Why is the American Academy of Actuaries Painting Such a Rosy Picture of Social Security’s Long-Term Financing Problems?

Added December 8, 2016:  In response to this post, the AAA has added several caveats to its Social Security Game in an effort to avoid providing potentially misleading information about the System's long-term financial situation.  The Academy's Game with the new caveats can be found here.

From time to time, we deviate (slightly) from our primary mission to offer our thoughts on Social Security’s (the System’s) financial condition.  We do this because:

• the System appears to have long-term financial problems, 
• the System’s future benefit and tax provisions can be changed at any time by Congress, and 
• changes in System benefits and taxes can affect almost everyone’s financial situation.

Thus, the financial condition of the System and the resulting uncertainty about its ability to pay scheduled benefits in the future should be an important consideration for individuals in the U.S. when developing their current spending/savings budgets.

How Big Is Social Security’s Problem?

There is considerable confusion regarding the size of the System’s long-term financing problem.  In the American Academy Actuaries’ (AAA) “Social Security Game,” the AAA claims the System’s problem can be “fixed” with approximately a 23% increase in the current System tax rate.  This is one option of many in the menu developed for the Game.

Using CBO and Trustees Assumptions to Estimate the Size of the Problem

On the other hand, as discussed in our May 17, 2016 post, Steve Goss, the Chief Actuary of Social Security has said, “Remedying OASDI’s [Social Security’s] fiscal shortfall for 2034 and beyond will require a roughly 25 percent reduction in the scheduled cost of the program, a 33 percent increase in scheduled tax revenue or a combination of these changes.”  Thus, based on the Trustees’ assumptions about the future, the Social Security’s Chief Actuary believes the problem is much larger than as indicated by the AAA.  In his recent testimony before the House Subcommittee on Social Security, Keith Hall, the Director of the Congressional Budget Office (CBO) noted that, based on CBO’s assumptions, their estimate of the System’s long-term problem was even greater than the Social Security Trustees’ estimate.

The graph below, shown in Figure 2 of Mr. Hall’s testimony, shows projected Social Security Tax Revenues and Outlays for the period 2000-2090 under both the CBO’s and Trustees’ assumptions.  This graph does a very good job of quantifying the projected shortfall between System revenues and scheduled benefits from the period 2030 to 2090 under the two sets of assumptions.  Under either set of assumptions, the shortfall is projected to be relatively constant, when measured as a percentage of the country’s projected Gross National Product for this period.   One can fairly easily see from this graph that the projected shortfall in revenues is relatively close to the 33% figure quoted by Mr. Goss under the Trustees assumptions, and something in the neighborhood of 45% under the CBO assumptions.  These figures can be confirmed by comparing projected 2090 outlays with projected 2090 tax revenues in the first section of Table 2 of Mr. Hall’s testimony.1 Under either set of assumptions, we are talking about significantly higher tax revenue shortfalls than the 23% figure claimed to “fix” the System in the AAA’s Social Security Game.  If you prefer to think in terms of necessary benefit reductions rather than required tax increases, the percentages are about 25% under the Trustees’ assumptions and about 30% under the CBO assumptions.2

  
AAA’s Fix 
     
So why has the AAA low-balled the size of the System’s long-term problem, when even the System’s Chief Actuary (using the Trustees’ assumptions) has indicated that we are looking either at much higher potential tax increases or benefit reductions?  Unfortunately, it is not clear to me why a profession that prides itself in “substituting facts for appearances” and “demonstrations for impressions” would want to provide this potentially misleading information.   In fact, Precept 8 of the profession’s own Code of Conduct expressly requires that an individual actuary “who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.”  It doesn’t appear to me that the AAA has taken such reasonable steps, but technically the Code of Conduct doesn’t apply to the organization representing the profession, only its individual members.

Planning Implications of Future System Reform

It is important to note that the 25% decrease in scheduled benefits (or approximately 30% under CBO assumptions) will automatically take place when the System’s Trust Fund runs out of assets if Congress fails to act prior to the Trust Fund Exhaustion date.  This is effectively an across-the-board decrease in benefits payable to beneficiaries at that time.  If Congress acts prior to the Trust Fund Exhaustion Date (by increasing tax revenue, decreasing benefits or some combination of the two), it is likely that some individuals will be less affected and some will be more affected than they would be under the default across the board benefit reduction scenario.

