Frequently we see advice from “experts” regarding how much of your nest egg you should withdraw each year. For example, a recent Motley Fool article, “Forget the 4% Rule: Here’s a Better Way to Approach Your Savings” tells us that the 4% Rule may not actually be all that bad as a rough guide but you need to be flexible in its application. Like most rules of thumb (Rot) approaches, the 4% Rule (or even a more flexible version of the 4% Rule) is a methodology used to “tap” one’s retirement savings and is generally not part of a strategic plan to meet a retiree’s financial objectives in retirement. Since the typical Rot approach doesn’t even consider a retiree’s specific circumstances or specific financial goals, it is unlikely to have a high probability of successfully achieving such goals.
In his most recent blogposts on May 17th and May 27th, Dirk Cotton encourages retirees and their financial advisors to use strategic planning processes similar to those used in business to develop retirement plans for individual retiree households. As part of his recommended process, Dirk advocates that the retiree household adopt a mission statement, whose purpose is “to identify their strategic objectives [or goals], or those things that, at retirement's end, they would need to have achieved in order to consider their retirement to have been successful.” According to Dirk, “The challenge of retirement planning is to find a strategy (and there may be several) that meets the desires of our mission statement but also falls within the limits imposed on us by the economy and our household’s resources.” I encourage you to read Dirk’s recent posts.
The Actuarial Approach advocated in this website can help financial advisors and retirees refine their strategic goals by indicating which goals are financially “possible” [fall within the limits imposed by household resources]. For example, a household may desire to leave a significant legacy to heirs but they may have insufficient assets at this time to fund expected future essential expenses. The “Budget by Expense” tab of the Actuarial Budget Calculator can help the household plan how they will spend their assets (if all current assumptions about the future are realized) enabling them to determine which strategic goals are most important to them. The calculator can also help the household make decisions about how much risk to assume for certain types of future expenses, how their home equity should be spent, etc. The Actuarial Approach also provides a reasonable measure of whether the household is progressing satisfactorily toward the achievement of the goals selected (or to revise goals in the future). Unless your goal is to simply not run out of your savings, adoption of a Rot approach is not likely to be as successful at achieving your strategic goals.
Wednesday, June 1, 2016
Wednesday, May 25, 2016
How Much of that Part-Time Income Can You Afford to Spend in Retirement?
Many individuals who are retired take a part-time job to supplement their income in retirement. Frequently, these retirees believe that this income can increase their annual retirement spending budget by the net amount received during the year from such employment (wages minus increase taxes and increased employment-related expenses). This post will encourage retirees who work to possibly consider taking a longer-term “actuarial” perspective by spreading the present value of this extra income over their remaining period of retirement.
Let’s look at an example of how this may work. John is age 65 with an annual Social Security benefit of $20,000 and accumulated savings of $525,000. He estimates his essential non-health expenses (including taxes) are currently about $36,000 this year, and he expects these expenses to increase with inflation in the future. He estimates that his essential health expenses are currently $6,000 this year and will increase by inflation plus 2% in the future. He believes that the equity in his home will cover his long-term care expenses (or will be used for his bequest motives), and he would like to have an emergency fund budget of $25,000. The rest of his assets will be used for non-essential expenses, which he plans to budget spending at about the same amount each year of his retirement without any assumed future increases due to inflation (essentially decreasing in the future in real dollar terms).
John goes to the Input page of the Actuarial Budget Calculator V 1.1 and inputs his Social Security benefit and accumulated savings as well as the recommended assumptions (and no bequest motive). He sees that the present value of his current and expected future retirement income is $984,747. He then goes to the “Budget by Expense-type” tab of the spreadsheet and enters “0” for long-term care expenses, $25,000 for the present value of unexpected expenses, $36,000 increasing by 2.5% for essential health expenses and $6,000 increasing by 4.5% for essential health expenses. At this point, John sees that his assets (the present value of his future spending budgets) are insufficient to provide for these three items, let alone provide for any non-essential expenses. In fact, it looks like he has to reduce his budget for unexpected expenses by $1,823 to develop a $40,000 per year spending budget (excluding unexpected expenses) under these assumptions with a $0 budget for non-essential expenses.
