Should You use a Dynamic Process with Guardrails to Keep Spending on Track in Retirement? Yes, But Not with a Monte Carlo Model Typically Used by Financial Advisors

This post is a follow-up to our post of March 7, 2021 and several other of our posts and articles noting that a model like the Actuarial Financial Planner (AFP) is a better model to use when employing a dynamic process to keep spending on track during retirement. 

The Actuarial Approach--Better Than The 4% Rule, Simpler Than Monte Carlo Modeling and More Effective Than Either

Looking to keep your spending on track and consistent with your spending goals in retirement? Forget the 4% Rule and complicated Monte Carlo simulations. Use the same basic approach/process that actuaries use for Social Security and pension plans. 

The Actuarial Approach involves:

1. Periodically (we recommend annually) comparing the present value of your assets with the present value of your spending liabilities to determine your Funded Status.
2. Taking appropriate actions when your Funded Status falls outside reasonable guardrails.

That’s it! And you can use one of our free Actuarial Financial Planners to perform the present value calculations. As discussed in our previous post, this process does involve annually entering your granular spending budget items and your sources of income as well as expected future increase rates for these items. But, we believe the effort you put into this annual process will be worth it.

Better Planning Starts with Granular Budgeting

Thanks to Rivan Stinson for teeing up the Actuarial Approach in Stinson’s recent Washington Post article titled, “Retiring soon? Plot a detailed budget first before tapping your 401(k).” In her article, Stinson writes,

“Once you make this granular budget, it’s time to crunch the numbers on how much your savings and investments, along with Social Security and a pension (if you have one), would cover.”

Creating a granular budget and comparing the present value of expected spending under the budget with the present value of household assets (including future payments from Social Security, annuities, pensions or other sources of income) to determine the household Funded Status are essential steps in the Actuarial Approach Recommended financial planning process.

How Bad is Social Security’s Financial Condition?

This post is a follow-up to our post of October 14, 2024 entitled, “Social Security Financing---When You’re in a Hole, Stop Digging.” In this post, we will look at the retirement plan of a hypothetical couple with approximately the same underfunded status as Social Security. We employ this analogy to try to give readers a better sense of the system’s current financial predicament and the need for sooner, rather than later, action to address it.

Are You Financially Better Off Today Than You Were on January 1, 2021?

According to many of the talking heads at Fox and other conservative media sources, a huge factor in selecting who to vote for in the upcoming presidential election is whether you are better or worse off financially than you were at the beginning of the Biden/Harris term. While we don’t believe that this comparison should be anywhere as important in your decision process as suggested by members of the conservative media, let’s take a look at the math involved in answering this question so that you can estimate the change in your own financial status rather than simply focusing on how much prices on certain items have increased since January 1, 2021.

Social Security Financing--When You’re in a Hole, Stop Digging

In this website, we encourage retired households to periodically (generally annually) compare the present value of their assets with the present value of their spending liabilities to determine a snapshot Funded Status. We also promote monitoring the household Funded Status over time to see whether adjustments in assets or spending liabilities may be necessary or appropriate to keep spending in retirement on track and consistent with spending goals.

As discussed many times in this website, this is the same process that is used by actuaries to measure and monitor funding progress for many other financial systems, including defined benefit pension plans and Social Security. If a system’s Funded Status (Assets/Liabilities) is significantly in excess of 100% and exhibits a pattern of increasing over time, it may be reasonable to decrease system assets and/or increase system liabilities to avoid over-funding. On the other hand, if a system’s Funded Status is less than 100% and has exhibited a pattern of decreasing over time, actions should be taken to bring the system’s Funded Status back up to at least 100% to ensure long-term system sustainability. 

Don’t Undervalue Your Sources of Lifetime Income

Kudos to the American Academy of Actuaries (AAA) for releasing a new Issue Brief encouraging public pension plan administrators to provide eligible plan members with certain reference amounts when offering lump-sum “buy-outs” in exchange for some or all of their pension benefits The Issue Brief concludes, “members may find the following reference amounts particularly helpful:

• An estimate of the cost to replace any benefits otherwise payable in the private
  market; and
• The approximate annual investment return on the buyout amount required to replace
  the forgone benefits, assuming an average life expectancy.”

