This post is a follow-up to several of my recent posts on Social Security financing. It is a call to my profession to fulfill its mission and vision by advocating adoption of a basic actuarial principle for Social Security: ensuring sustainability of the program through automatic maintenance of the actuarial balance between expected system assets and liabilities on a going-forward basis.
Background
The American Academy of Actuaries is the public voice of the actuarial profession on public policy issues. In its June, 2016 Issue Brief, An Actuarial Perspective on the 2016 Social Security Trustees Report, the Social Security committee of the Academy said, “The Social Security Committee believes that any modification to the Social Security system should include sustainable solvency as a primary goal.” The issue brief goes on to define this term as follows:
“Sustainable solvency means the program is not expected to deplete reserves any time in the 75-year projection period, and trust fund ratios are expected to finish the 75-year projection period on a stable or upward trend.” This is essentially the same definition used by the Social Security actuaries, who are a little more precise and talk about Sustainable Solvency “under a given set of assumptions.” This is an important distinction because sustainable solvency depends to a significant degree on exact realization of assumptions made about the next 75 years.
The concept of Sustainable Solvency was developed by the Social Security actuaries to address the problem of unrecognized deficits after the end of the 75-year projection period. This concept did not exist at the time of the 1983 amendments, as discussed on our post of May 17, 2016, “What went wrong with the 1983 Social Security Fix?” when Congress supposedly “solved” the program’s financial problems for the next 75-years by reducing the 75-year actuarial deficit in existence at that time to zero. Note, however, that with the additional requirement with respect to the trend at the end of the 75-year projection period, Sustainable Solvency is essentially the same as the 75-year actuarial balance requirement used in the 1983 Amendments.
As part of the annual Trustee’s report, the Social Security actuaries perform an actuarial valuation of the program by comparing program assets with program liabilities under various sets of assumptions about the future. The most publicized results of these actuarial valuations are the expected trust fund exhaustion date and the 75-year actuarial deficit under the Intermediate (or best estimate) assumptions. For many years now the Trustees and the actuarial profession has been using the results of these valuations to encourage Congress to act sooner rather than later to bring the program back into actuarial balance under the Intermediate set of assumptions. For example, the Academy’s most recent Issue Brief said, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.”
When reform proposals are now submitted to the Social Security actuaries for scoring, the Social Security actuaries determine whether such proposals meet the requirements for Sustainable Solvency based on the Intermediate assumptions used in the most recent Trustee’s Report. For example, as discussed in our post of June 16, 2016, The Bipartisan Policy Center’s Commission on Retirement Security and Personal Savings Report got very excited when the Social Security Actuaries indicated that their Social Security proposals met the requirements for Sustainable Solvency. Their report erroneously concluded “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…” These statements were erroneous because they were based on the premise that all of the Intermediate assumptions used in the 2015 OASDI Trustees report would be exactly realized in the future, which we know won’t occur.
As discussed in our post of June 16, it is foolish to believe that assumptions made by Social Security actuaries today will be accurate over the next 75 years, so a claim of Sustainable Solvency is shaky at best and potentially misleading. No sound actuarial process proclaims solvency for a period of 75 years without anticipating making periodic adjustments in future years as experience emerges.
Truly Sustainable Solution
The common sense solution to providing true Social Security sustainability is to require that the system automatically be placed in actuarial balance on a periodic basis in the future, as is the case for all sound actuarial processes. For example, current law could be changed to require the program’s tax rate be automatically changed effective for the year following an actuarial valuation that shows the program has fallen out of actuarial balance by 5% or more. Congress could, of course, take other actions to bring the program back into actuarial balance rather than have the automatic tax rate increase (or decrease) take effect.
As an example of how this automatic process might work, let’s look back at the 1983 Amendments, which were supposed to fix the system for 75 years. In 1989 (which by the way, was just 6 years after the 1983 Amendments), the system went out of long-term actuarial balance (as that term was defined at the time using a 5% threshold). If the proposed automatic adjustment had been in place at the time, a small tax increase would have been required to bring the program back into actuarial balance. Additional tax increases would also have been required in subsequent years, unless Congress took other actions. If no benefit reductions were adopted during this period, today we would have a higher tax rate but no impending significant reductions to consider.
Reasons Why the Profession Should Endorse this Solution
Here are some of the reasons why the actuarial profession should advocate in favor of this solution:
- The solution is consistent with the expressed mission statement of the American Academy of Actuaries “to serve the public and the United States actuarial profession.”