John decides that he could use some more money in retirement and he also would like to get out of the house a little anyway. He decides to take a part-time job that will pay him $1,000 per month. After taxes and employment-related expenses, John figures that this job will net him about $700 per month in extra income, or about $8,400 per year. John’s initial thought is that this job will be enable him to increase his unexpected expenses budget to $25,000 and increase his non-essential expense budget by almost $8,400 per year.
But, after John gives this a little more thought, he concludes that he really doesn’t want to do this part-time job for more than 5 years. So if he spends all of the extra net income from the part-time job each year, he will have a significant drop in his spending budget once his part-time employment is terminated. Instead of simply adding his expected net income from employment to his budget, John decides to treat the expected net income as another retirement income source like Social Security or his accumulated savings. He goes to the present value calculator in this website and determines that the present value of $8,400 starting 0.5 years from now and payable for 5 years is $37,696. He goes back to the input page of the Actuarial Budget Calculator and inputs this amount as the present value of other sources of income. This increases the present value of his future spending budgets to $1,022,443 and enables John to establish his $25,000 unexpected expenses budget and increases the present value of his non-essential expense budget to $35,873. If he decides to spread this present value over his expected retirement period with no future increases, it will provide him with a first year non-essential expense budget of $2,107 and a total spending budget of $42,107 (excluding unexpected expenses). When he determines his spending budget for next year, John will input the present value of 4 years of part-time work assuming he still believes he will only work until age 70. Using this alternative approach, John hopes to avoid the significant a decrease in his spending budget when his part-time employment is terminated. In effect, he is saving some of his part-time income for his future retirement years.
As I have said many times in this blog, developing a reasonable spending budget in retirement is part science and part art. John can annually spend anywhere from an extra $2,107 to $8,400 as a result of his part time employment. He has to decide the spending level that is most consistent with his objectives in retirement. The Actuarial Budget Calculator and this website give him the tools to make a more informed decision.
Let’s look at an example of how this may work. John is age 65 with an annual Social Security benefit of $20,000 and accumulated savings of $525,000. He estimates his essential non-health expenses (including taxes) are currently about $36,000 this year, and he expects these expenses to increase with inflation in the future. He estimates that his essential health expenses are currently $6,000 this year and will increase by inflation plus 2% in the future. He believes that the equity in his home will cover his long-term care expenses (or will be used for his bequest motives), and he would like to have an emergency fund budget of $25,000. The rest of his assets will be used for non-essential expenses, which he plans to budget spending at about the same amount each year of his retirement without any assumed future increases due to inflation (essentially decreasing in the future in real dollar terms).
John goes to the Input page of the Actuarial Budget Calculator V 1.1 and inputs his Social Security benefit and accumulated savings as well as the recommended assumptions (and no bequest motive). He sees that the present value of his current and expected future retirement income is $984,747. He then goes to the “Budget by Expense-type” tab of the spreadsheet and enters “0” for long-term care expenses, $25,000 for the present value of unexpected expenses, $36,000 increasing by 2.5% for essential health expenses and $6,000 increasing by 4.5% for essential health expenses. At this point, John sees that his assets (the present value of his future spending budgets) are insufficient to provide for these three items, let alone provide for any non-essential expenses. In fact, it looks like he has to reduce his budget for unexpected expenses by $1,823 to develop a $40,000 per year spending budget (excluding unexpected expenses) under these assumptions with a $0 budget for non-essential expenses.