So, what does this all mean to retirees and pre-retirees in the U.S. who are counting on certain levels of future Social Security benefits?   That is the $64,000 question.  Will you be one of those individuals whose benefits are mostly unaffected or will you be one of those individuals whose future benefits or taxes will be significantly affected?  To paraphrase Harry Callahan in the movie “Dirty Harry” (by deleting the ending pejorative), “you’ve gotta ask yourself one question.  Do I feel lucky?  Well, do ya…?”

History has shown us that, when making changes to the System, Congress has been more inclined to reduce benefits and increase taxes mostly for those who are not close to retirement age.  Thus, it is unlikely that Congress will allow the default across the board benefit reduction scenario to take place.  On the other hand, it is also unlikely that Congress is going to place the entire burden of shoring up the System on the shoulders of our younger workers.  It appears likely that those with relatively higher incomes (young and old) will be asked to bear a significant portion of the increased cost in this next round of System reform.

The System is currently funded primarily with payroll taxes.  It is possible that the next round of System reform may involve other sources of revenue.  In any event, your current financial planning should consider the possibility that the scheduled (or actual) Social Security benefit you input in our Actuarial Budget Calculator worksheet may be reduced in some manner, your future taxes increased or some combination of the two.  Unfortunately, the changes necessary to truly “fix” the System may be larger than you thought.

Notes:

1. Projected Percentage Shortfall in Revenues using Projections for 2090:
(6.34 – 4.29) / 4.29 = (20.08 – 13.59) / 13.59 = 48% using CBO assumptions
(6.14 – 4.63) / 4.63 = (17.68 – 13.33) / 13.33 = 33% using Trustees assumptions

2. Necessary Percentage Benefit Reductions using Projections for 2090:
(6.34 – 4.29) / 6.34 = (20.08 – 13.59) / 20.08 = 32% using CBO assumptions
(6.14 – 4.63) / 6.14 = (17.68 – 13.33) / 17.68 = 25% using Trustees assumptions

Using Multiple “Data Points” to Determine How Much You Should Spend

The primary purpose of this website is to help individuals (with possible assistance from their financial advisors) determine how much they can afford to spend each year.  Our website was initially established in 2010 to help retirees with this issue, but we have recently expanded the scope of our purpose to address this issue for pre-retirees as well.  We have developed several spreadsheets that utilize basic actuarial principles to help individuals develop reasonable spending budgets.  And while we believe the development of a reasonable spending budget is an important part of an individual’s spending decision process, it is but one “data point” of several  that may be considered.  This post will discuss other possible data points that may also be useful in your spending decision process.

Applying the ABC Data Point

The Actuarial Budget Calculator (ABC) contained in this website determines a spending budget for the current year by mathematically balancing an individual’s assets (current assets and the present value of future income from other sources) with her current and future spending liabilities.  Thus, significant increases or decreases in the individual’s current assets from one year to the next can result in some volatility in the actuarially calculated spending budget from year to year.  As we have said many times in this blog, we have no problem if a retiree chooses to smooth her spending budget from year to year or to smooth her actual spending.  In fact, we have suggested that retirees consider establishing a “rainy day fund” after one or two favorable investment years to be available in subsequent unfavorable years as one approach to mitigate such fluctuations.  Thus, last year’s spending level may be another “data point” to consider.

The ABC with Recommended Assumptions Data Point

We understand that some of the users of the ABC do not use the recommended assumptions to determine their spending budgets.   These users may feel that because they invest a significant portion of their assets in risky investments, our recommended investment return/discount rate is too conservative and does not represent their best estimate.  We also understand that some retirees and/or their financial advisors may use any number of non-actuarial approaches to determine spending budgets.  And this is fine, too.  We don’t insist that the ABC using recommended assumptions is the one and only true answer.  However, we do suggest to these individuals that they also run the ABC with the recommended assumptions as another data point, for comparison purposes.  The ABC with recommended assumptions produces an actuarially calculated spending budget under the assumption that assets will be invested in relatively low-risk investments (approximately interest rates imbedded in life annuity products).  A significant positive difference between the retiree’s spending budget and this actuarially calculated budget can provide a measure of how much extra risk the retiree is “capitalizing” through his or her investment strategy.  In any event, running the ABC with recommended assumptions provides another data point that tells the retiree how far off the “actuarially balanced” track she may have strayed with her current spending strategy.

