How Much Do You Really Need to Save Each Year to Achieve Your Financial Goals?

Since its inception in 2010, this website has been primarily focused on helping retirees develop a spending budget in retirement.  We have advocated using several basic actuarial principles to do this.  The first basic actuarial principle involves matching your assets with your spending liabilities using this balance equation:

Accumulated savings

+

PV future income

=

PV expected non-recurring expenses

+

PV future spending budgets

A second basic actuarial principle is to revisit this calculation periodically (we recommend annually) to maintain the actuarial balance in the equation above.  Actuaries call this basic principle “annual actuarial valuations.”

Most of the calculations required to match one’s assets with one’s spending liabilities involve making assumptions about the future, and calculating PVs of streams of payments.  Our website includes a Present Value Calculator spreadsheet for this purpose, and the ABC spreadsheet that anticipates some of the more common PV calculations for individuals, and is thus designed to reduce much of the math burden for users.  When in doubt, however, it is always wise to go back to the basic principle embodied in the equation above.

While we have focused on helping retirees determine how much they can afford to spend in retirement, these same actuarial principles (including the asset/liability matching equation above) can be applied to the question of:

• how much a pre-retiree can afford to spend and 
• how much he or she should be saving in order to meet financial goals. 

This post will discuss how pre-retirees can use the new Pre-Retirement Spending Savings tab we have added to the ABC spreadsheet to develop a reasonable pre-retirement spending/savings budget.  An example of how to use our new tab will be included in a future post. 

How Much Do You Need to Save?

So, how much do you really need to save each year to achieve your financial goals?  Most “experts” recommend saving as much as possible or some rule of thumb percentage.  For example, a recent Nerdwallet study suggests that 22% of income may be the new retirement saving target for millennials.  Our advice is that it depends on many factors, including:

• Your financial goals 
• Your accumulated savings 
• Your other expected sources of income 
• How much your assets will earn, how long you will live, and the rate of future inflation and its impact on your expected future expenses 
• Other non-recurring expenses you may have 
• How long you want (or will be able) to work 
• Your capacity and willingness to save, etc.

The new Pre-Retirement Spending Savings tab in our revised ABC spreadsheet gives you the ability to model the impact, on your expected retirement spending budget, of variations in your assumed future savings rate, as well as variations in the items above.  If you are already retired, you can continue to use the ABC spreadsheet and simply ignore the new tab. 

How to Use the New Pre-Retirement Spending Savings Tab in the ABC

In order to determine how much of your current gross pay you can afford to spend while saving the remainder in order to accomplish your financial goals, we expanded the PVs in the equation above to cover both pre-retirement and post-retirement periods.  The ABC already considers post-retirement, so the new tab includes assets and liabilities for the pre-retirement period.

The first step in this process is to determine the PV Future (Retirement) Spending Budgets, by entering data into the Input tab of the ABC spreadsheet:

• Accumulated savings (cell B7) 
• Estimated amounts of future retirement income, such as Social Security (cell B9) and any life annuity (cells B13, B17 or B21), and expected commencement of such income (cells B11, B15, B19 or B23) 
• The PV other sources of income in retirement, including proceeds from asset sales or reverse mortgages, income from part-time employment, rental income, etc. (cell B25) 
• Assumptions about the future, including future investment returns (cell B27), future rates of inflation (cell B35), and lifetime planning period (pre-retirement period + expected payout period) (cell B29), and Desired amount remaining at end of lifetime planning period (cell B33)

Note:  If you have an estimate of your Social Security benefit payable at some age in the future that is in current dollars, you will need to increase that estimate based on future pre-retirement inflation.

The significant result of inputting these items is the PV Future (Retirement) Spending Budgets found in cell B41 (row 41 and column B) of this Input tab of the ABC spreadsheet, which becomes the starting value on the new Pre-Retirement Spending Savings tab.  Once you have completed this first step, proceed to the new Pre-Retirement Spending Savings tab.

In Step 1 of the new tab, PV future gross pay (cell C9) is developed, which, when added to the PV other pre-retirement income (such as employer contributions to a defined contribution plan) (cell B10) becomes PV Pre-Retirement Assets (cell C11).  This is added to the starting value of PV Future (Retirement) Spending Budgets (cell D3).  If you anticipate working on a part-time basis after retirement, that expected PV should be entered as part of PV Other Sources of Income (cell B25) of the Input tab, not here.  Also note that Social Security applies an earnings test to employment earnings prior to your Social Security Normal Retirement Age.  Therefore, you need to coordinate the Desired number of future years until retirement (B7) with the Social Security benefit commencement year (cell B11 on the Input tab).