In addition, AAA also encourages disclosure of the assumptions used to develop the buy-out offer (and also presumably disclosure of the assumptions used to develop the above reference amounts.)

Self-Insuring Your Long-Term Care (and Other Non-Recurring Expenses)

This post is a follow-up to our post of April 16, 2022 regarding planning for non-recurring expenses in retirement, with emphasis in this post on long-term care costs. We also build on the example discussed in our previous post.

Expenses in retirement are not generally linear from year to year. That is why simple spending rules of thumb like the 4% Rule (with or without guardrails), or even more sophisticated Monte Carlo models that develop probabilities that a household can spend $X per year in real dollars, frequently fail to reflect real-world spending in retirement and are, therefore, likely to miss the mark. Developing and maintaining a robust spending plan in retirement is a classic actuarial problem involving the time-value of money and life contingencies. This problem is easily solved utilizing basic actuarial principles, including periodic comparisons of household assets and spending liabilities.

The Future Won’t Happen as Assumed

Thanks to Justin Fitzpatrick at Nerd’s Eye View for his recent article reminding us that planning assumptions about the future (in his article, mortality/longevity assumptions) are just assumptions that may not (generally won’t) be exactly realized as actual future experience emerges. He suggests that such assumptions should be monitored and tested periodically so that the risks to the client’s plan resulting from differences between actual future experience and assumed experience can be assessed and communicated to the client for the purpose of possibly changing the client’s plan.

Actuaries Double Down on Questionable Primary Cause of Social Security’s Financial Deterioration

Last week, the American Academy of Actuaries (AAA) released An Actuarial Perspective on the 2024 Social Security Trustees Report. This Issue Brief was released about six months after the release of the brief covering the 2023 Trustees Report that we discussed in our post of January 20, 2024.

Like the previous issue brief, the 2024 brief includes a shaded [added emphasis] area entitled, “Why Didn’t the 1983 Social Security Reform Work Out as Expected?” These briefs imply that, for the most part, the shortfall since 1983 resulted primarily from economic factors, including the growth of taxable payroll falling below expectations and lower than expected portfolio returns. 

Good Time to Check Your Client’s Funding Buckets

Be sure to read our latest Advisor Perspectives article about the “buckets” used to fund essential and discretionary expenses in retirement under the Actuarial Approach.

500th Post—We’re Retiring

This is the 500^th post of How Much Can I Afford to Spend in Retirement. The primary purposes of this post are to:

• Celebrate our 500^th post,
• Announce our retirement from active blogging, and
• Thank those who have helped us with the website in one way or another over the past 14 years

Retirement 

What does retirement mean in this context? It means that we are planning to cut way down on the quantity of our posts to pursue other goals in retirement. It does not mean that we won’t infrequently update the Actuarial Financial Planner spreadsheets, or that we won’t respond to reader comments or questions about the spreadsheets or maybe even add a new post infrequently.

We still believe that the Actuarial Approach (with its deterministic Actuarial Financial Planner model, general actuarial process and suggested spending adjustment guard-rails) is a superior approach for determining household spending in retirement. We also still believe that you should be using the Actuarial Approach in lieu of, or in addition to, the approach you are currently using for this purpose.

We simply no longer plan to respond to each financial planning opinion we read in the press that suggests otherwise. 

What Percentage Drop in Your Assets Might Trigger a Reduction in Your Discretionary Spending?

Nice to see two more recent articles in the retirement income press discussing the advantages of dynamic retirement approaches like ours that use guardrails to adjust spending in retirement. These two articles are:

• “Why Guyton-Klinger Guardrails Are Too Risky For Most Retirees (And How Risk-Based Guardrails Can Help)” and
• ‘Probability of Success’ Doesn’t Mean What Your Clients Think It Means
  

In the first article, the authors say:

“We think including spending adjustments in retirement planning is a major step forward.”

