A lot of retirement experts get pretty excited about what is commonly referred to in discussions about spending in retirement as “sequence of returns risk.” This risk is generally the negative impact on retirement portfolios associated with spending during periods of poor investment performance. Frequently the experts will focus on the period just after retirement when they claim this risk is highest. For example, in his recent Forbes articles “Navigating One of the Greatest Risks of Retirement Income Planning” and Evaluating the Impact of Sequence Risk on Retirement Income”, Dr. Wade Pfau states, “Even with the same average returns over a long period of time, retiring at the start of a bear market is very dangerous; wealth can be rapidly depleted as withdrawals are made from a diminishing portfolio, leaving little money to benefit from a subsequent market recovery”; “if negative returns are experienced when you start spending from your portfolio, you will face an insurmountable hurdle that cannot be overcome even if the market offers higher returns later in retirement” and “In the withdrawal phase of retirement, the specific sequence of market returns matters a great deal.”
I agree that the sequence of returns matters. I’m not so sure that it matters more when you have just retired vs. when you have been retired for quite a while, but the point of this post is to show you that sequence of return risk can be mitigated by decreasing spending during unfavorable return periods. Since the Actuarial Approach recommended in this website encourages retirees to annually determine a spending budget that matches their assets to their liabilities on a “mark to market” basis, it automatically adjusts spending budgets to mitigate or reduce sequence of returns risk.
Let’s look at a simple example to illustrate this point. Throughout this example, I will be using the five-year projection tab of the Actuarial Budget Calculator spreadsheet from this website. This tab allows the user to vary future investment returns and actual spending to see the effect on retiree assets and future spending budgets. We are going to look at a 65-year old retiree with an annual Social Security benefit of $20,000 and $500,000 of accumulated savings, no bequest motive and a desire to have future spending budgets increase with inflation. For simplicity sake, we are going to look at our example retiree’s spending budget as a whole and not separate it into different budgets by expense type as we would normally recommend.
If we enter the sample retiree’s data and recommended assumptions into the “input” tab of the spreadsheet, we develop a first year spending budget under the Actuarial Approach of $41,751 ($20,000 from Social Security and $21,751 from accumulated savings). The “run-out” and “inflation-adjusted run-out” tabs of the spreadsheet are based on the assumption that the 4.5% investment return that we entered in the input tab will be exactly realized each future year. As discussed in prior posts, this is clearly not a realistic assumption about the future, but we include these tabs simply to show that the math works. These tabs show that if the retiree earns 4.5% each year on his assets and all the other assumptions are realized, his real dollar spending budget will remain at $41,751 each year and his accumulated savings at after five years at age 70 is expected to be $492,651 in nominal dollars ($435,432 in inflation-adjusted dollars).
With this example retiree as background, we are going to shift to the 5-year projection tab and model a different sequence of returns to see how real spending amounts and assets remaining after the five-year projection period are affected. Instead of assuming constant 4.5% investment returns, we are going to assume the following sequence of returns: -25%, -5%, 10%, 20% and 32.5%. The geometric average of this sequence of returns is approximately 4.5% per annum. So, if you had invested one dollar at the beginning of the 5-year period and didn’t make any withdrawals, you would have approximately the same amount of money ($1.246) at the end of 5 years under either the constant 4.5% return sequence or this alternative sequence.
Now we will look at the impact on spending budgets and assets at the end of the five-year projection period of using different spending approaches. The four different spending approaches considered are: the Actuarial Approach without Smoothing, the Actuarial Approach with Smoothing, the 4% Rule and the Guyton Decision Rules starting with a 5.5% withdrawal rate. The Actuarial Approach without smoothing is just application of the approach recommended in this website without any smoothing of the budget or spending amount. The Actuarial Approach with Smoothing applies the following smoothing algorithm: Increase the prior year’s budget amount by inflation but the result must fall within 10% of this year’s calculated budget using the Actuarial Approach. The 4% Rule takes 4% of the initial year’s accumulated savings and adds that year’s Social Security benefit. Each year thereafter, the initial year’s amount withdrawn from savings is increased by inflation irrespective of investment return for that year. Under the Guyton Decision Rules (discussed more in our post of April 26, 2015), the amount withdrawn from savings is increased by inflation each year, but is reduced by 10% for a year in which the current year’s withdrawal rate is more than 20% higher than the initial withdrawal rate and increased by 10% for a year in which the current year’s withdrawal rate is less than 20% below the initial withdrawal rate. In this example, the initial withdrawal rate used was 5.5%.