John decides that he could use some more money in retirement and he also would like to get out of the house a little anyway. He decides to take a part-time job that will pay him $1,000 per month. After taxes and employment-related expenses, John figures that this job will net him about $700 per month in extra income, or about $8,400 per year. John’s initial thought is that this job will be enable him to increase his unexpected expenses budget to $25,000 and increase his non-essential expense budget by almost $8,400 per year.
But, after John gives this a little more thought, he concludes that he really doesn’t want to do this part-time job for more than 5 years. So if he spends all of the extra net income from the part-time job each year, he will have a significant drop in his spending budget once his part-time employment is terminated. Instead of simply adding his expected net income from employment to his budget, John decides to treat the expected net income as another retirement income source like Social Security or his accumulated savings. He goes to the present value calculator in this website and determines that the present value of $8,400 starting 0.5 years from now and payable for 5 years is $37,696. He goes back to the input page of the Actuarial Budget Calculator and inputs this amount as the present value of other sources of income. This increases the present value of his future spending budgets to $1,022,443 and enables John to establish his $25,000 unexpected expenses budget and increases the present value of his non-essential expense budget to $35,873. If he decides to spread this present value over his expected retirement period with no future increases, it will provide him with a first year non-essential expense budget of $2,107 and a total spending budget of $42,107 (excluding unexpected expenses). When he determines his spending budget for next year, John will input the present value of 4 years of part-time work assuming he still believes he will only work until age 70. Using this alternative approach, John hopes to avoid the significant a decrease in his spending budget when his part-time employment is terminated. In effect, he is saving some of his part-time income for his future retirement years.
As I have said many times in this blog, developing a reasonable spending budget in retirement is part science and part art. John can annually spend anywhere from an extra $2,107 to $8,400 as a result of his part time employment. He has to decide the spending level that is most consistent with his objectives in retirement. The Actuarial Budget Calculator and this website give him the tools to make a more informed decision.
Tuesday, May 17, 2016
What Went Wrong with the 1983 Social Security Fix?
This is a follow-up to several of my prior posts on Social Security’s financial problems, with the most recent being on November 5th of last year. The inspiration for this post comes from an article entitled, Understanding Social Security’s Long-Term Fiscal Outlook, by Steve Goss, Chief Actuary, U.S. Social Security Administration. In his article, Steve states, “The Social Security program faces a substantial financing challenge for the future, largely due to demographic changes that have been long known and understood.” Steve also indicates that, “Remedying OASDI’s [Social Security’s] fiscal shortfall for 2034 and beyond will require a roughly 25 percent reduction in the scheduled cost of the program, a 33 percent increase in scheduled tax revenue or a combination of these changes.” So, why are we facing this “substantial financing challenge” when the 1983 Amendments to the program promised system solvency for the foreseeable future?
Well, ok, while some media sources in 1983 indicated that the 1983 Amendments promised system solvency for the foreseeable future, it is more accurate to say that the 1983 Amendments brought the system into “long-term (or “long-range”) Actuarial Balance.” Like the actuarial measurement of assets and liabilities recommended for retirees in this website, Social Security’s actuarial balance measurements compare system assets (including the present value of future revenues) with system liabilities based on assumptions made about the future and are recalculated annually based on actual data and possibly revised assumptions. Unfortunately, Social Security’s long-term actuarial balance measurement is limited to 75 years, and the significant deficits expected after the end of the 75-year projection period in the 1983 measurement (that of would of course emerge in subsequent years’ measurements) were ignored. So, the 1983 Amendments anticipated accumulation of large amounts of Trust Fund reserves during the first half of the 75-year projection period that would be expected to be used to fund tax-rate revenue shortfalls during the last half of this period, with reserves ultimately to be exhausted around 2060 if all assumptions about the future were realized. After 2060, however, significant tax increases were expected to be required to pay scheduled benefits.