- It is consistent with the Academy’s vision statement that “financial systems in the United States be sound and sustainable…”
- According to the Academy’s 2015 Public White Paper, Sustainability in American Financial Security Programs, “The American public relies on the promises made under many different financial security programs—whether they are public programs like Social Security and Medicare or offered through the private sector such as employer-sponsored pension plans or insurance products. The public must have confidence that these programs can be sustained and continue to meet their goals.” I believe adoption of the proposed solution would increase public confidence in the system.
- The proposed solution is consistent with the Academy’s Social Insurance Committee’s belief that, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.” Clearly, frequent automatic adjustments would involve earlier implementation and would be less disruptive than infrequent, more disruptive reforms.
- The proposed solution is consistent with the Academy’s public policy objective “to address pressing issues that require or would benefit by the sound application of actuarial principles.” If current law already provided for such automatic adjustments, I can’t imagine that the profession would support legislation to eliminate them. So, why the reluctance to endorse them?
- Endorsement of this solution is an opportunity to enhance the profession’s public image. Conversely, failure to endorse this solution increases the possibility of damaging the profession’s reputation. The reputational risk involved with Social Security financing may be even greater than the risk associated with performing actuarial valuations for public pension plans.
Conclusion
Sustainable solvency as defined by the profession and Social Security actuaries is a misnomer and is potentially misleading. It is based on exact realization of assumptions made for the next 75 years that will not come true. True system sustainability can be achieved through periodic adjustments to maintain the system’s actuarial balance as actual experience emerges.
The 1983 Amendments failed to provide us with system sustainability, and we are looking at significant reform proposals as a result. This time around, however, the changes should result in a more sustainable program on which the American public can truly depend. It is time for us to remember the old proverb, “fool me once, shame on you; fool me twice, shame on me.” We shouldn’t just accept a reform “fix” that is similar to the “fix” adopted in 1983. For this reason, I call on the actuarial profession to step up its game and advocate true system sustainability through automatic periodic adjustments to keep the program in actuarial balance on a going forward basis.
In his most recent CBS MoneyWatch article, my friend and fellow actuary Steve Vernon reminds us that home rich/cash poor Americans can use their home equity to fund their retirement. He discusses various ways this can be done, including downsizing and reverse home mortgages. He concludes his article by saying, “It's simply common sense to carefully consider how to deploy all the retirement assets you own.” Well, thank you very much, Steve, because careful consideration of how to deploy all the retirement assets you own is what the Actuarial Approach for developing a reasonable spending budget is all about.
The basic concept of the Actuarial Budget Calculator spreadsheet provided in this website is to match your retirement assets (including the present value of future Social Security benefits, pension benefits and future sales of other assets) with the present value of your future spending budgets and the present value of your bequest motive (called Desired Amount of Savings Remaining at Death in our spreadsheet). And don’t be frightened by the fact that the calculations involve present values; our Actuarial Budget Calculator spreadsheet does them for you.
Before I give an example of how you can use the Actuarial Budget Calculator spreadsheet to “deploy” your home equity, I would like to, once again,point out that even though it may be common sense to deploy all your assets to meet your retirement spending objectives, you generally won’t find much discussion of how to accomplish this with rule of thumb withdrawal approaches such as the 4% Rule or other safe withdrawal rate approaches. What you do hear with those approaches is something like, “trust us, based on complicated Monte Carlo modeling, if you invest your accumulated savings at least 50% in equities, you will have a 95% chance of not running out of money.” On the other hand, with the Actuarial Approach, you develop a reasonable spending budget based on your best estimates of future experience and your financial situation.
Recently one of my readers wanted to know how to determine a reasonable spending budget during a period of time prior to commencing his Social Security benefit recognizing, that he had a fair amount of equity in his home in addition to a fair amount of more liquid accumulated savings. I’m going to change his fact situation somewhat for simplicity sake. Let’s assume that
“David” is age 65,
no longer working,
has $500,000 of liquid accumulated assets,
$400,000 of equity in his home, and
he projects his Social Security benefit will be $30,000 per year when he commences it at age 70 (in 5 years).
David believes that, in about 15 years, he will downsize his house to a condominium and,at that time, he will be able to pull out about 50% of his equity. He wants to use what he can pull out when he downsizes to increase his current spending budget. David wants to use the remaining 50% of his equity for long-term care costs when he no longer can live by himself in his condominium. Thus, David estimates the present value of the equity he will be able to pull out of his current home when he downsizes to a condominium at $200,000 (half of the $400,000 of equity in his home). David assumes that his home equity will increase by 4.5% per year, the same assumption he makes for investment return on his more liquid accumulated savings.