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The graph shows that the 4% Rule produces the smoothest pattern of real dollar spending budgets for this particular example retiree. The Actuarial Approach without smoothing produces the most year to year variation in real dollar spending. The two smoothing approaches provide more smoothing of real dollar spending than the Actuarial Approach without Smoothing but less than the 4% Rule. At the end of fifth year, the Actuarial Approach without Smoothing has assets of $492,644. This amount is basically the same (off by rounding) as the assets expected ($492,651) under the 4.5% per year investment return run-out in nominal dollars. By comparison, the end of the fifth year assets under the Actuarial Approach with smoothing is $475,758; it is $463,848 under the 4% Rule and $445,657 under the Guyton Decision Rule starting at a 5.5% withdrawal rate. Thus, approaches that involve high initial withdrawal rates, like the Guyton Decision Rule in this example, or that don’t adjust spending, like the 4% Rule, are more sensitive to sequence of return risk. While the Actuarial Approach without smoothing produces the most year to year variation of real dollar spending budgets, its use completely mitigates the sequence of risk problem in this particular example.
As I have indicated in previous posts, you can either smooth your spending budget or you can smooth your actual spending. You can also spend more now and thereby increase the risk of having to spend less later. Smoothing your spending budget or front-loading your spending can increase your sequence of return risk. Reducing your spending after experiencing poor investment returns, as recommended under the Actuarial Approach with or without smoothing can reduce this risk. If you use a smoothing approach to develop your spending budget, I encourage you to annually monitor the spending called for under the approach you use with that called for under the Actuarial Approach to see how far off track you may have wandered.
This month, the Bipartisan Policy Center’s Commission on Retirement Security and Personal Savings issued a report entitled, “Securing Our Financial Future: Report of the Commission on Retirement Security and Personal Savings.” This report includes many policy recommendations designed to strengthen the retirement system in the U.S., and with one exception that I will discuss below, I believe the recommendations are very well thought-out. If you are interested in possible changes in Social Security and retirement related law in the U.S., I encourage you to read this report. The report’s recommendations are organized into six major areas:
I. Improve Access to Workplace Retirement Savings Plans
II. Promote Personal Savings for Short-Term Needs and Preserve Retirement Savings for Older Age
III. Facilitate Lifetime-Income Options to Reduce the Risk of Outliving Savings
IV. Facilitate the Use of Home Equity for Retirement Consumption
V. Improve Financial Capability Among All Americans
VI. Strengthen Social Security’s Finances and Modernize the Program
By far the most controversial recommendations to strengthen our retirement system are the ones regarding Social Security. According to the report, long-term solvency is achieved under their proposal by increasing system revenues by about 53% and by decreasing scheduled net benefits (there are some proposed increases) by 47%. The Commission notes that their proposed package of changes would not only solve the 75-year actuarial deficit, but it would also result in “sustainable solvency” as that term is defined by the Social Security actuary.
The only real bone I have to pick with the Commission’s conclusions with respect to Social Security’s long-term solvency is that these conclusions are valid only if the 2015 Trustees assumptions are exactly realized (or are more favorable) and not changed over the next 75 years. For example, the Commission proudly announces that, “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…” The commission neglects to point out that these statements are conditioned on the accuracy of the assumptions made for the 75-year period. And since very few people can accurately predict the future (not even actuaries), it would seem imprudent to assume that assumptions made in 2015 will be accurate for 75 years or longer. After all, even though the assumptions made in 1983 weren’t horribly inaccurate, they were still wrong to some degree, and we now find ourselves facing the very significant changes recommended by the Commission earlier than predicted in 1983. No sound “actuarial” process involves making assumptions for 75 years without anticipating making periodic adjustments in future years. The current approach just isn’t sustainable.
As I said in my post of May 17, 2016, “There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities. Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits…, or because of changes in assumptions, experience losses or gains, or from other sources. Unfortunately, the Commission does not address this problem in their recommendations, so instead of achieving their goal of providing predictable Social Security benefits that workers can plan on, workers relying on Social Security could once again in the near future find themselves in a position similar to Charlie Brown trying to kick a football being held by Lucy van Pelt.