So what is the big deal? As Steve indicates in his article, these demographic problems have been long known and understood (well before 1983). The actuaries thus knew that the 1983 Amendments were a “kick-some-of-the-problem-down-the-road” solution. So, instead of the problem occurring as expected around 2060, we are now looking at possibly 2034 as the “fall-off-the-cliff-date” because actual experience after 1983 wasn’t quite as favorable as assumed back then and the actuaries changed some assumptions to reflect this less than favorable experience. Not to worry, however, because according to Steve, “Whenever the reserves begin to decline and approach depletion, Congress must act to make timely adjustments. Such adjustments to tax rates and scheduled benefit levels always have been made throughout the 80-year history of the program.”
Steve points out that the 1983 Amendments, “substantially improved the financial status of the program for decades into the future.” You will get no argument from me on this statement. And while reducing the 75-year actuarial deficit to zero (as was done in the 1983 Amendments) is a reasonable first step, there are two problems with any proposed reform options that simply reduce Social Security’s 75-year actuarial deficit to zero:
Some may legitimately question the wisdom of a long-term financing solution that is not expected to be sustainable in the long-run. On the other hand, there are those who argue that it is beneficial for Social Security to actually have to go through a “challenging” periodic process of re-evaluation rather than operate on an automatic basis similar to the actuarial approach used for the Canada Pension Plan.
Social Security’s financial problem is an actuarial problem that requires an actuarial solution. However, as discussed in my November 5 post, the public voice for the U.S. actuarial profession, the American Academy of Actuaries, appears to be sending out mixed messages on this topic. While it’s 2015 public policy white paper, Sustainability in American Financial Security Programs, touts the benefits of sustainability and states the profession’s commitment “to working toward solutions that help restore confidence in and enhance the sustainability of these important programs,” the Academy’s Social Security Game congratulates players for fixing Social Security by adopting the same type of 75-year “kick-some-of-the-problem-down-the-road” solutions adopted in the 1983 Amendments.
And so, how will Social Security’s latest “financial challenge” be addressed? In addition to questions of when the “solution” will be effective, who will be effected by the solution and by how much, you can add the important question of how long will it be after the solution is adopted before we (or our children) can expect to address the program’s financial problems once again.
Well, ok, while some media sources in 1983 indicated that the 1983 Amendments promised system solvency for the foreseeable future, it is more accurate to say that the 1983 Amendments brought the system into “long-term (or “long-range”) Actuarial Balance.” Like the actuarial measurement of assets and liabilities recommended for retirees in this website, Social Security’s actuarial balance measurements compare system assets (including the present value of future revenues) with system liabilities based on assumptions made about the future and are recalculated annually based on actual data and possibly revised assumptions. Unfortunately, Social Security’s long-term actuarial balance measurement is limited to 75 years, and the significant deficits expected after the end of the 75-year projection period in the 1983 measurement (that of would of course emerge in subsequent years’ measurements) were ignored. So, the 1983 Amendments anticipated accumulation of large amounts of Trust Fund reserves during the first half of the 75-year projection period that would be expected to be used to fund tax-rate revenue shortfalls during the last half of this period, with reserves ultimately to be exhausted around 2060 if all assumptions about the future were realized. After 2060, however, significant tax increases were expected to be required to pay scheduled benefits.
So what is the big deal? As Steve indicates in his article, these demographic problems have been long known and understood (well before 1983). The actuaries thus knew that the 1983 Amendments were a “kick-some-of-the-problem-down-the-road” solution. So, instead of the problem occurring as expected around 2060, we are now looking at possibly 2034 as the “fall-off-the-cliff-date” because actual experience after 1983 wasn’t quite as favorable as assumed back then and the actuaries changed some assumptions to reflect this less than favorable experience. Not to worry, however, because according to Steve, “Whenever the reserves begin to decline and approach depletion, Congress must act to make timely adjustments. Such adjustments to tax rates and scheduled benefit levels always have been made throughout the 80-year history of the program.”