Next, in Steps 2 and 3 input expected PV Long-term Care Costs (cell B13) and the PV Unexpected Expenses (cell B15).  The program then subtracts these amounts from the remaining PV from the previous step.  If there are other expected non-recurring expenses, such as expected college expenses, add the PV of such items in one of these two steps.  (See our post ofJanuary 12, 2016 for a discussion of how you can modify your estimate of Long-term Care Costs to reflect a reduction in normal annual expenses associated with moving into an assisted living facility.)

In Step 4, the spreadsheet calculates PV Pre-Retirement Spending and subtracts it from the remaining PV from the previous steps.  It does this by asking you to input the percentage of your pre-retirement gross pay you intend to save this year and every year until you retire, Desired percentage of annual gross pay savings (cell B18).  This percentage multiplied by your gross pay is your savings budget.  The remainder of your pre-retirement gross pay constitutes your pre-retirement spending budget, and is intended to cover all your expenses including taxes.

In Step 5, the spreadsheet takes the amount of remaining PV after Step 4 (cell D20) and spreads it over your expected period of retirement (your lifetime planning period (Input tab B29) minus the Desired number of years until retirement (cell B7)), based on the input desired annual increase in post-retirement spending budget (cell B23).  As discussed in previous posts, if most of your expenses in retirement will be essential expenses, you will probably want your post-retirement spending to keep up with inflation.  If a significant portion of your post-retirement expenses are discretionary, it may be ok to assume future spending increases less than assumed inflation.

These calculations produce a retirement spending budget replacement ratio (ratio of first year retirement spending budget to final working year spending budget, in real dollars (cell E26) under the assumptions entered into the spreadsheet.  It is not unrealistic to plan on some decline in real dollar spending in the first year of retirement, as taxes will generally be lower, work-related expenses will be lower and mortgages may be paid off.  How much of a reduction in your pre-retirement standard of living you are comfortable with is, of course, the purpose of this exercise.  For example, if you are not comfortable with the estimated decrease in your post-retirement spending, you may need to increase your Desired percentage of annual gross pay savings (cell B18) or increase your Desired number of years until retirement (cell B7) or both.  Or you may need to increase the PV of post-retirement part-time work you entered in cell B25 of the Input tab.  There are many levers in this spreadsheet you can vary in your pre-retirement spending/savings budget planning.

Caution: Note that the Runout, Inflation Adjusted Runout, 5-year Projection and Budget by Expense-Type tabs in this spreadsheet will not be valid for this pre-retirement spending/savings budget exercise.  They were developed to provide additional information to retirees who have commenced spending their retirement assets.

Got Those “Conflicting Social Security Deficit Estimate” Blues Again

This post is a follow-up to my post of January 22, 2016, where I noted that relatively small tweaks in assumptions about the future appeared to have a fairly large impact on Social Security’s 75-year actuarial balance calculation, and my post of July 30, 2016, where I called upon the actuarial profession to advocate adoption of automatic approaches to maintain Social Security’s actuarial balance as part of the next round of system reform to enhance the system’s sustainability. 

This week, Keith Hall, the Director of the Congressional Budget Office (CBO), appeared before the House Subcommittee on Social Security to explain why CBO’s calculation of Social Security’s 75-year actuarial deficit was so much higher than the deficit calculated by Social Security’s actuaries and included in the official Trustee’s report.  Here is a link to his testimony.  Mr. Hall explained that by tweaking a few assumptions, the CBO calculated the 2016 75-year actuarial deficit to be 4.68% of the system’s taxable payroll vs. the 2.66% figure calculated by the Trustees.  In other words, the CBO calculated deficit, when measured as a percentage of taxable payroll was about 75% higher than the deficit calculated by the Trustees.  It is also important to note that neither of these two calculations recognizes the significant deficits projected for years after the 75-year projection period under current law, and therefore both actually understate the long-term problem.

As discussed in my post of January 22, I have no idea whose assumptions are more accurate, and frankly that is not the point of this post anyway.   The point is that no one can predict the next 75 years accurately, and it is just foolish to believe that changes made today, tomorrow or five years from now based on 75 years of assumptions about the future are definitely going to solve the system’s long-term funding problems for 75 years or more.  Yet that is just what we heard when Congress supposedly solved the system’s problem for 75 years back in 1983, and that is just what we heard more recently from the Bipartisan Policy Commission when they proudly announced 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…”  Statements such as these are conditioned on future experience closely following the assumptions made by the Trustees.  So, if actual future experience is just a little worse (say like experience assumed by the CBO), all bets are off.  