As I have said in previous posts on Social Security financing, we just need to look at what Canada did with their Canada Pension Plan for an example of how to use sound actuarial principles to provide “Self-Sustaining Sustainable Solvency.”
The Society of Actuaries has published an article authored by me in its May/June issue of the Pension Section News. The article is entitled, “Using Sound Actuarial Principles to Better Manage Retirement Finances.” In this article I make a case for why I believe the actuarial profession should take a more active role in helping retirees and near retirees develop reasonable spending budgets.
The problem of determining how much to spend in retirement is a basic actuarial problem that requires an actuarial solution. A November, 2014 Survey of financial advisors by Russell Investments concluded that not enough financial advisors were using “math and science to develop spending budgets for their clients and should be periodically comparing the client’s assets with the client’s liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans.” This was a clear shout-out to the actuarial profession to step up its game and become part of the solution.
The public voice of the actuarial profession is the American Academy of Actuaries. The stated mission of this profession body is to serve the public and the United States actuarial profession. “Through its public policy work, [the Academy] seeks to address pressing issues that require or would benefit by the sound application of actuarial principles.” I suggest in the article that helping retirees and near retirees develop reasonable spending budgets is indeed a pressing issue for our country that would benefit significantly by the sound application of actuarial principles.
This post is a follow-up to my post of May 9, where I described all the adjustments to the 4% Rule recommended by Charles Schwab to make it work. And Schwab is not alone in this pursuit. There is no shortage of experts out there proposing adjustments to the 4% Rule to come up with what they believe is a better safe withdrawal rate approach. As indicated in my previous post, the Motley Fool suggested that perhaps instead of using the 4% Rule, you might want to use 3% or perhaps you may want to withdraw “more” than the spending called for under the 4% Rule after a good investment year and “less” after a poor investment year. In my June 24, 2015 post, I looked at Michael Kitces’ proposal to “ratchet up” spending under the 4% Rule by 10% whenever the retiree’s account balance exceeds more than 150% of the initial account balance. He further proposed that if the account balance continues to remain high thereafter, the retiree can continue to apply further increases every three years. He indicated that these spending increases can be “ratcheted” up without much concern about subsequent declines.
As readers of this blog know, I’m not a big fan of safe withdrawal rate (SWR) approaches. My most recent list of the disadvantages of SWR approaches is contained in my post of April 25, 2016. There are, however, two significant potential advantages of using a SWR when compared with a more dynamic approach such as the Actuarial Approach: simplicity and stability of withdrawals. Of course, if you implement all these recommended adjustments, these potential advantages quickly fade away.
Thanks once again to Martin from Maine for providing me with more grist for my blog mill. This time, he alerted me to yet another individual who believes that the 4% Rule needs to be adjusted to work properly. Rob Bennett has developed a “new school” of safe withdrawal rate analysis that adjusts the safe withdrawal rate to reflect market valuations at time of retirement. His website, PassionSaving.com, includes a safe withdrawal rate calculator that requires four input items: “(1) the [Shiller] P/E10 (valuation) level that applies at the start of the retirement; (2) the real return being paid on Treasury Inflation-Protected Securities (the non-stock investment class examined by the calculator); (3) the stock-allocation percentage; and (4) the percentage balance that the retiree desires at the end of 30 years.” For 80% stock allocation percentages, the safe withdrawal rates developed by Mr. Bennett’s calculator vary dramatically depending on the inputted P/E10 level. Using the default assumptions, for example, the safe withdrawal rate (95% probability of not-running out of assets over 30 years and no desired legacy assets) varies from 9.13% for an initial P/E10 ratio of 8 to 2.02% for an initial P/E10 ratio of 44.
Mr. Bennett’s “new school” differs from the “old school” in that current market expectations are expected to affect future investment experience rather than old school techniques that project future experience based on historical results without regard for current market conditions. Mr. Bennett’s default results for Scenario 3 (P/E10 of 26, which is approximately the current level) are not much different from results obtained by Blanchett, Finke and Pfau in their article, Retiring in a Low-Return Environment, which used similar concepts to account for current market conditions (Mr. Bennett’s calculator produces somewhat higher safe withdrawal rates).