Steve points out that the 1983 Amendments, “substantially improved the financial status of the program for decades into the future.” You will get no argument from me on this statement. And while reducing the 75-year actuarial deficit to zero (as was done in the 1983 Amendments) is a reasonable first step, there are two problems with any proposed reform options that simply reduce Social Security’s 75-year actuarial deficit to zero:
- Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period. Over time, these deficits will emerge in the actuary’s annual calculations.
- There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities. Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources.
Some may legitimately question the wisdom of a long-term financing solution that is not expected to be sustainable in the long-run. On the other hand, there are those who argue that it is beneficial for Social Security to actually have to go through a “challenging” periodic process of re-evaluation rather than operate on an automatic basis similar to the actuarial approach used for the Canada Pension Plan.
Social Security’s financial problem is an actuarial problem that requires an actuarial solution. However, as discussed in my November 5 post, the public voice for the U.S. actuarial profession, the American Academy of Actuaries, appears to be sending out mixed messages on this topic. While it’s 2015 public policy white paper, Sustainability in American Financial Security Programs, touts the benefits of sustainability and states the profession’s commitment “to working toward solutions that help restore confidence in and enhance the sustainability of these important programs,” the Academy’s Social Security Game congratulates players for fixing Social Security by adopting the same type of 75-year “kick-some-of-the-problem-down-the-road” solutions adopted in the 1983 Amendments.
And so, how will Social Security’s latest “financial challenge” be addressed? In addition to questions of when the “solution” will be effective, who will be effected by the solution and by how much, you can add the important question of how long will it be after the solution is adopted before we (or our children) can expect to address the program’s financial problems once again.
Monday, May 9, 2016
Adjust the 4% Rule Enough and You Might End up with Something as Good as the Actuarial Approach
Charles Schwab recently released their guidance regarding how much a retiree can spend each year entitled, “Retirement Spending: How Much Can You Afford?” The authors state, “The 4% rule is a simple rule of thumb, but needs adjustment to fit current market conditions and your situation.” The adjustments to the 4% Rule recommended by the authors include:
How different are these withdrawal rates from comparable rates developed using the Actuarial Approach? Not very. If we are looking at a retiree with only accumulated savings and a Social Security benefit that is currently payable, the withdrawal rates determined using recommended assumptions under the Actuarial Approach are 4.35% for a 30-year period of retirement, 5.97% for a 20-year period and 10.89% for a 10-year period, or very similar to the rates shown in Schwab’s chart above for confidence levels somewhere between 90% and 75%.
The authors suggest that retirees annually revisit their spending plan, “and increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.” So retirees have a choice in the future between increasing last year’s spending by inflation or recalculating a new withdrawal rate based on the chart above (using interpolation methods if necessary). This is very similar to the Actuarial Approach, where you essentially have the same choice (to use the actuarially calculated withdrawal or a smoothed value).
So, I believe the Schwab approach can probably produce a reasonable spending budget for a certain type of retiree. That type of retiree:
One final note on the Schwab article. It strongly implies that since the life expectancy of a 65-year old male or female is currently much less than 30 years, the 30-year retirement horizon used to develop the 4% Rule may not be appropriate for time horizons for many retirees. I encourage retirees not to use current life expectancy to develop a retirement horizon as 50% of all individuals are expected to live past their life expectancy. See my last post for guidance on selecting retirement horizons.
- Adjustments to reflect your investment allocation
- Adjustments to reflect your selected confidence level of not running out of money
- Adjustments to reflect your planned time horizon, and
- Possibly annual adjustments to reflect changes in future conditions
How different are these withdrawal rates from comparable rates developed using the Actuarial Approach? Not very. If we are looking at a retiree with only accumulated savings and a Social Security benefit that is currently payable, the withdrawal rates determined using recommended assumptions under the Actuarial Approach are 4.35% for a 30-year period of retirement, 5.97% for a 20-year period and 10.89% for a 10-year period, or very similar to the rates shown in Schwab’s chart above for confidence levels somewhere between 90% and 75%.