In the second article, the author says”:

“Retirement planning that rejects success/failure framing can help clients understand that a realistic retirement journey involves not failure, but adjustments.

Advisors can help clients plan for those adjustments by establishing a “spend more” guardrail that tells clients when their risk of underspending and regret is too high, and so they can afford to live a little and spend more. It also means setting a “spend less” guardrail that tells clients when their risk of overspending is too high, so they should find a way to tighten the belt or adjust their goals to bring that risk down.”

We agree.

Trying to Help Households Determine How Much They Can Afford to Spend in Retirement

It’s been almost 14 years since our first post on How Much Can I Afford to Spend in Retirement? This post is our 498^th post. As implied by the title of our website, our primary goal is to help individuals (or financial advisors for those individuals) determine how much they (or their clients) can afford to spend in retirement. Unlike most financial advisors, however, we attempt to do this by applying proven actuarial principles and processes to the decumulation problem.

Does Your Retirement Plan Have Spending Guardrails?

Ongoing planning in retirement involves periodically assessing whether spending may be increased or must be decreased to remain on track. In his recent Kitces.com article, How Communicating Guardrails Withdrawal Strategies Can Improve Client Experience and Decrease Stress, Dr. Derek Tharpe says:

“However, the results of these [Monte Carlo] simulations generally don't account for potential adjustments that could be made along the way (e.g., decreasing withdrawals if market returns are weak and the probability of success falls, or vice versa), making them somewhat less useful for ongoing planning engagements where an advisor could recommend spending changes if they become necessary.”

He also notes:

“Nonetheless, while these thresholds and the dollar amount of potential spending changes might be clear in the advisor's mind, they often go unspoken to the client. Which can lead to tremendous stress for clients, as they might see their Monte Carlo probability of success gradually decline but not know what level of downward spending adjustment would be necessary to bring the probability of success back to an acceptable level.”

If your retirement plan does not have spending guardrails, or your spending guardrails are “uncommunicated” by your financial advisor, you may wish to use the Actuarial Approach set forth in this website, or encourage your advisor to do so. For more discussion of our recommended guardrails, see our post of January 7, 2023.

Financial System Sustainability Superstars

Actuaries measure and monitor the health of financial systems by systematically comparing assets and liabilities and making adjustments when necessary to ensure system sustainability.

You can do the same thing for your personal financial system/retirement plan with assistance of the Actuarial Financial Planner (AFP) and by following the general actuarial process.

For more discussion of the general actuarial process, see our post of August 23, 2023.

Simplify Your Retirement Planning

As discussed in prior posts, the key to successful retirement planning is to

• annually determine your Funded Status,
• monitor it from year to year and
• Adjust spending when your Funded Status falls outside pre-determined guardrails (suggested: 95%, 120%)

In her recent Go Banking Rates article, Hanna Horvath outlines six key steps to building an effective retirement plan and spending budget. We agree that the steps outlined by Ms. Horvath are important, but each of these steps (and much more) is anticipated in the simpler process we recommend. 

Why does simplicity matter? You are much more likely to adopt and follow an approach if it is relatively easy to understand and to implement. Entering relevant data into the Input section of the Actuarial Financial Planner enables you to quickly develop your household Funded Status, and therefore, build a more effective retirement plan and spending budget.

We’ve Updated the Actuarial Financial Planner Models

In response to suggestions from several of our readers, we have added cells to the AFP models to permit inputting of additional non-recurring income and expense items. These new cells will enable you to estimate present values of items such as:

• Social Security survivor benefits
• Survivor benefits under Joint and Survivor annuities
• Future home sales
• Possible future Social Security cuts, and
• Many types of expected future non-recurring expenses

Simple Key to Retirement Planning Success

Key: You should determine your Funded Status annually and monitor it from year to year.

Why? Your Funded Status is a summary statistic that reflects actual experience and can keep you on track to meet your spending goals in retirement.

For more discussion of the importance of determining and monitoring your Funded Status, and why doing so is superior to using the 4% Rule (and its many variations) or typical Monte Carlo models, see our post of April 16,2023.