If I had to use a SWR approach, I might consider the results of Mr. Bennett’s calculator as another data point to use in my selection process. Fortunately, I am not required to use a SWR approach, and I will stick with the Actuarial Approach, which I believe to be a much sounder approach. And, as I have indicated many times in prior posts, the Actuarial Approach produces a spending budget for the year; it does not tell you how much you must spend. If you are bothered by the potential volatility associated with the Actuarial Approach, you can always smooth the results from year to year (or smooth your actual spending or reduce the expected volatility of your investments). If you insist on using a SWR approach, you can still use the Actuarial Approach to see how far off track you may have strayed. But, of course if you do this, you are adding yet another layer of complication to all those adjustments the experts want you to make to the “simple” 4% Rule.
Frequently we see advice from “experts” regarding how much of your nest egg you should withdraw each year. For example, a recent Motley Fool article, “Forget the 4% Rule: Here’s a Better Way to Approach Your Savings” tells us that the 4% Rule may not actually be all that bad as a rough guide but you need to be flexible in its application. Like most rules of thumb (Rot) approaches, the 4% Rule (or even a more flexible version of the 4% Rule) is a methodology used to “tap” one’s retirement savings and is generally not part of a strategic plan to meet a retiree’s financial objectives in retirement. Since the typical Rot approach doesn’t even consider a retiree’s specific circumstances or specific financial goals, it is unlikely to have a high probability of successfully achieving such goals.
In his most recent blogposts on May 17th and May 27th, Dirk Cotton encourages retirees and their financial advisors to use strategic planning processes similar to those used in business to develop retirement plans for individual retiree households. As part of his recommended process, Dirk advocates that the retiree household adopt a mission statement, whose purpose is “to identify their strategic objectives [or goals], or those things that, at retirement's end, they would need to have achieved in order to consider their retirement to have been successful.” According to Dirk, “The challenge of retirement planning is to find a strategy (and there may be several) that meets the desires of our mission statement but also falls within the limits imposed on us by the economy and our household’s resources.” I encourage you to read Dirk’s recent posts.
The Actuarial Approach advocated in this website can help financial advisors and retirees refine their strategic goals by indicating which goals are financially “possible” [fall within the limits imposed by household resources]. For example, a household may desire to leave a significant legacy to heirs but they may have insufficient assets at this time to fund expected future essential expenses. The “Budget by Expense” tab of the Actuarial Budget Calculator can help the household plan how they will spend their assets (if all current assumptions about the future are realized) enabling them to determine which strategic goals are most important to them. The calculator can also help the household make decisions about how much risk to assume for certain types of future expenses, how their home equity should be spent, etc. The Actuarial Approach also provides a reasonable measure of whether the household is progressing satisfactorily toward the achievement of the goals selected (or to revise goals in the future). Unless your goal is to simply not run out of your savings, adoption of a Rot approach is not likely to be as successful at achieving your strategic goals.
Many individuals who are retired take a part-time job to supplement their income in retirement. Frequently, these retirees believe that this income can increase their annual retirement spending budget by the net amount received during the year from such employment (wages minus increase taxes and increased employment-related expenses). This post will encourage retirees who work to possibly consider taking a longer-term “actuarial” perspective by spreading the present value of this extra income over their remaining period of retirement.
Let’s look at an example of how this may work. John is age 65 with an annual Social Security benefit of $20,000 and accumulated savings of $525,000. He estimates his essential non-health expenses (including taxes) are currently about $36,000 this year, and he expects these expenses to increase with inflation in the future. He estimates that his essential health expenses are currently $6,000 this year and will increase by inflation plus 2% in the future. He believes that the equity in his home will cover his long-term care expenses (or will be used for his bequest motives), and he would like to have an emergency fund budget of $25,000. The rest of his assets will be used for non-essential expenses, which he plans to budget spending at about the same amount each year of his retirement without any assumed future increases due to inflation (essentially decreasing in the future in real dollar terms).
John goes to the Input page of the Actuarial Budget Calculator V 1.1 and inputs his Social Security benefit and accumulated savings as well as the recommended assumptions (and no bequest motive). He sees that the present value of his current and expected future retirement income is $984,747. He then goes to the “Budget by Expense-type” tab of the spreadsheet and enters “0” for long-term care expenses, $25,000 for the present value of unexpected expenses, $36,000 increasing by 2.5% for essential health expenses and $6,000 increasing by 4.5% for essential health expenses. At this point, John sees that his assets (the present value of his future spending budgets) are insufficient to provide for these three items, let alone provide for any non-essential expenses. In fact, it looks like he has to reduce his budget for unexpected expenses by $1,823 to develop a $40,000 per year spending budget (excluding unexpected expenses) under these assumptions with a $0 budget for non-essential expenses.