The authors suggest that retirees annually revisit their spending plan, “and increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.” So retirees have a choice in the future between increasing last year’s spending by inflation or recalculating a new withdrawal rate based on the chart above (using interpolation methods if necessary). This is very similar to the Actuarial Approach, where you essentially have the same choice (to use the actuarially calculated withdrawal or a smoothed value).
So, I believe the Schwab approach can probably produce a reasonable spending budget for a certain type of retiree. That type of retiree:
- Has already set aside separate reserves for long-term care costs (or has sufficient insurance), emergency expenses, and legacy costs
- Has no other sources of income, such as fixed dollar pensions, annuities, deferred annuities or deferred Social Security benefits.
One final note on the Schwab article. It strongly implies that since the life expectancy of a 65-year old male or female is currently much less than 30 years, the 30-year retirement horizon used to develop the 4% Rule may not be appropriate for time horizons for many retirees. I encourage retirees not to use current life expectancy to develop a retirement horizon as 50% of all individuals are expected to live past their life expectancy. See my last post for guidance on selecting retirement horizons.
Sunday, May 8, 2016
Actuaries Longevity Illustrator
This week the American Academy of Actuaries and the Society of Actuaries jointly released the Actuaries Longevity Illustrator, an online tool designed to illustrate the potential range of future lifetime based on input of four factors: age, gender, whether or not you smoke and your general health. The tool designers claim that these four factors have been shown to be reasonable predictors of a person’s longevity. The results are based on the 2010 Social Security Administration mortality table, with future mortality improvement projected using the Society of Actuaries’ MP-2015 scale. We will be adding a link to this tool in our “other calculators and tools” section.
With one exception, I found the tool very easy to use and potentially helpful for determining the “expected payout period” input item for the Actuarial Budget Calculator in this website. The one exception is the input item called “illustration age.” Most (or all) of the time, you are going to want to leave that box blank, which was not particularly intuitive to me.
The chart in the results section that I found most helpful was the “Planning Horizon” chart. This chart shows probabilities of living “x” more years. The 50% probability is your life expectancy under the assumptions used in the model. As I have discussed in previous posts (see for example my post of December 3, 2014), if you use your life expectancy as your expected payout period, your spending budget will decrease as you age, all other factors being equal. That is why I have recommended assuming death occurs at age 95, or life expectancy if greater. Therefore, I recommend that retirees focus on the 25% probability of living “x” years in this chart when determining a spending budget. If you do this and enter “no smoking” and “excellent health,” the tool will generally produce a 25% probability of living past age 94 for males and 96 for females unless you are over age 80. This result is very similar to my recommendation of using age 95 or life expectancy if greater for the expected payout period in my spreadsheet.
Being an actuary, I found it interesting that inputting different general health assumptions had less of an effect on longevity than whether or not someone was a smoker. For example, a non-smoking, average health 65-year old male had a life expectancy of 20 years and a 25% probability of living 27 years, while if he smoked, his life expectancy was 13 years and he had a 25% probability of living 20 years. The smoker/non-smoker difference (7 years for males at age 65) was less for females (6/5 years). General health variations were typically 2 years for each health category at age 65.
What does this tool (and others like it) tell us? Generally, these tools confirm that we don’t know when we are going to die and that makes planning more difficult. Based on average statistics, there can be a fairly wide range of results. And the assumption we make today may change tomorrow. The expected period of retirement you choose for planning purposes will likely depend on many factors, such as results from this tool, your knowledge about family health history, your race, your income level, where you live, your personal eating and drinking habits, your smoking habits and most importantly, your risk tolerance for having to reduce your spending budget (or parts of it) if you live longer than you expect. My recommendation to use age 95, or life expectancy if greater is a relatively conservative assumption that is consistent with enjoying excellent health, not smoking and not desiring decreasing real spending budgets until reaching your late 80s. Using a less conservative assumption (fewer years of expected retirement) will increase your current spending budget and increase your risk of decreasing budgets later in life, all things being equal. On the other hand, if you have solid information that indicates your life expectancy is less than average, it makes sense to factor this knowledge into your planning calculations. For example, if you are a smoker, you may want to consider using fewer retirement years to determine your spending budget. I don’t recommend, however, that you take up smoking just to increase your current spending budget.