To determine your Funded Status, download and complete one of our Actuarial Financial Planners from the Spreadsheets section of our website.

A Planning Process That Works

You are responsible for your finances in retirement and need a plan that works. The Actuarial Approach, with its Funded-Status-focused process can help you:

• Grow your assets,
• Protect your assets,
• Spend your assets in a manner consistent with your goals, and
• Make better financial decisions.

To read more about the proven actuarial process we recommend, including a few hints for using the Actuarial Financial Planning models we provide, see our post of January 5, 2024. 

Check out our most recent Advisor Perspectives article if you are concerned about how future Social Security reforms may affect your plan.

Want a More Realistic Retirement Plan?

If you (or your financial advisor) aren’t planning for non-recurring expenses in retirement, you probably don’t have a realistic retirement plan. 

If you use a Strategic Withdrawal Approach (like the 4% Rule or its many variations) or your financial advisor uses a traditional Monte Carlo approach, your annual spending budget is usually expressed as a constant real dollar amount each year. Assuming constant real dollar spending for your entire period of retirement can either overstate or understate the assets you need to fund your retirement. This can occur because:

• Some non-recurring expenses (such as travel expenses, new cars, pre-Medicare healthcare premiums, home remodeling expenses) are primarily front-loaded during retirement, or
• Some non-recurring expenses (such as long-term care or bequest motives) are primarily back-loaded during retirement

If you want to develop a more realistic financial plan during retirement that reflects non-linear spending, we recommend you use a model like the Actuarial Financial Planner (AFP). The AFP distinguishes between future expected essential, discretionary, recurring and non-recurring expenses. See our post of April 16, 2022 for more discussion of this topic and our post of December 8, 2023 for discussion of steps you can take if there are an insufficient number of cells in the AFP to perform calculations of the present values of your non-recurring expenses (or other present values).

Time to Reduce Your Investment Risk?

With the S&P creeping up over 5,000, it may be time for retirees to look into decreasing their investments in risky assets, especially if their Floor Portfolio of non-risky assets/investments does not cover the present value of their expected future essential expenses. 

You can read more about what we consider to be the most important planning decision in retirement in our post of October 16, 2022.

American Academy of Actuaries Reinserts Caveat Language into Their Social Security Challenge/Game

Kudos to the American Academy of Actuaries (AAA) for reinserting the following caveat language in its Social Security Challenge tool. 

Actuaries Confuse the Primary Causes of the Social Security Funding Shortfall

The American Academy of Actuaries (Academy) recently published its annual Actuarial Perspective on the annual OASDI (Social Security) Trustees Report. Usually, these briefs are published by the Academy shortly after release of the trustee’s report, but this year’s brief (covering last year’s 2023 report) was significantly delayed for some reason.

Among other things, this year’s actuarial perspective on Social Security attempts to convince us that system’s current funding shortfall “was mostly caused by economic factors that came up short of expectations, including the growth of taxable payroll, and trust fund investment returns.” This is apparently the same conclusion reached by the system’s Chief Actuary as discussed in the article entitled, “Here’s the real cause of the Social Security funding shortfall, according to the program’s chief actuary”

It’s that Time Once Again for Retired Households to Perform Their Actuarial Valuations

At the beginning of each calendar year, we encourage our retired (or near-retired) readers to perform an actuarial valuation of their household assets and spending liabilities to see whether changes should be made to their financial plans. A household actuarial valuation involves calculating and comparing present values of household assets and household spending liabilities for the purpose of determining the household’s Funded Status. To do this, we suggest you follow the easy 5-step valuation process outlined below using our Actuarial Financial Planner (AFP) models.

2023 was a better year for retirees after a pretty tough 2022. Most of us experienced better-than-assumed investment return experience, rising interest rates and lower levels of price inflation. As a result, we increased the default assumptions used in the AFP to estimate future investment returns and decreased the default assumption for future inflation (as discussed in our post of November 16, 2023). The combined effect of more favorable experience during 2023 and changes in our default assumptions will generally increase household funded statuses as of January 1, 2024.