Using the Actuarial Budget Calculator, David enters
$500,000 in accumulated savings,
$30,000 in Social Security benefits commencing in 5 years,
$200,000 as the present value of other sources of income and
the recommended assumptions (4.5% investment return, 2.5% inflation and 30- year retirement period).
He has no bequest motive.
Since we are going to use the Budget by Expense tab and look at the components of David's spending budget, we don't need to make an assumption about the desired increase in David's total spending budget in the input tab.
The present value of David’s retirement assets under these input items and assumptions is $1,181,925 (plus the 50% remaining equity that is assumed to cover David’s long-term care costs).
David assumes:
$50,000 for the present value of unexpected expenses,
$35,000 increasing with inflation for essential non-health expenses and
$7,000 increasing with inflation plus 2% for essential health costs.
He then goes to the Budget by Expense-type Tab of the spreadsheet and budgets
$0 for long-term care costs (because they are to be covered by his condominium equity), and the three assumptions above.
This leaves him with $117,367 for the present value of his non-essential expenses, which he decides to spread over his expected retirement as the same constant dollar per year, giving him a current year non-essential spending budget of $6,895 and a total current year spending budget of $48,895. Note that because he is not currently receiving Social Security benefits, this amount must come entirely from his liquid accumulated savings and represents about 9.8% of his current liquid assets.
While a 9.8% withdrawal from David’s liquid assets is relatively high, he knows that withdrawals from his liquid assets will decrease when he starts collecting his increased Social Security benefit and he also knows that if he runs low on his liquid assets, he can choose to downsize his home earlier than planned to take out some of his equity. He also knows that his situation will change each year and he will have to revisit his calculations annually to make necessary adjustments.
Had he been advised to use the 4% Rule, there is no telling what portion of his liquid accumulated savings David would have decided to spend. $20,000 (= .04 x $500,000)? $20,000 plus the amount of the Social Security benefit he could have received if he wasn’t deferring? Something more than this based on his knowledge that he has a fair amount of home equity?
With the Actuarial Approach, David has set aside money for long-term care, future unexpected expenses, future essential expenses and future non-essential expenses. This is the real benefit to David of doing a little number crunching rather than blindly relying on some rule of thumb approach.
Recent research has shown that some retirees may be underspending their assets in retirement. In their article, “Spending in Retirement: Determining the Consumption Gap”, Researchers Browning, Guo, Cheng and Finke noted, “retirees seem to spend much less than theory would predict. Rather than spending down savings during retirement, many studies have found that the value of retirees’ financial assets hold steady or even increase over time.” These researchers refer to this phenomenon as “the Consumption Gap.” The Society of Actuaries “2015 Risks and Process Survey” report that I discussed in my previous post noted a similar trend. In this post, I will outline how the Actuarial Approach discussed in this website can address this issue for retirees who may not be happy with their current spending levels.
With respect to this consumption gap, Browning et al speculate that “Fear, failure to plan, and a lack of confidence in pre-determined drawdown strategies may be significant contributors to the conservative consumption observed among retirees,” and “Feelings of inadequate preparation may shift retirees’ mindsets from decumulation to preservation.” Figure 1 of the Society of Actuaries’ report notes the following top five significant concerns expressed by surveyed retirees (percentage indicating very or somewhat concerned by the item).
- You might not have enough money to pay for a long stay in a nursing home or a long period of nursing home care at home (58%)
- The value of your savings and investments might not keep up with inflation (52%)
- There might come a time when you (and your spouse/partner) are incapable of managing your finances (48%)
- You might not have money to pay for adequate health care (47%)
- You might not be able to maintain a reasonable standard of living for the rest of your life (45%)
As I have previously said, the purpose of this blog is to help retirees (and their financial advisors) develop reasonable spending budgets. I’m not here to tell you how much you should actually spend each year. If you want to spend less than your actuarial spending budget each year and grow (or preserve) your assets in retirement, that is fine with me. If these are your goals in retirement, far be it for me to tell you that your goals are wrong.