ABC Run-Out Tabs Data Point

The ABC also provides run-out tabs that show future spending and assets if all assumptions are realized in the future and spending exactly follows the budget plan.  In situations where the retiree expects to receive income from deferred sources (such as from a future sale of an asset or from deferred annuity contracts) the run-outs may show assets declining precipitously prior to receipt of the deferred income if spending continues course.  In such situations, the run-out tab information can serve as another data point in the spending decision process.

ABC 5-Year Projection Tab Data Point

In the 5-year projection tab, the ABC also provides the capability to model future investment and spending experience that differs from assumptions.  The results of this tab can be useful for developing contingency plans in the event actual experience deviates significantly from assumed experience and can also provide another data point in the spending decision process.

As indicated in our post of October 31 of this year, the run-out tabs also indicate what next year’s assets will be if all assumptions are realized during the budget year and spending exactly follows the budget, so this number is also another data point in determining this year’s spending if it looks like assets at the end of the year will be significantly different from this number.

Historical Record Data Points

We encourage retirees to maintain a record of prior years’ spending budget calculations and prior years’ expenses.  This historical information can also serve as additional data points to help with future spending decisions.  The information can also be useful in selecting assumptions about the future, particularly about future assumed increases in various types of expenses.

Your Gut Instinct

As we said in our post of October 17 of last year, “Unlike many experts who think that most retirees aren’t smart enough or motivated enough to manage their own money, I believe that most retirees possess the necessary skills to successfully manage their finances in retirement, much like they successfully managed their finances when they were employed.  Of course, for those retirees who can afford one, a financial advisor can be very helpful in this process.  However, when push comes to shove, it is you, Mr. or Ms. Retiree, who are ultimately responsible for making the investment and spending decisions that affect your financial situation during your retirement.”  This brings us to our final data point – your gut instinct.  As we have said many times in this website, it is ok to spend less than your spending budget.  It may also be ok to spend more sometimes (but, please don’t use this as your excuse for running out and buying a big boat).  Once you have gathered sufficient information, you and your significant other, if you have one, need to make the final call on your spending.

Gathering all these data points to make spending decisions may seem like a lot of extra work.  For some retirees (those with just one or two sources of retirement income, for example), it may not be necessary or worthwhile to gather this additional information.  For those with more complicated situations (including those with multiple sources of retirement income), it may.  You must find the appropriate balance between the time you spend managing your retirement and just enjoying your retirement.  We are here to help you (or your financial advisor) find the best answer for your specific situation.

Deferring Commencement of Social Security Benefits is Ok, Deferring Retirement is Better—Part II

This post is a follow-up to our post of April 28, 2014, where we looked at the effect on a hypothetical 65-year old’s annual spending budget under the following scenarios:

1. Retiring at age 65 and commencing Social Security immediately, 
2. Retiring at age 65 and deferring commencement of Social Security until age 70, and 
3. Continuing to work 5 more years, retiring at age 70 and commencing Social Security at 70.
   

We concluded that while Scenario #2 might increase one’s spending budget by something in the neighborhood of 5%-10% over Scenario #1, Scenario #3 might increase one’s spending budget in retirement by 40% or more.

Now, in a recent study entitled, “Is Uncle Sam Inducing the Elderly to Retire”, the authors use some mysterious (to me) methodologies to conclude that the financial benefits of continuing to work an additional five years is much lower than the 40% figure we previously developed.  The authors conclude, “We find that if all elderly now working were to continue to work for five more years, they would, on average, raise their sustainable living standards (annual discretionary spending per household member with an adjustment for economies in shared living) by roughly 5 to 8 percent depending on their age and position in the resource distribution.”
 
As an actuary, my first reaction is to look at some numbers to see what they support.  So let’s use the Actuarial Budget Calculator (ABC) to look at a 65-year old male making $50,000 per annum gross wages.  Let’s assume he has $200,000 in accumulated savings and his home equity will cover his future expected non-recurring expenses. 