John decides that he could use some more money in retirement and he also would like to get out of the house a little anyway. He decides to take a part-time job that will pay him $1,000 per month. After taxes and employment-related expenses, John figures that this job will net him about $700 per month in extra income, or about $8,400 per year. John’s initial thought is that this job will be enable him to increase his unexpected expenses budget to $25,000 and increase his non-essential expense budget by almost $8,400 per year.
But, after John gives this a little more thought, he concludes that he really doesn’t want to do this part-time job for more than 5 years. So if he spends all of the extra net income from the part-time job each year, he will have a significant drop in his spending budget once his part-time employment is terminated. Instead of simply adding his expected net income from employment to his budget, John decides to treat the expected net income as another retirement income source like Social Security or his accumulated savings. He goes to the present value calculator in this website and determines that the present value of $8,400 starting 0.5 years from now and payable for 5 years is $37,696. He goes back to the input page of the Actuarial Budget Calculator and inputs this amount as the present value of other sources of income. This increases the present value of his future spending budgets to $1,022,443 and enables John to establish his $25,000 unexpected expenses budget and increases the present value of his non-essential expense budget to $35,873. If he decides to spread this present value over his expected retirement period with no future increases, it will provide him with a first year non-essential expense budget of $2,107 and a total spending budget of $42,107 (excluding unexpected expenses). When he determines his spending budget for next year, John will input the present value of 4 years of part-time work assuming he still believes he will only work until age 70. Using this alternative approach, John hopes to avoid the significant a decrease in his spending budget when his part-time employment is terminated. In effect, he is saving some of his part-time income for his future retirement years.
As I have said many times in this blog, developing a reasonable spending budget in retirement is part science and part art. John can annually spend anywhere from an extra $2,107 to $8,400 as a result of his part time employment. He has to decide the spending level that is most consistent with his objectives in retirement. The Actuarial Budget Calculator and this website give him the tools to make a more informed decision.
This is a follow-up to several of my prior posts on Social Security’s financial problems, with the most recent being on November 5th of last year. The inspiration for this post comes from an article entitled, Understanding Social Security’s Long-Term Fiscal Outlook, by Steve Goss, Chief Actuary, U.S. Social Security Administration. In his article, Steve states, “The Social Security program faces a substantial financing challenge for the future, largely due to demographic changes that have been long known and understood.” Steve also indicates that, “Remedying OASDI’s [Social Security’s] fiscal shortfall for 2034 and beyond will require a roughly 25 percent reduction in the scheduled cost of the program, a 33 percent increase in scheduled tax revenue or a combination of these changes.” So, why are we facing this “substantial financing challenge” when the 1983 Amendments to the program promised system solvency for the foreseeable future?
Well, ok, while some media sources in 1983 indicated that the 1983 Amendments promised system solvency for the foreseeable future, it is more accurate to say that the 1983 Amendments brought the system into “long-term (or “long-range”) Actuarial Balance.” Like the actuarial measurement of assets and liabilities recommended for retirees in this website, Social Security’s actuarial balance measurements compare system assets (including the present value of future revenues) with system liabilities based on assumptions made about the future and are recalculated annually based on actual data and possibly revised assumptions. Unfortunately, Social Security’s long-term actuarial balance measurement is limited to 75 years, and the significant deficits expected after the end of the 75-year projection period in the 1983 measurement (that of would of course emerge in subsequent years’ measurements) were ignored. So, the 1983 Amendments anticipated accumulation of large amounts of Trust Fund reserves during the first half of the 75-year projection period that would be expected to be used to fund tax-rate revenue shortfalls during the last half of this period, with reserves ultimately to be exhausted around 2060 if all assumptions about the future were realized. After 2060, however, significant tax increases were expected to be required to pay scheduled benefits.
So what is the big deal? As Steve indicates in his article, these demographic problems have been long known and understood (well before 1983). The actuaries thus knew that the 1983 Amendments were a “kick-some-of-the-problem-down-the-road” solution. So, instead of the problem occurring as expected around 2060, we are now looking at possibly 2034 as the “fall-off-the-cliff-date” because actual experience after 1983 wasn’t quite as favorable as assumed back then and the actuaries changed some assumptions to reflect this less than favorable experience. Not to worry, however, because according to Steve, “Whenever the reserves begin to decline and approach depletion, Congress must act to make timely adjustments. Such adjustments to tax rates and scheduled benefit levels always have been made throughout the 80-year history of the program.”