If, on the other hand, your underspending in retirement is driven by the concerns/fears summarized in the Society of Actuaries survey above (or some other fears) and you would spend more if you were convinced you could afford to do so, then this is where the Actuarial Budget Calculator may be helpful to you. Unlike most rule of thumb asset withdrawal strategies (like the 4% Rule or other Safe Withdrawal Rate approaches) that are mathematically designed to have an x% probability of not running out of money over a given period of time as long as assets are invested in a certain manner, historical returns are achieved in the future and exactly $Y real dollars are withdrawn each year, the Actuarial Budget Calculator enables you to match your liabilities with your assets, using your best estimates of future experience (or conservative estimates if you prefer) regarding the economy, your investment returns, your expected period of retirement, your future essential and discretionary expenses, etc. Thus, rather than simply worry about whether you will have enough money to pay your expected long-term care costs, make reasonable assumptions about when and how much those costs might be and set aside funds today to cover those expected costs. We discussed how you might do this in our post of January 12th of this year. Similarly, you know that you will have unexpected future expenses that will not be covered by your annual x% withdrawal, such as home repairs or a new car. Don’t simply worry about how those expenses will be paid; make reasonable assumptions about when and how much these costs might be in the future and set aside funds today to cover these costs.
The Budget by Expense tab of the Actuarial Budget Calculator allows you to develop a comprehensive spending budget that can cover all your future expected and unexpected expenses as well as your desired bequest motive. You can be as conservative as you like in developing your total spending budget. And, as discussed in the last post, you can even set up a Rainy Day Fund to mitigate future investment losses. After making reasonable assumptions and developing a reasonable spending budget, you just might find that you can spend more today than you think. And even if you can’t increase your current spending, you might be able to increase it in the future if the assumptions you made about the future turn out to be too conservative. Unless your goals include growing your assets, you need to find the appropriate balance between spending too little and not spending enough. As we discussed in our post of October 12, 2015, it is important not to let fear unduly influence this task.
I agree with Browning et al when they specifically point to a lack of confidence in popular draw-down strategies as a significant contributor toward underspending by retirees. I also agree with the authors’ statement that, “Retirement income conversations may need to move away from sustainable withdrawal rates toward strategies that maximize spending for a given level of financial assets, while addressing client concerns about uncertainties.” This is exactly what you can do with the Actuarial Approach. It can provide you with the information and knowledge you need reduce your stress and help you get past these fears.
Inspiration for this post comes from an article by Joe Tomlinson in Advisor Perspectives entitled, “Retirement Planning and the Impact of Investment Market Performance” and a survey entitled, “The Society of Actuaries 2015 Risks and Process of Retirement Survey.” This post is also a follow-up to my previous post regarding using The Actuarial Approach to mitigate sequence of return risk and my post of June 27, 2015 entitled, “You Can Save During Retirement Too.” The primary focus of today’s post is to discuss the use of a Rainy Day Fund to reduce or mitigate year to year variations in spending budgets.
In his article, fellow actuary Joe Tomlinson uses Monte Carlo modeling to “stress” several different “withdrawal” strategies including the 4% Rule and “actuarial approaches” like the one I recommend in this blog. Joe’s models incorporate an average Equity Risk Premium assumption of 3% and T Bond returns of 0.5% to determine which withdrawal strategies are the most resilient in a “stressed” economic environment. Of course frequent readers of my site are well aware that I advocate development of reasonable spending budgets and specifically advise against using “withdrawal strategies” to “tap one’s savings.” Notwithstanding its emphasis on withdrawal strategies, Joe’s article is worth reading, and he reaches a number of interesting conclusions for budgeting during “stressed” economic conditions, including:
- “Although the 4% rule is widely used in retirement research, it is not well suited to real-world retirement planning.”
- “actuarial approaches” don’t reduce the average failure rate [based on Joe’s unique definition of failure discussed more below], but do reduce the average shortfall associated with failure. In addition, actuarial approaches increase average “consumption”, reduce average bequests but increase the volatility of consumption from year to year.
- Smoothing the actuarial approach can reduce volatility of consumption from year to year, but it does not reduce the average failure rate. On the other hand, using a relatively large portion of ones accumulated savings to purchase an annuity can significantly reduce both volatility of consumption from year to year and also avoid Joe’s definition of failure.
Like most retirement researchers using Monte Carlo modeling, Joe assumes that retirees will spend (or consume) exactly their spending budget every year. I call assumptions like this one “Monte Carlo reality” as opposed to “reality.” As a practical matter, retirees frequently spend what they want or need to spend during a year without regard to their spending budget (if in fact they have one). This brings us to the second item of inspiration for this post: the most recent Society of Actuaries survey. Unlike the theoretical Monte Carlo world, this survey attempts to capture what retirees actually do.
There is a lot of good material in this survey, but I am going to focus on the strategies that retirees are actually taking to manage risks in retirement as background for the discussion that follows. The survey results for this item are summarized in Figure 53 and for those already retired, the strategies with the highest percentage “already done or plan to do” include:
- Eliminate all your consumer debt (86%)
- Cut back on spending (76%)
- Try to save as much as you can (74%)
The strategies with the lowest percentages for retirees include:
- Work in retirement (30%)
- Buy a product or choose an employer plan option that will guarantee income for life (22%)
- Postpone taking Social Security (20%)
- Postpone retirement (12%)
Figure 59 shows that 85% of surveyed retirees would reduce expenditures significantly if they were running out of money due to unforeseen circumstances.