If we go to the Social Security Quick Calculator, we see that if this hypothetical individual retires and begins commencement of his Social Security benefit immediately, he would receive approximately $1,275 per month based on the assumptions made for his prior earnings history by the calculator.  The calculator also indicates that if he has no future employment income but he defers commencement of his benefit until age 70, his age 70 benefit in today’s dollars would be approximately $1,806 per month, and if he continues to work until age 70, his age 70 Social Security benefit would be $1,932 in today’s dollars.

Let’s assume that our hypothetical individual desires to have future spending budgets keep pace with inflation and uses the assumptions we recommend for the ABC.  He has no bequest motive.

For Scenario #1 (inputting an annual Social Security benefit of $15,300 – monthly benefit of $1,275 – starting immediately and $200,000 of accumulated savings), we get an annual spending budget of $24,011.

For Scenario #2 (annual Social Security of $23,928 – monthly benefit of $1,806 increased by 5 years of assumed inflation starting in 5 years), we get an annual spending budget of $25,842, an increase of 7.6% over Scenario #1.

For Scenario #3, we input an annual Social Security benefit of $25,597 (a monthly benefit of $1,932 increased by 5 years of inflation) starting in 5 years.  We then go to the new pre-retirement tab and assume that our hypothetical individual will receive annual 2% per annum pay increases, will save 10% of his pay each year and will not receive any additional pre-retirement income (such as a matching employer contribution).  Under this scenario, our hypothetical individual is expected to have a real dollar spending budget of $45,000 for 5 years and, at age 70, his real dollar spending budget is expected to decrease to $35,530 and remain at that level for the rest of his life.  Note, however, that this ultimate real spending budget is almost 48% higher than the Scenario #1 spending budget. 

Yes, he will have FICA taxes, income taxes, work-related expenses and savings that will need to be paid while he continues to work.  However, he had these expenses in prior years, so these are not new for him if he continues to work.   And, yes, he will not be receiving Social Security benefits while he works (of course he could if he wanted starting at his Social Security Normal Retirement Age of 66, but he decides to defer).

The authors are undoubtedly correct that there is some confusion in the general population regarding how the Social Security Earnings Test works.  For most readers of this blog, however, the concept is not that difficult.  Per “How Work Affects Your Benefits” prepared by the Social Security Administration, “You can get Social Security retirement or survivors benefits and work at the same time. But, if you’re younger than full retirement age, and earn more than certain amounts [generally $15,720 for 2016], your benefits will be reduced.  The amount that your benefits are reduced, however, isn’t truly lost. Your benefit will be increased at your full retirement age to account for benefits withheld due to earlier earnings.”

In their analysis, the authors assume that the Earnings Test is a “pure tax on benefits”, i.e., they ignore the increase in future benefits that results.  We respectfully disagree with the reasonableness of this assumption and, as a result, find the author’s conclusion misleading.

Bottom line:  I’m not buying the author’s argument that Uncle Sam is inducing the elderly to retire through operation of its tax and subsidy policies.  Of course, results will vary from individual to individual.   For most people, however, there is still plenty to be gained financially by continuing to work.  But, don’t just take our word for it.  Use our Actuarial Budget Calculator spreadsheet to crunch your own numbers.

Pension Actuaries Discuss Best Ways to Employ Assets to Mitigate Risks in Retirement

This post recommends two recent articles written by pension actuaries:  Mark Shemtob and Steve Vernon.

I volunteer with Mark Shemtob on the American Academy of Actuaries’ Lifetime Income Task Force.  The original mission of this task force was to “address the risks and related issues of inadequate guaranteed lifetime income among retirees.”  Mark is a consulting pension actuary like I was before I retired.  He is also a Certified Financial Planner and a Retirement Management Analyst.  His recent article, “The Retiree Nest Egg—Navigating the Risks” appears in the November/December 2016 issue of Contingencies Magazine, published by the American Academy of Actuaries.