Common sense tells us that rather than waiting to have Congress make very significant changes to the Nation’s retirement program every thirty years or so to put it back into actuarial balance, it would be preferable to have minor changes made on a more frequent basis.  This why I have recommended consideration of automatic adjustments to the system’s tax and/or benefit structure to maintain the system’s actuarial balance.  This is what they do in Canada for the Canada Pension Plan.  This is what is done in almost all financial programs funded using basic actuarial principles.   I believe that adoption of such an automatic adjustment approach would go a long way to enhancing the sustainability of and faith in this critical program.

So, in my post of July 30, 2016 I called on my profession to fulfill its duty to the public and advocate automatic adjustments to maintain the program’s actuarial balance.  I also sent a link to my post to all of the leaders of all of the U.S. actuarial organizations.  Despite my many years of volunteering for most of these organizations, I received essentially no response, and certainly nothing resembling an explanation of why the profession wouldn’t even consider suggesting or recommending such an approach to Congress. 

I believe that the actuarial profession fumbled the Social Security football back in 1983.   With potential and significant Social Security reform on the horizon, it looks like the actuarial profession will be given another chance to carry the ball.  Unfortunately, based on actions I’ve observed to date, it appears the profession will once again fumble the ball.  One has but to look at the American Academy of Actuaries’ Social Security Game for an example.  Simply make a couple of changes in the current tax/benefit structure to solve the 2015 Trustees estimate of the 75-year actuarial deficit and the Game congratulates you for winning the Game by fixing Social Security.  If only it were that easy.

Recommended Assumed Annual Rate of Investment Return Lowered Again

From time to time I look at immediate annuity purchase rates for the purpose of possibly revising my recommendation for the expected annual rate of investment return assumption and the rate of inflation assumption to use in the Actuarial Budget Calculator.   The assumption for the expected annual rate of investment return is also referred to as the discount rate as it is the rate used in the Actuarial Budget Calculator to discount future expected payments to obtain present values.  Readers of my blog know that I like to recommend a discount rate that is roughly consistent with the discount rate implied in immediate annuity purchase rates, as this rate is approximately the discount rate at which a retiree could settle some or all of his or her retirement liabilities (generally the present value of future spending budgets).  It also gives a retiree a pretty good estimate of the relatively low-risk cost to fund their retirement.  Yes, investment in risky assets may result in higher investment returns (and a potentially higher discount rate), but risky assets also carry greater risk.  Therefore, while I don’t make recommendations on how you should invest your assets, I do recommend that you assume that your assets will earn a fairly conservative rate.  If your assets actually earn more than this conservative rate in the future, you can increase your future spending budgets (or you can increase your rainy day fund as discussed in our post of July 4, 2016). 

Historically, I have also recommended using a future inflation assumption that is 200 basis points below the discount rate as this is roughly the historical difference between inflation and returns on bonds; the investments used in annuity products.

Only the actuaries at the actual insurance companies know the assumptions and methods they use to price their immediate annuity products.   These assumptions and methods include mortality, mortality improvement, anti-selection, interest rates and other factors, such as desired levels of insurance company profits, commission schedules and whether they have already written their quota of business for the year.  So, I don’t claim to really know the discount rate (or more likely different discount rates by year) assumption they use.  I can only make a crude educated guess.   Historically in prior posts, I have done that by solving for the discount rate that is approximately consistent with age 65 annuity purchase rates using the age 65 life expectancy for a 65-year old male (22.9 years) or a 65-year old female (24.9 years) under the 2012 Society of Actuaries’ Individual Annuity Mortality Table with 1% per year mortality improvement. 

Recently I looked at how much monthly immediate fixed dollar annuity income could be purchased for $100,000 in California by 65-year old males and females from the following three online sources:

• Immediateannuity.com 
• Incomesolutions.com 
• Annuityquickquote.com
  

The table below shows the highest quoted monthly income for age 65 males and females and the respective implied discount rate for each quote based on the methodology described above. 

(click to enlarge)

As shown in the table, the annuity quotes and implied discount rates from annuityquickquote.com appeared to be significantly higher than those from incomesolutions.com, which, in turn, appeared to be higher than those from immediateannuities.com.  The annuity quotes from immediateannuities.com list the actual insurance company and their AM Best rating, while the quotes from the other two online sources do not.  For example, the quote from Met Life on immediateannuities.com on September 3rd for a 65-year old male was $490 per month and was $467 per month for a 65-year old female.  Under the methodology described above, this translates into about a 2.74% annual discount rate for the male annuity and a 2.84% annual discount rate for the female annuity offered by Met Life.  

