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.
We also want to thank Mr. Fitzpatrick for his “shout-out” to the actuarial profession by noting that actuarial science offers tools that can help advisors assess risks. He said,
“Ultimately, the key point is that creating a plan based on how long a client will live is most effective when both mortality and longevity risk factors are considered. Actuarial science offers tools that can help advisors assess these considerations so that they can adjust mortality assumptions and longevity expectations as part of an ongoing process of monitoring and updating a plan. And by making these adjustments collaboratively and regularly, advisors can help clients develop a relevant and realistic strategy to manage their mortality and longevity risks as they journey into retirement!”
We agree 100% with Mr. Fitzpatrick. As noted in Step 7 of our 7-Step Actuarial Planning Process, we recommend periodically modelling deviations from assumed experience by stress-testing significant assumptions for the purpose of risk mitigation. In this post, we will discuss how easily this can be done using the Actuarial Financial Planner (AFP) spreadsheet available on our website. For more discussion of managing risks in or near retirement using basic actuarial principles, you can read our posts of May 3, 2022 and January 10, 2023.
Using the AFP and Stress-testing to Assess Risk of Premature Death Within the Couple.
We took the data for John and Mary from Mr. Fitzpatrick’s article and entered it in the AFP for Retired Couples and further assumed that their annual recurring expense/spending target of $117,600 in today’s dollars was 80% essential and 20% discretionary. We assumed no targeted non-recurring spending other than $25,000 in final expenses in today’s dollars, and we assumed that Mary’s recurring targeted spending would be 2/3rds of the couple’s recurring spending after John passed.
We used our default assumptions (including lifetime planning periods of 29 and 31 years for John and Mary, respectively) and calculated the present value of Mary’s increased Social Security benefit commencing at John’s “planned” passing by entering an amount of $28,279 ( $12,000 x (1.03 **29)), a deferred period of 29 years, a payment period of 2 years, annual rate of increase of 3% and 0% upside (100% non-risky) in row 27 to determine the present value of her Social Security survivor benefits of $13,610.
John and Mary’s Funded Status under the assumptions described above was 100.87% determined by dividing the present value of their total assets 0f $2,673,561 by the present value of their future spending liabilities of $2,650,526. Note that this financial status is somewhat less robust than the status developed in Mr. Fitzpatrick’s article owing to the use of a somewhat more conservative investment return assumption to determine the couple’s essential spending liability.
To stress-test the risk posed by John’s early passing, we overrode John’s default lifetime planning period assumption in Row 53 by clicking on the button in Column D, selecting “override” and inputting 1 year in Column F. It is important to go through this process to override default assumptions in the spreadsheet, and not to simply change the assumption in Column H, or you will destroy the programming of the spreadsheet for that cell. We also had to recalculate the present value of Mary’s Social Security survivor benefits under this stress-test scenario by entering an amount of $12,360 ($12,000 x 1.03), a deferred period of 1 year, a payment period of 30 years, annual rate of increase of 3% and 0% upside in row 27 to determine the present value of her revised Social Security survivor benefits of $270,923.
John and Mary’s Funded Status under the revised “stress-test” assumptions was 103.56%, determined by dividing the present value of their total assets of $1,890,768 by the present value of their future spending liabilities of $1,825,795. Thus, from a purely mathematical perspective, Mary would be slightly better off financially if her spouse passed earlier than expected under these assumptions.
A key assumption to be examined in this exercise would be the desired reduction in household spending upon John’s passing. We assumed a 33% reduction in the example above. If we had assumed a 25% reduction, the couple’s Funded Status under the 1-year stress test assumption would be somewhat less than the couple’s Funded Status determined under default lifetime planning period assumptions. Either way, results of the stress test should be useful in helping the couple decide whether they should buy life insurance for John or should take other actions, such as purchasing a life annuity for Mary with some of their portfolio.
Summary
The AFP is a robust model that can help retirees and their financial advisors assess the risks that future experience may deviate from assumed experience. Assumptions about the future can be easily changed to stress-test the household’s financial plan, assess financial risks and facilitate risk management strategies. This is important because the one thing that we do know about the future is that it won’t happen exactly as we assume.