Figure 159 tells us that only 22% of surveyed retirees had a plan for spending down financial assets while the rest had no plan or planned to grow assets or maintain asset values in retirement.
Thus, the survey tells us that rather than buy annuities, most retirees are managing their risk in retirement by reducing their spending during poor economic times and saving some of their assets during good economic times.
Unlike failure under the 4% Rule (which requires actually running out of money), Joe defines failure under the actuarial approaches as any future year during which his sample couple’s annual spending budget drops below $70,000. This strikes me as an arbitrary measure of failure as the couple could simply spend more than their budget in such a year or they could transfer assets from funds earmarked for discretionary spending purposes. It is somewhat hard for me to believe that a couple with $1.5 million in assets and $40,000 in annual Social Security income is going to perceive a temporary spending budget less than $70,000 as being a failure. Rather than looking at this as failure, it seems to me that most retirees view a temporary reduction in their spending budget as simply the price to pay for investing in risky assets rather than buying an annuity.
Joe is right, however, that, all things being equal, an actuarial approach can produce a budget that is more volatile from year to year than the 4% Rule or other safe withdrawal rate approaches. Joe is also right that one way to dampen the budget volatility of an actuarial approach is to invest some of the assets that were invested in risky assets into less risky assets, such as annuities. I happen to like annuities and have written favorably in this blog about the potential advantages of combining annuities with investments. However, given their dismal endorsement in the SoA survey, it is clear that they are not everyone’s cup of tea. Fortunately, there are other ways to either smooth budgets or to smooth spending.
It is important to point out once again that budgets are not equal to actual spending, so when Joe says that “the tradeoff [of going to an actuarial approach] is that the year to year volatility of consumption increases significantly, he is not being 100% accurate. In Joe’s Monte Carlo reality where budgets equal spending equals consumption, this may be true, but in reality, either budgets or actual spending can be smoothed when investment returns are volatile. One approach, as mentioned by Joe in his article and by me in my previous post, is simply to smooth the budgets produced by the actuarial approach. Another approach, which I discussed in my post of June 27, 2015, is to set-up and use a “Rainy Day Fund” (RDF). Under this approach, investment gains (investment returns in excess of those expected based on the investment return assumption) are transferred to the RDF while investment losses (to the extent they are covered by the RDF) are transferred back to the fund used to determine the budget when needed. The RDF assets are ignored for budget determination purposes and are intended to be used during periods of poor investment performance, or to be used for other expenses when and if the RDF becomes too large.
To illustrate how the RDF can work, let’s use the same example we used in the previous post (a 65-year old retiree with $500,000 of accumulated savings, $20,000 annual Social Security benefits and a first year spending budget of $41,751), but with the following sequence of actual investment returns over the next five years: 10%, 0%, 20%, -5%, 4.5%. At the end of the first year, expected assets are $499,770, but actual assets are $526,074 (assuming the retiree spends exactly the budget amount for the year). Therefore, the retiree will transfer the investment gain of $26,304 from the budget fund to the RDF. Transferring this amount will keep the second year spending budget constant in real dollars at $41,751. Because of the less than expected investment return in the second year, the retiree will transfer assets back from the RDF to the budget fund to maintain the constant $41,751 real dollar budget and the RDF will drop to $4,817 as a result. The same process is used for subsequent years. The graph below compares spending budgets prepared by the Actuarial Approach with no smoothing with the Actuarial Approach utilizing the RDF approach. Amounts are shown in inflation adjusted dollars. At the end of the fifth year, the RDF would contain $31,934. Note that the gains and losses transferred back and forth from the RDF could also include gains and losses other than investment gains and losses and the annual gain/loss would be easily determined as the difference, if any, between actual end of year assets (including the RDF) and expected end of year assets shown in the Actuarial Budget Calculator run out tab. If the RDF falls to zero, then budgets would have to be reduced as discussed in the previous post.
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This graph shows that for certain investment sequences volatility in year to year spending budgets can be avoided through the use of the Actuarial Approach with an RDF. This can be important for those retirees who are concerned about such volatility but who may not want to spend significant amounts of their savings on annuity products to manage this risk. Alternatively, you can live with the volatility, spend what you want and simply use the Actuarial Approach with no smoothing to periodically justify adjustments in your spending.
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.