Steve points out that the 1983 Amendments, “substantially improved the financial status of the program for decades into the future.” You will get no argument from me on this statement. And while reducing the 75-year actuarial deficit to zero (as was done in the 1983 Amendments) is a reasonable first step, there are two problems with any proposed reform options that simply reduce Social Security’s 75-year actuarial deficit to zero:
- Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period. Over time, these deficits will emerge in the actuary’s annual calculations.
- There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities. Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources.
Both of these problems can be addressed through the use of traditional actuarial principles that automatically adjust the program’s tax rate to maintain the system’s actuarial balance in future years.
Some may legitimately question the wisdom of a long-term financing solution that is not expected to be sustainable in the long-run. On the other hand, there are those who argue that it is beneficial for Social Security to actually have to go through a “challenging” periodic process of re-evaluation rather than operate on an automatic basis similar to the actuarial approach used for the Canada Pension Plan.
Social Security’s financial problem is an actuarial problem that requires an actuarial solution. However, as discussed in my November 5 post, the public voice for the U.S. actuarial profession, the American Academy of Actuaries, appears to be sending out mixed messages on this topic. While it’s 2015 public policy white paper, Sustainability in American Financial Security Programs, touts the benefits of sustainability and states the profession’s commitment “to working toward solutions that help restore confidence in and enhance the sustainability of these important programs,” the Academy’s Social Security Game congratulates players for fixing Social Security by adopting the same type of 75-year “kick-some-of-the-problem-down-the-road” solutions adopted in the 1983 Amendments.
And so, how will Social Security’s latest “financial challenge” be addressed? In addition to questions of when the “solution” will be effective, who will be effected by the solution and by how much, you can add the important question of how long will it be after the solution is adopted before we (or our children) can expect to address the program’s financial problems once again.
Charles Schwab recently released their guidance regarding how much a retiree can spend each year entitled, “Retirement Spending: How Much Can You Afford?” The authors state, “The 4% rule is a simple rule of thumb, but needs adjustment to fit current market conditions and your situation.” The adjustments to the 4% Rule recommended by the authors include:
- Adjustments to reflect your investment allocation
- Adjustments to reflect your selected confidence level of not running out of money
- Adjustments to reflect your planned time horizon, and
- Possibly annual adjustments to reflect changes in future conditions
The authors provide a chart of recommended withdrawal rates based on time horizons, allocations and confidence levels. The interesting result of this chart to me is that differences in withdrawal rates resulting from different combinations of asset allocations confidence levels are much smaller than differences resulting from different time horizons. In fact, I would say that for most combinations of asset allocations and confidence levels, the differences are almost negligible for the same time horizon.
How different are these withdrawal rates from comparable rates developed using the Actuarial Approach? Not very. If we are looking at a retiree with only accumulated savings and a Social Security benefit that is currently payable, the withdrawal rates determined using recommended assumptions under the Actuarial Approach are 4.35% for a 30-year period of retirement, 5.97% for a 20-year period and 10.89% for a 10-year period, or very similar to the rates shown in Schwab’s chart above for confidence levels somewhere between 90% and 75%.
The authors suggest that retirees annually revisit their spending plan, “and increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.” So retirees have a choice in the future between increasing last year’s spending by inflation or recalculating a new withdrawal rate based on the chart above (using interpolation methods if necessary). This is very similar to the Actuarial Approach, where you essentially have the same choice (to use the actuarially calculated withdrawal or a smoothed value).
So, I believe the Schwab approach can probably produce a reasonable spending budget for a certain type of retiree. That type of retiree:
- Has already set aside separate reserves for long-term care costs (or has sufficient insurance), emergency expenses, and legacy costs
- Has no other sources of income, such as fixed dollar pensions, annuities, deferred annuities or deferred Social Security benefits.
If a retiree does not fit this criteria, then that retiree will have to make additional adjustments to the Schwab approach to develop a reasonable spending budget. Of course, rather than making all these adjustments to the 4% Rule, the retiree could simply use the Actuarial Approach.