With one exception, I found the tool very easy to use and potentially helpful for determining the “expected payout period” input item for the Actuarial Budget Calculator in this website. The one exception is the input item called “illustration age.” Most (or all) of the time, you are going to want to leave that box blank, which was not particularly intuitive to me.
The chart in the results section that I found most helpful was the “Planning Horizon” chart. This chart shows probabilities of living “x” more years. The 50% probability is your life expectancy under the assumptions used in the model. As I have discussed in previous posts (see for example my post of December 3, 2014), if you use your life expectancy as your expected payout period, your spending budget will decrease as you age, all other factors being equal. That is why I have recommended assuming death occurs at age 95, or life expectancy if greater. Therefore, I recommend that retirees focus on the 25% probability of living “x” years in this chart when determining a spending budget. If you do this and enter “no smoking” and “excellent health,” the tool will generally produce a 25% probability of living past age 94 for males and 96 for females unless you are over age 80. This result is very similar to my recommendation of using age 95 or life expectancy if greater for the expected payout period in my spreadsheet.
Being an actuary, I found it interesting that inputting different general health assumptions had less of an effect on longevity than whether or not someone was a smoker. For example, a non-smoking, average health 65-year old male had a life expectancy of 20 years and a 25% probability of living 27 years, while if he smoked, his life expectancy was 13 years and he had a 25% probability of living 20 years. The smoker/non-smoker difference (7 years for males at age 65) was less for females (6/5 years). General health variations were typically 2 years for each health category at age 65.
What does this tool (and others like it) tell us? Generally, these tools confirm that we don’t know when we are going to die and that makes planning more difficult. Based on average statistics, there can be a fairly wide range of results. And the assumption we make today may change tomorrow. The expected period of retirement you choose for planning purposes will likely depend on many factors, such as results from this tool, your knowledge about family health history, your race, your income level, where you live, your personal eating and drinking habits, your smoking habits and most importantly, your risk tolerance for having to reduce your spending budget (or parts of it) if you live longer than you expect. My recommendation to use age 95, or life expectancy if greater is a relatively conservative assumption that is consistent with enjoying excellent health, not smoking and not desiring decreasing real spending budgets until reaching your late 80s. Using a less conservative assumption (fewer years of expected retirement) will increase your current spending budget and increase your risk of decreasing budgets later in life, all things being equal. On the other hand, if you have solid information that indicates your life expectancy is less than average, it makes sense to factor this knowledge into your planning calculations. For example, if you are a smoker, you may want to consider using fewer retirement years to determine your spending budget. I don’t recommend, however, that you take up smoking just to increase your current spending budget.
Saturday, April 30, 2016
Use the Actuarial Approach to Win the “Retirement Finance Game”
In three recent posts in The Retirement Cafe, Dirk Cotton, winner of the 2015 RIIA Practitioner Thought Leadership Award, has developed a “top-level” model for Retirement Planning. In his third installment Dirk, who likes to use game theory in explaining his concepts, said “Retirement finance is a random walk along a Markov chain, or to a game theorist, a sequential game against nature. Each year we make forecasts based on what we know (our current financial status and the financial environment), what we expect to happen in the future, and what unexpected outcomes we believe we might experience in the future (risks). We make our move based on this analysis and our risk tolerance. Then nature takes its turn and we repeat.” I recommend reading all three of Dirk’s posts for a different (and eloquent) description of the complicated problem with which most of us retirees must struggle in order to meet our financial goals in retirement.
