately, a lot can potentially go wrong with personal financial assumptions. For example,
- We may live longer than our expected lifetime planning periods
- The value of properties we own may decrease or not increase as expected
- Our long-term care or other medical expenses may be more costly than we assumed
- The household member with greater lifetime income assets may die early or we may divorce,
- Our taxes or our premiums for various types of insurance may increase faster than expected
- Our future Social Security benefits may be reduced (or not fully indexed with inflation)
- Higher than assumed Inflation may make some or all our planned expenses higher than assumed,
- Our investments may experience periods of lower-than-expected returns
- We may suffer uninsured losses or be a victim of fraud,
- We, or other members of our family, may experience emergencies requiring unexpected expenses, or
- We may, for whatever reason, simply spend more than we thought we would
The events described above (and potentially others) will generally either increase our spending liabilities relative to our assets or decrease our assets relative to our spending liabilities. In response, we may have to reduce planned spending, increase household assets or we will have to temporarily dip into our rainy-day funds to keep spending liabilities in approximate balance with our assets.
In the current economic environment, we are looking at real possibilities of higher-than-expected levels of inflation, longer life expectancies, other unexpected increases in spending, lower than historical returns on investments and reductions in future Social Security benefits. These risks are definitely enough to give a retiree a bad case of agita and cause him or her to lose some sleep.
So, what is a retiree to do today to mitigate financial risks and sleep better at night?
Manage Your Financial Risks in Retirement Like an Actuary
Instead of simply having faith that historical returns will continue in the future and believing your financial advisor’s assessment that you have a 90% probability of not running out of money if you spend exactly $X per year, we recommend using the steps outlined below to better manage your financial risks in retirement.
#1 General Actuarial Process
Instead of using a static spending approach (like the 4% Rule or a Monte Carlo projection) which will subject you to greater sequence of returns investment risk, we recommend following the General Actuarial Process most recently outlined in our post of August 23, 2023. This process calls for annually measuring your Funded Status using the Actuarial Financial Planner (AFP) and, as described in Step 5 of that process,
“When warranted, make changes to assets or liabilities (or both) to restore desired Funded Status (and/or to address possible cash flow issues). See our post of January 7, 2023 for our recommend algorithm (guardrails) for determining when plan changes should be implemented”
Changes that involve increasing (or strengthening) your assets may include:
- Going back to work or working in part-time employment
- Selling an asset that was previously not considered a retirement asset
- Renting a vacation home, parking space, boat or room in your house
- Deferring commencement of Social Security
- Purchasing an immediate annuity
Changes that involve decreasing your spending liabilities may include:
- Decreasing discretionary spending
- Reclassifying recurring expenses as non-recurring
- Decreasing desired estate
- Assuming some expenses will decrease as you age
- Minimizing taxes
- Decreasing assumed expenses after first death within the couple
By using this dynamic, self-correcting process, spending may vary from year to year, but it can be smoothed to some degree (within the spending guardrails). Further, as discussed below, if discretionary spending is adjusted first, it may not be necessary to adjust essential expense spending. See our post of April 16, 2023 encouraging you to plan on making future changes to your plan. It is important to note that while static approaches imply more spending stability, such stability is based on assumptions that will likely not materialize and stability is not guaranteed by your financial advisor.
#2 Use a Floor Portfolio to Fund Essential Expenses
The second way to mitigate financial risks in retirement is to find the proper balance between investment in non-risky and risky assets. Here at How Much Can I Afford to Spend in Retirement, we encourage retired households to consider establishing two separate investment buckets to fund their total spending in retirement:
- A Floor Portfolio comprised of relatively safe (non-risky) investments and assets used primarily to fund Essential Expenses, and
- An Upside Portfolio comprised of more risky investments used primarily to fund Discretionary Expenses.
This liability-driven investment (LDI) strategy attempts to match relatively safe household assets with more critical household spending liabilities for the purpose of protecting the assets that fund essential expenses, while using an Upside Portfolio to grow assets that may be used to fund more discretionary expenses. This LDI risk mitigation strategy has been variously described in personal finance literature as:
- a Safety-First approach,
- immunization of essential expenses, or
- funding needs vs. funding wants.
In our opinion, if you are not using a similar LDI strategy, you may be assuming too much (or too little) risk in your personal retirement plan. And, while you may need to reduce expenses in the future if the assumptions used in the AFP turn out to be too optimistic, it is likely that such reductions will involve discretionary expenses and not essential expenses.
While it is important to fully fund one’s Floor Portfolio with non-risky assets, it is also important to have adequate funding of one’s Upside Portfolio. Investments in both non-risky and risky assets enable households to balance their needs to protect and grow their assets, and discretionary spending from the Upside Portfolio can be more flexible than essential expense spending. It is important to remember that the expenses you designate as “essential” or “discretionary” are under your control and can change over time depending on your tolerance for risk and investment preferences.
#3 Use Conservative Assumptions
The third way to mitigate personal financial risks is to use more conservative assumptions. If your expectations about the default assumptions used in the AFP change, you can input different “override” assumptions to perform “what if” scenario testing. For example, see our post of March 20, 2022 for override inflation assumptions that may be used in lieu of the current default inflation assumption. This action will change the amounts shown in the Actuarial Balance Sheet by increasing the present values of essential and discretionary expenses. This, in turn, may cause you to consider changes to your financial plan to rebalance your assets and your liabilities under the override assumption. So, decreases in your spending budget can either occur “by evolution” over time as actual experience emerges, or they can occur “by revolution” by changing assumptions.
#4 Spend Less
The fourth way to mitigate personal financial risks is to spend less than your current year spending budget or otherwise increase the size of your Rainy-Day Fund (strengthen your Funded Status). You are not required to actually spend all of your current year spending budget every year. Your Rainy-Day Fund can be used in future years to smooth spending volatility resulting from unfavorable experience.
Conclusion and Thank You, Jimmy Buffett
Successfully achieving your financial goals in retirement is a risky business. Financial risks occur when actual future experience differs from expectations (assumptions). And while it is impossible to completely eliminate all risks in retirement, some risks can be mitigated through purchase of insurance, by using conservative assumptions, by using a dynamic process or by other means. Households must find the proper balance between protecting their assets, growing their assets and carefully spending their assets. We believe that using the general actuarial process and the AFP recommended in this website can help retirees mitigate their risks, worry less about their financial future and sleep better at night.
One of our generation’s poet/singer/songwriter/(very) successful businessmen passed away yesterday. I don’t consider myself a Parrott Head, but I do appreciate his music. Relative to this post, Mr. Buffett is credited with saying, “I can’t change the direction of the wind, but I can adjust my sails to reach my destination.” We encourage you to follow this philosophy and the dynamic general actuarial process when sailing your financial boat through retirement.