One final note on the Schwab article. It strongly implies that since the life expectancy of a 65-year old male or female is currently much less than 30 years, the 30-year retirement horizon used to develop the 4% Rule may not be appropriate for time horizons for many retirees. I encourage retirees not to use current life expectancy to develop a retirement horizon as 50% of all individuals are expected to live past their life expectancy. See my last post for guidance on selecting retirement horizons.
This week the American Academy of Actuaries and the Society of Actuaries jointly released the Actuaries Longevity Illustrator, an online tool designed to illustrate the potential range of future lifetime based on input of four factors: age, gender, whether or not you smoke and your general health. The tool designers claim that these four factors have been shown to be reasonable predictors of a person’s longevity. The results are based on the 2010 Social Security Administration mortality table, with future mortality improvement projected using the Society of Actuaries’ MP-2015 scale. We will be adding a link to this tool in our “other calculators and tools” section.
With one exception, I found the tool very easy to use and potentially helpful for determining the “expected payout period” input item for the Actuarial Budget Calculator in this website. The one exception is the input item called “illustration age.” Most (or all) of the time, you are going to want to leave that box blank, which was not particularly intuitive to me.
The chart in the results section that I found most helpful was the “Planning Horizon” chart. This chart shows probabilities of living “x” more years. The 50% probability is your life expectancy under the assumptions used in the model. As I have discussed in previous posts (see for example my post of December 3, 2014), if you use your life expectancy as your expected payout period, your spending budget will decrease as you age, all other factors being equal. That is why I have recommended assuming death occurs at age 95, or life expectancy if greater. Therefore, I recommend that retirees focus on the 25% probability of living “x” years in this chart when determining a spending budget. If you do this and enter “no smoking” and “excellent health,” the tool will generally produce a 25% probability of living past age 94 for males and 96 for females unless you are over age 80. This result is very similar to my recommendation of using age 95 or life expectancy if greater for the expected payout period in my spreadsheet.
Being an actuary, I found it interesting that inputting different general health assumptions had less of an effect on longevity than whether or not someone was a smoker. For example, a non-smoking, average health 65-year old male had a life expectancy of 20 years and a 25% probability of living 27 years, while if he smoked, his life expectancy was 13 years and he had a 25% probability of living 20 years. The smoker/non-smoker difference (7 years for males at age 65) was less for females (6/5 years). General health variations were typically 2 years for each health category at age 65.
What does this tool (and others like it) tell us? Generally, these tools confirm that we don’t know when we are going to die and that makes planning more difficult. Based on average statistics, there can be a fairly wide range of results. And the assumption we make today may change tomorrow. The expected period of retirement you choose for planning purposes will likely depend on many factors, such as results from this tool, your knowledge about family health history, your race, your income level, where you live, your personal eating and drinking habits, your smoking habits and most importantly, your risk tolerance for having to reduce your spending budget (or parts of it) if you live longer than you expect. My recommendation to use age 95, or life expectancy if greater is a relatively conservative assumption that is consistent with enjoying excellent health, not smoking and not desiring decreasing real spending budgets until reaching your late 80s. Using a less conservative assumption (fewer years of expected retirement) will increase your current spending budget and increase your risk of decreasing budgets later in life, all things being equal. On the other hand, if you have solid information that indicates your life expectancy is less than average, it makes sense to factor this knowledge into your planning calculations. For example, if you are a smoker, you may want to consider using fewer retirement years to determine your spending budget. I don’t recommend, however, that you take up smoking just to increase your current spending budget.
In three recent posts in The Retirement Cafe, Dirk Cotton, winner of the 2015 RIIA Practitioner Thought Leadership Award, has developed a “top-level” model for Retirement Planning. In his third installment Dirk, who likes to use game theory in explaining his concepts, said “Retirement finance is a random walk along a Markov chain, or to a game theorist, a sequential game against nature. Each year we make forecasts based on what we know (our current financial status and the financial environment), what we expect to happen in the future, and what unexpected outcomes we believe we might experience in the future (risks). We make our move based on this analysis and our risk tolerance. Then nature takes its turn and we repeat.” I recommend reading all three of Dirk’s posts for a different (and eloquent) description of the complicated problem with which most of us retirees must struggle in order to meet our financial goals in retirement.
I believe the Actuarial Approach (and its annual valuation, or “discrete-time states” process) is entirely consistent with the top-level conceptual model developed by Mr. Cotton and provides very useful tools to help retirees win the “retirement finance game.”