Mark’s common sense advice to baby boomers regarding retirement planning can be summarized as follows:

1. Continue to work (if you can) until you are satisfied you are financially ready to retire 
2. Consider deferring commencement of your Social Security benefit until age 70 or purchasing a longevity annuity 
3. If the sum of your Social Security and pension benefits doesn’t fully cover your fixed living expenses, consider purchasing a life annuity to cover the shortfall 
4. Have a plan to cover future health-care costs, long-term care expenses and unexpected expenses 
5. If your retirement spending strategy involves withdrawals from invested assets, make sure to monitor investment fee levels and selectively limit investment risk (perhaps by using a “bucketing” investment strategy that is coordinated with income to be received from other sources).

I worked with Steve Vernon for many years, and readers of this blog will recognize his name from the frequent references to his articles.  Steve was also a consulting pension actuary.  In his recent article, “6 retirement strategies from a local pro,” Steve discloses his own personal retirement strategy.  Not surprisingly, many of his 6 strategies are similar to those recommended by Mark.  Steve includes a couple of strategies that are not strictly financial.

I found the recommendations in Mark’s and Steve’s articles to be excellent and, for the most part, consistent with the opinions and recommendations we make in this website.   We may have small differences of opinion (like the best way to determine spending from investments, for example), but our thinking on retirement planning is not miles apart.   And maybe that is because we all think like pension actuaries.

You Want Software that Models the Effect on Your Retirement Spending Budget of Assuming Different Rates of Future Increases for Multiple Expense Categories? We’ve Got It!

I like to read the financial planning strategy posts from Michael Kitces.  I especially enjoy his weekly “Weekend Reading for Financial Planners.”  Michael is a good writer and is very prolific.  I don’t always agree with everything he says, but I give him big-time kudos for the expertise and energy he brings to financial planning discussions.

In his post of November 2, Michael summarizes much of the latest research on spending patterns in retirement.  I won’t summarize the research here again as you can simply read Michael’s post, and we have previously discussed much of this research in our posts of March 31 and August 20 of this year, entitled “Planning for Constant Real-Dollar Spending in Retirement – Is It Setting the Bar Too High (Parts I & II).”
  
At the end of his post, Michael says, “In practice, doing this kind of projected retirement spending may also be more difficult in today’s financial planning software, simply because most of the tools aren’t built to handle multiple different spending categories, each with their own inflation rates and age-banded spending cuts.”  Well, our Actuarial Budget Calculator (ABC) is not “most of the tools,” and it is built to handle 3 different spending categories:

• essential health-related expenses 
• essential non-health related expenses 
• and non-essential expenses,
  

each with its own assumed future increase rates.  You will find this useful feature in the Budget by Expense-Type tab of the ABC.  And it wouldn’t be all that difficult to modify the results of this tab to look at more than 3 spending categories, if desired.

After you have used the Budget by Expense-Type tab to develop a current spending budget utilizing different assumptions for future increases in the 3 expense categories, you can go back to the Input tab of the ABC spreadsheet to see what single rate “desired increase in future budget amounts” produces an equivalent current spending budget (if you are curious).  For example, in the Budget by Expense-Type tab you might assume future increases equal to assumed inflation for essential non-health related expenses, inflation plus 2% for essential health-related expenses and 0% increases for non-essential expenses.  Depending on the relative mix of these expected expenses, the resulting current spending budget may be equivalent to that produced in the Input tab by assuming inflation minus 0.5% increases (or some other value) in your total recurring future spending budgets.

Happy Budgeting!

Is it Time for a 2016 Spending Check?

The last thing I want to do with this post is put a damper on your holiday season, but we only have two months left in the calendar year, and for many retirees, the holiday season can involve increased expenses.  Before you generously shower gifts on your family and friends this year, you might want to check to see how you are doing so far with your 2016 spending and investments. 

As discussed in our post of September 4 of last year, if you are using the Actuarial Approach to determine your spending budget, there is a relatively easy process you can use to check to see how you are doing in terms of meeting your spending and investment targets for the year.   The Runout Tab of the Actuarial Budget Calculator you used to determine your 2016 spending budget showed your expected accumulated savings at the beginning of year 1 (2017) if all assumptions were realized and you spent exactly your 2016 spending budget.  