Based on the data in the table above, I have decided to lower my recommended discount rate and inflation rate by 0.5% to:

• Recommended discount rate: 4.0% 
• Recommended inflation rate:2.0%

I would certainly not argue with you, however, if you wanted to use a lower discount rate and a consistent assumed rate of inflation.

What are the implications for your spending budget of using a lower assumed discount rate?  All things being equal (i.e., your future inflation assumption remains unchanged), it means that your spending budget will decrease somewhat, as the anticipated cost of your retirement will be more expensive.  If your assumed inflation assumption is reduced by 50 basis points as well, however, your spending budget may actually increase depending upon how much fixed dollar income you anticipate receiving and how you plan to spread the present value of your future spending budgets. 

Planning for Constant Real-Dollar Spending in Retirement — Is It Setting the Bar Too High? Part II

This post is a follow-up to my post of March 31 of this year in which I encouraged you (or your financial advisor) to use the Budget by Expense-Type Tab of the Actuarial Budget Calculator to develop a reasonable spending budget that more closely meets your spending objectives with respect to the various types of expenses you expect to incur in the future.

Initial Spending Budget
 
Developing an initial spending budget using the Actuarial Approach is a two-step process:

• The first step in the process is to determine the total present value of the assets you have to spend.  This present value includes your current liquid assets, the present value of your Social Security benefits, the present value of your defined benefit plan benefits, the present value of any annuity income you may have, the present value of non-liquid assets you may own that you plan to sell in the future, the present value of rental income from properties you may own, the present value of future wages you may earn, etc. 
• The second step in the process is to determine how you want to spread this total present value of assets over your expected payout period.
  

The result, Current Year's Total Actuarial Spending Budget based on annual desired increase (shown in row 42 of the Input Tab of the Actuarial Budget Calculator spreadsheet), shows this year’s actuarially determined spending budget:

• if you decide to spread the total present value of your assets, less Desired amount of savings remaining at death (input in row 33), over 
• the Expected payout period (input in row 29), based on the assumption that future spending budgets will increase each year by the Annual desired increase in future budget amounts percentage (input in row 31).
  

If the same assumption is input for the Annual desired increase in future budget amounts (in row 31) as is input for Expected annual rate of inflation (in row 35), you are essentially planning for constant real-dollar spending throughout your retirement:

• assuming all the assumptions input in the spreadsheet (including the mortality assumption) are exactly realized (and unchanged), and 
• your actual spending exactly matches your spending budget each year.
  

We know, however, that all of the assumptions you input in our spreadsheet won’t be exactly realized (and/or unchanged) each year, and your actual spending will probably not be exactly equal to your spending budget.  That is why we added the 5-year Projection Tab, so that you could see how variations in investment returns and actual spending could affect your future spending budgets.

We also know that not all of your future expenses are likely to increase at the same rate, which is why we added the Budget by Expense-Type Tab to the spreadsheet.  This tab gives you the ability to spread the present value of your assets (which is also equal to the present value of your future spending budgets) between five different types of expense:

• long-term care 
• unexpected 
• essential non-health (ENH) 
• essential health (EH) 
• non-essential (NE)
  

and to make different future increase assumptions for these expenses:

• essential non-health (ENH) 
• essential health (EH) 
• non-essential (NE)
  

This is one of the many benefits of using the Actuarial Approach that you just don’t get with many other approaches — the flexibility to decide how you want to budget the spending of your retirement assets.

Planning for Constant vs. Decreasing Real-Dollar Spending
 
And the foregoing brings us to the inspiration for today’s post (with my apologies for taking so long to get here).

Three of retirement researcher Wade Pfau’s recent articles,

• Retirement Spending Increases and Decreases Over Time 
• What Is the “Retirement Spending Smile?” 
• What Is Age Banding And What Does It Mean For Retirees?
  

note that average spending appears to decrease consistently during retirement, until individuals become quite old, at which time their expenses (mostly health-related) increase.  Therefore, according to Dr. Pfau and other researchers, “Suggesting that retirees should plan for constant inflation-adjusted spending may overestimate the required retirement savings that many households will require for a successful retirement.”  Stated in another way, this research appears to support some degree of “front-loading” of the early years’ real-dollar spending budgets, relative to later years (i.e., larger early year budgets than later year budgets, measured in real dollars).  In his “Smile” article, Dr. Pfau cites research from David Blanchett that shows that real-dollar spending for a retiree whose initial spending is about $100,000 is expected to decrease by about 1% per year until the retiree reaches her early 80s, at which time health-related expenses will tend to increase real-dollar spending.
 
