The Actuarial Financial Planner (AFP) workbooks (for single retirees and retired couples) are robust actuarial models integral to each of the three “M” steps outlined below in our recommended process for keeping your spending on track and consistent with your spending goals in retirement:
Actuarial Approach--Three Key Planning Steps
- Measure your Funded Status (Assets/Liabilities) at the beginning of each year
- Monitor your Funded Status from year to year, and
- Manage your spending, assets and risks in retirement as necessary
We have received questions about the AFPs over the years. In this post we will once again attempt to briefly answer five of the most frequently asked questions.
- How do I input data in the other income/expected non-recurring expense rows of the spreadsheet to determine present values of these items?
Present values of other income/expected non-recurring expenses are generally determined by entering data into the following cells:
Annual Amount | Deferral Period | Payment Period | Annual Rate of Increase | % Upside (assets) or %Essential (Liabilities) |
Where “annual amount” is the expected amount in today’s dollars increased by inflation (or some other reasonable rate of increase) from the current year until the expected year of first payment; the deferral period is the period in which no payments are assumed; payment period is the number of expected years of payment for this income item/expense after the deferral period; annual rate of increase is the expected rate of increase once payments are expected to commence, and % upside/% essential is the users estimate of how risky this particular asset/investment is or how essential this particular expense is.
For example, let’s assume a married household expects to remodel their kitchen 10 years from now and the current cost of the remodeling project is $25,000 in today’s dollars. Further assume that the couple has determined that this project is 50% essential. Using the current default assumption for inflation of 3% per annum, they would enter $33,598 as the annual amount ($25,000 X [(1.03)**10]). This is the current cost in today’s dollars increased by 3% per annum for 10 years. They would enter 10 as the deferral period, 1 as the payment period, 0% as the rate of increase after the job is expected to be completed and 50% as their estimate of how essential this project is.
The present value of this project (as calculated in the PV Calcs tab) under the default assumptions is $17,899. Note that the discount rate used to determine this present value is 6.5%, or 50% of the floor portfolio discount rate of 5% and 50% of the upside portfolio discount rate of 8% per annum.
- Why are there two default expected rates of investment return/discount rates?
Under the Actuarial Approach, two separate buckets are assumed to be used to fund household expenses: The floor portfolio, which is used to fund essential expenses, and if assets are matched to spending liabilities will consist of non-risky investments/assets. The current default investment return/discount rate for the floor portfolio is 5% per annum. The Upside portfolio is used to fund discretionary expenses. The current default investment return/discount rate for the upside portfolio is 8% per annum.
- Why should I input the percentage upside or percentage essential for some input items?
As discussed in the question above, we encourage users to consider using a Liability Driven Investing (LDI) strategy where non-risky investments/assets are matched with essential expenses. Some assets, like Social Security are assumed to be 100% non-risky (or floor portfolio) assets and some spending liabilities, like essential expenses, are assumed to be 100% essential and also belong in the floor portfolio. For other less obvious assets or expenses, we leave it up to the user to determine how risky a certain asset/investment is or how essential a certain expense item is.
- What if I disagree with a default assumption or otherwise want to change an assumption to stress test what the effect would be of an alternative assumption on my Funded Status?
The process for overriding default assumptions is described in the spreadsheet. You must use the specified process. Otherwise, you may mess up the spreadsheet and you may have to download a new spreadsheet and start over again.
- What if the present value of my floor portfolio assets is less than the present value of my essential expense liabilities?
As discussed above, we encourage our readers to fully fund their floor portfolio by matching the present value of their essential expenses with the present value of their non-risky investments/assets. If your floor portfolio is not fully funded, you can consider one of the following actions:
- Transferring assets from the Upside Portfolio and investing them in non-risky investments
- Reclassifying some of your essential expenses as discretionary, or
- Ignoring our suggestion completely or partially
We are not investment or financial advisors. We are actuaries who believe that the problem of decumulating assets in retirement is a classic actuarial problem that can be solved by applying basic actuarial principles, similar to the principles used to fund other financial systems such as Social Security and pension plans.