To see how well you have done so far for 2016, you will need to

• estimate your spending and income for the final two months of 2016 and 
• compare your estimated end-of-year accumulated savings with the beginning of year 1 (2017) amount shown in the Runout tab of the 2016-year calculation.

If your estimate of year-end accumulated savings is significantly lower than the expected value (either because of over-spending or lackluster investment returns (or a combination of the two), you might want to consider reducing some of your expenses for the remainder of the year if you can.  To see the impact of over-spending or under-earning on your 2017 actuarially determined spending budget (before any smoothing you might choose to use), just enter your end-of-year accumulated savings estimate in the spreadsheet and pretend you are doing the calculation at the beginning of 2017. 

Focus on Your Spending Budget in Retirement–Not How Much You Can Withdraw from Your Investment Portfolio

It seems like every other week some retirement expert, financial planner or investment firm is coming out with their recommendation for the best withdrawal strategy to use to tap one’s savings in retirement.  The new and improved strategy may be “fixed”, “variable,” or a hybrid of the two.  It may be a “safe” withdrawal rate (as contrasted with one that is unsafe?)  It may have “guardrails.”  It may involve using the Excel PMT financial function.  It may be a rate that retirees should “feel free” withdrawing, or it may be one of the many approaches that adjusts the 4% Rule in some manner to supposedly make it better.  I refer to these systematic withdrawal approaches as “rule of thumb” (RoT) approaches.

All of these RoT approaches miss the point.  The point of the exercise is to determine approximately how much you can afford to spend each year while meeting your financial objectives, not how much to withdraw.  Sometimes adding the amount you can withdraw under these RoT approaches to other income you may be receiving for a given year will give you something close to a reasonable spending budget for that year, and sometimes it won’t.

The current widely-followed practice of first determining how much can be withdrawn from savings and then adding that amount to other available income for the year is just bass-ackward and, in my opinion, should be changed.
 

The process recommended in this website involves

• first determining a reasonable spending budget based on sound actuarial principles and 
• then subtracting other available income for the year to determine how much, if any, should be withdrawn from accumulated savings.

Thus, the reasonable actuarially-developed spending budget and the other income you may be receiving during the year determines how much you should  withdraw from your accumulated savings, not some RoT approach that doesn’t even consider how much other income you may or may not be receiving that year.

Under the Actuarial Approach, withdrawals from savings may be much greater than or much less than withdrawals suggested by RoT approaches, and this situation may change over the period of retirement.  An example of the former situation is when income in retirement is deferred (such as when Social Security or income from an anticipated home sale is deferred).  An example of the latter situation is when income in retirement is front-loaded (such as when a retiree works in part-time employment or receives other income for a temporary period of time).

Note:  It is certainly possible that the annual income from various sources in retirement may even temporarily exceed the year’s actuarially calculated spending budget.  In that event the withdrawal from accumulated savings for that year will be negative.  In other words, instead of withdrawing and spending x% from savings that year as the retiree may do under a RoT approach, under the Actuarial Approach she would actually be saving to fund future spending needs.

If you (or your financial advisor) are currently using a RoT approach to develop your spending budget, I strongly recommend that you change your mindset (as suggested in the graphic above) and consider the Actuarial Approach as a better alternative.  At a minimum, we encourage you to compare the spending budgets developed under your approach with that developed under the Actuarial Approach and make sure you are comfortable with any significant differences.

For those of you still wondering about the graphic above:  No I am not calling for a small change (20 cents) in practice.  I am calling for a paradigm shift.

Development of Betsy’s Pre-Retirement Spending/Savings Budget

In our post of September 29, we introduced a new tab in the Actuarial BudgetCalculator (ABC) to help pre-retirees develop a reasonable spending budget in order to achieve their financial goals. That post discussed how to use the Input tab and the Pre-Retirement Spending & Savings tab of the ABC for this purpose and promised to include an example in a future post. This post includes the promised example for a hypothetical pre-retiree named Betsy.

 

Since release of the latest version of the ABC last month, we have decided that eventually we will probably develop separate ABC spreadsheets for pre-retirees and retirees as the current version is somewhat “clunky.”  For the time-being, however, pre-retirees can use this somewhat more clunky version. 