While I agree that non-essential expenses are likely to decrease in real dollars as we age in retirement, I also agree with Dr. Pfau that other types of expenses in retirement are likely to remain constant in real dollars or even increase.  It is for this reason that I recommended different rates of assumed increases for

• essential non-health (ENH) expenses, 
• essential health (EH) expenses and 
• non-essential (NE) expenses
  

for determining 2016 spending budgets in my post of December 21 of last year.

It is important to note, however, that if we assume:

• essential non-health (ENH) expenses will increase with inflation in the future, 
• essential health (EH) expenses will increase faster than general inflation and 
• non-essential (NE) expenses will increase at a rate less than inflation,
  

then the expected rate of increase or decrease in the total real-dollar spending budget will depend on the relative levels of these three separate budget components.

The larger the portion of the spending budget that is represented by non-essential expenses (using different rates of assumed increases for essential non-health (ENH) expenses, essential health (EH) expenses and non-essential (NE) expenses), the greater the annual decrease expected in future real-dollar total spending budgets.

Examples using James and Michael

Let’s take a look at two different retirees to illustrate this point.  Both James and Michael are:

• 65-year old males 
• with $20,000 annual Social Security benefits, 
• a $10,000 annual pension benefit, 
• no other sources of retirement income and 
• no bequest motive.
  

The only difference between James and Michael is their accumulated savings:

• James has accumulated savings of $500,000 and 
• Michael has accumulated savings of $1,000,000.
  

Both retirees use the Actuarial Budget Calculator to develop their spending budget for this year and our recommended assumptions of:

• 4.5% discount rate 
• 2.5% inflation 
• expected retirement period equal to age 95 minus attained age or life expectancy if greater.
  

Under these assumptions, the present value of assets are:

• $1,129,966 for James, and 
• $500,000 higher, or $1,629,966 for Michael’s.
  

If these present values are spread over their expected retirement periods as a constant real-dollar amount (increasing each year at the same 2.5% annual rate assumed for inflation), their spending budgets for this year would be:

• $49,156 for James 
• $70,907 for Michael.
  

 
Examples Using Budget by Expense-Type Tab

Both James and Michael have determined their expenses as:

• essential non-health (ENH) expenses for the upcoming year are $30,000 
• essential health (EH) expenses are $7,000 
• essential non-health (ENH) expenses will increase by inflation in the future (2.5% as stated above) 
• essential health (EH) expenses will increase by inflation (2.5%) plus 1.5%, or 4.0% 
• non-essential (NE) expenses will remain constant in nominal dollars
  

For the sake of simplicity, we are going to assume that both have separately set up sufficient reserves for long-term care expenses and unexpected expenses.

If instead of planning for constant real-dollar spending, these retirees use the Budget by Expense-Type Tab of the spreadsheet and the increase assumptions for each budget expense type discussed above,

• James will develop a total spending budget for this year of $51,351 (or about 4.5% greater than his constant dollar spending budget), while 
• Michael’s total spending budget would be $80,725, (or about 13.8% higher than his constant dollar spending budget).
  

The reason for the different rates of increase is that non-essential (NE) expenses represent a much larger proportion of James’ total spending budget than for Michael’s.

Charts
 
The following two charts illustrate this concept by showing expected real-dollar budget components and total spending budgets for the two retirees by age, if all assumptions are realized.

click to enlarge

click to enlarge

It is important to note that we show expected budget components and totals only until age 90.  This is because real-dollar spending budgets developed as the sum of these three budget components under the Actuarial Approach are expected to decrease significantly once the retiree’s current age plus life expectancy starts to exceed age 95.  At that time, however, the retiree presumably has long-term care and unexpected expense reserves to dip into.
 
Over the 25-year period from age 65 to age 90, James’ expected total real-dollar spending budget decreases by about .25% per year, while Michael’s total real-dollar spending budget decreases by about 1% per year.  Thus, the results for Michael are very close to the results for the average retiree with initial income of $100,000 noted by David Blanchett.  However, it is important to look at your own situation to determine what is appropriate for you.

Retired Actuary Calls for Actuarial Profession to Advocate True Social Security Sustainability

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.

“It’s Simply Common Sense” to Develop Your Spending Budget in Retirement by Carefully Considering How to Deploy All the Retirement Assets You Own

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.