 

While most retirees know approximately how much their Social Security benefit is or will be in the future, some younger retirees and many pre-retirees may not have a good idea of how much they should input in our spreadsheets for their benefit.  This post will describe a process that can be used for this purpose. 

 

Betsy’s Financial Goals

  

• Betsy wants to retire from her current job at age 65 with no part-time employment thereafter
• Betsy would like her real dollar first year post-retirement spending to be no less than 75% of her real spending in her final year of employment
• Betsy has no other financial goals, such as paying for her son’s college expenses
• Betsy doesn’t want to over-save or under-save for her retirement.  In other words, she would like to maintain a reasonable balance between her pre- and post-retirement lifestyles.
• Betsy doesn’t want to become a burden on her son, but doesn’t feel a need to leave him a large estate. 

Betsy’s Data

  

• Betsy is age 50 and is divorced
• She is employed and her current gross pay is $70,000 a year
• Her employer matches her 401(k) contributions $.50 for each dollar up to 6% of pay
• The current value of her home is $250,000

Betsy’s Assets:  

  

• Accumulated savings, 401(k) and personal assets, of $100,000
• The present value of her future employment income
• The present value of her estimated future Social Security benefit of $46,900 per year commencing in 20 years at age 70.  Betsy develops her estimated age 70 Social Security benefit of $46,900 using the following process:

Step 1:  Betsy goes to the Social Security Quick Calculator on the Social Security website.

Step 2:  She enters her date of birth, gross pay in the current year and her desired future benefit commencement date.  She also indicates that she wants her benefit estimate to be in current dollars and submits her request.

Step 3:  She multiplies the resulting monthly benefit estimate by 12 and divides the result by her annual gross pay.  This gives Betsy a replacement ratio.

Step 4:  She multiplies the replacement ratio developed in Step 3 by her estimated pay in the year preceding her retirement (and if this date precedes her Social Security benefit commencement, by the anticipated increase in inflation for the bridge period).  Her estimated pay in the year preceding her retirement is based on her assumption for future pay increases as discussed in the assumptions section below. 

 

Betsy follows the process above and develops a replacement percentage of 46%, which she multiplies by her gross pay of $70,000 and 19 years of 2% per annum increases (a factor of 1.457) to produce an estimated annual age 70 benefit of about $46,900. 

• The present value of future employer matching contributions to the 401(k) plan
• The present value of proceeds from future home sales. 

Betsy’s Assumptions:

For present value calculations, Betsy, with assistance from her financial advisor, has selected these assumptions:

• Annual discount rate of 4%
• Annual rate of inflation of 2%
• She expects her employment will continue until she retires, and her gross pay will increase annually at the rate of inflation (2%)
• She expects to contribute, into her employer’s 401(k) plan, at least the minimum to receive the maximum matching contribution ($2,100 in the current year increasing by 2% per year).  She uses the Present Value Calculator in this website to estimate the present value of the matching contributions to be about $29,000.
• She expects her existing home mortgage will be paid off by the time she retires.  She expects to sell her home when she enters an assisted living facility and she expects that the value of her home will earn 4% per annum.
• She expects to live until age 95
• She expects her future essential expenses (excluding health related expenses) will increase with inflation, that her future essential health related expenses will increase with inflation +2% and her future non-essential expenses will remain constant in nominal dollars.  Based on her expected distribution of such expenses, she believes her total annual recurring expenses in retirement will increase by inflation minus 0.5% each year after retirement.
• She expects that she will have to live the last three years of her life in an assisted living facility.  She estimates the current cost of a three-year stay in her geographic area at $170,000 and she believes this cost will increase in the future by inflation plus 2% each year.  Based on the approximation technique outlined in our post of January 12, 2016 to reflect the reduction in other recurring expenses, she estimates a present value of her long-term care costs at $102,000 (60% of $170,000).
• She estimates the present value of her future unexpected expenses to be $25,000
• She estimates that $200,000 (in nominal dollars) will be sufficient to cover her funeral expenses, with any remainder to be left to her son.

Entries in Column B of the Input Tab

   

Row      Entry

7          $100,000 (Betsy’s accumulated savings)

9          $46,900 (Betsy’s projected Social Security benefit as developed above)

11        20 (the number of years before expected commencement of her

            benefit)

25        $250,000 (the present value of her home sale proceeds)

27        4% (Betsy’s expected rate of return on her investments/discount rate)

29        45 (Betsy’s lifetime planning period—95 minus her age)

33        $200,000 (The amount desired to be left at the end of Betsy’s lifetime

            planning period)

35        2% (the expected annual rate of future inflation)

The result in Row 41 with these input items is $743,813 (the present value of Betsy’s retirement spending budgets based on the input items above).  This amount is carried forward to the new pre-retirement spending and savings tab as the beginning value. 

 

Entries in Column B of Pre-Retirement Spending & Savings Tab

  

Betsy then goes to the Pre-Retirement Spending & Saving tab and makes the following entries:

 

Row      Entry

6          $70,000 (Betsy’s current gross pay)

7          15 (the number of years until her desired retirement age of 65)

8          2% (Betsy’s estimate of the annual future percentage increase in her

            gross pay)

10        $29,000 (Betsy’s estimate of the PV of future matching contributions to

            the 401(k) plan)

13        $102,000 (60% of Betsy’s estimate of 3 years of assisted living cost of

            $170,000)

15        $25,000 (Betsy’s reserve for unexpected expenses)

20        12% (the percentage of her gross pay she intends to save)

23        1.5% (the desired annual increase in Betsy’s recurring retirement

            spending budget)

 

The result shown in E 26 of the new tab with these input items is that if all of Betsy’s assumptions are realized in the future, her expected real dollar spending budget in her first year of retirement (age 65) would be 76.22% of her age 64 real dollar spending budget.   If she only wanted to save 8% of her pay each year rather than 12%, she could still reach her 75% real spending goal by working approximately another two years.  Betsy understands that because she has included the value of her home as an asset for budget purposes, she may have cash-flow problems later in her retirement that might require downsizing her home or taking out a reverse mortgage earlier than she might want.

 

Betsy also understands that (i) she may not be able to continue in her current employment until her desired retirement age, (ii) her estimated Social Security benefit may be reduced as a result of impending Social Security reform and (iii) some of her other assumptions may also turn out to be optimistic.  For this reason, she decides that she will try to save at least 15% of her pay each year just to be a little safer.  Of course, she will monitor her actual savings and spending each year and revisit this process every year to make sure she remains on track to meet her financial goals.

We’ve Updated the Present Value Calculator and Added a New Member to Our Team

Present Value Calculator

As discussed in our previous post, the fundamentals of the actuarial approach advocated in this website involve calculating the present values of future sources of revenue and future expected expenses.  We have developed two Excel spreadsheets to help our readers with these calculations:

• the Actuarial Budget Calculator (ABC) and
• the Present Value Calculator (PVC).
  

These spreadsheets can be found in the “Articles/Spreadsheet” section of our website.  Like the previous version of the PVC, the updated version (1.1) will permit you to calculate present values of future streams of annual payments or single payments, starting immediately or at a specified time in the future.  For simplicity’s sake, all steams of future payments are assumed to be made at the beginning of each year.  The updated version will also enable you to calculate the present value of a single payment to be made in the future, with the value of that payment assumed to increase by k% per year.

As always, we solicit your feedback for ways to improve our spreadsheets.  Please let us know how our spreadsheets can be improved and we will try to accommodate your requests.

New Team Member

I’m pleased to announce that Bobbie Kalben, FSA, has joined Kin Chan (our tireless web guru) and me in our quest to help retirees and pre-retirees (and their financial advisors) develop reasonable spending budgets.  Bobbie is another retired pension actuary whose specialties include communicating complicated subjects.  Bobbie’s self-described mission for this website is to translate some of the “actuarial-eze” that I too frequently use into plain English and to make some of the more complicated material here a little more accessible.  While Bobbie has already been helping me out for a couple of months, the updated PVC represents her first effort at making our spreadsheets a little more user-friendly.  She has also ambitiously agreed to update the ABC next.  Before she completes that task, however, I wanted to release a new version of that spreadsheet that includes a new tab to help pre-retirees develop a spending/savings budget.

We encourage you to use these spreadsheets in your financial planning, and if you like them, to recommend them to your friends.

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.