I believe the Actuarial Approach (and its annual valuation, or “discrete-time states” process) is entirely consistent with the top-level conceptual model developed by Mr. Cotton and provides very useful tools to help retirees win the “retirement finance game.”
I believe the Actuarial Approach (and its annual valuation, or “discrete-time states” process) is entirely consistent with the top-level conceptual model developed by Mr. Cotton and provides very useful tools to help retirees win the “retirement finance game.”
Monday, April 25, 2016
Please Call Off the Search for a Safe Withdrawal Rate
I know that I sound like a broken record on this issue, but as long as retirement experts keep touting safe withdrawal rates (the 4% Rule, etc.), I will continue to warn my readers that these approaches may not be consistent with their spending objectives in retirement. While not necessarily advocating the use of a safe withdrawal rate in his latest article, “The 4% Rule And The Search For A Safe Withdrawal Rate”, Dr. Wade Pfau points out that “75% of surveyed financial planners either ‘always’ or ‘frequently’ use systematic withdrawals with their clients. [So] They care about the safe withdrawal rate.”
For the umpteenth time, I will summarize some of the major downsides using a safe withdrawal rate approach:
Roberta enters her information and the recommended assumptions for 2016 into the Actuarial Budget Calculator. It tells her that the present value of her assets are $1,540,623 and when reduced by the present value of the amount she wants to leave to her daughter leaves a present value of her future spending budgets of $1,487,223.
Roberta then goes to the “Budget by Expense Type” tab. She inputs $100,000 as her reserve for future long-term care expenses (using the methodology described in our January 12, 2016 post, assuming 4.5% future annual cost increases and reflecting only 60% of the expected present value since other expenses will be reduced if and when Roberta enters a long-term care facility). She also enters $50,000 for the present value of her unexpected expenses.
She determines her 2016 non-medical essential expenses to be about $40,000 per year and she believes those expenses will stay relatively constant in real dollar terms in future years, so she enters the recommended inflation assumption of 2.5% per annum for the expected increase for this expense type. The total present value budget attributable to her current and future non-medical essential expenses is $919,494. She enters $6,000 for essential medical expenses with a 4.5% future increase assumption giving her a total present value budget for this item of $180,000. This leaves her with a $229,728 total spending budget for non-essential, discretionary expenses. She decides that she can live with the same dollar amount of non-essential expenses each year, so she inputs a 0% increase assumption for this item, giving her a 2016 non-essential spending budget of $13,966.
Roberta’s total spending budget determined using the Actuarial Approach (excluding any amounts attributable to long-term care or unexpected expenses) is $59,496. Note that this amount is $504 less than the sum she expects to receive during 2016 from Social Security and her pension. Thus, under the Actuarial Approach, in order to meet her spending objectives on an expected basis throughout her retirement, she must actually save $504 of her 2016 pension (or Social Security) in addition to spending $0 from her accumulated savings. By comparison, the 4% Rule would tell her to go ahead and spend $16,000 of her accumulated savings in 2016 in addition to her pension and Social Security.
The Actuarial Approach (and the Budget by Expense Tab) also tells Roberta approximately how much of the present value of her assets are dedicated to each expense type. If she is more concerned about her essential expense budgets, for example, she can choose to invest assets dedicated to those budgets more conservatively than assets dedicated to non-essential expenses. Or, at the end of 2016, she can transfer assets from one expense-type budget to another depending on actual experience during the year.
Most importantly, the Actuarial Approach tells Roberta where she stands each year depending on her actual spending and actual investment performance. Roberta can always choose to smooth her budgets or spending from year to year, but she doesn’t have to rely on blind faith in historical investment results (or restrict actual spending) to develop a reasonable spending budget each and every year of her retirement.
Because of all the unknowns involved, determining a spending budget can sometimes be more art than science. If you a greater than average risk taker, you can always spend more of the present value of your assets now rather than later (with the risk that you may have to spend less later). However, don’t be misled into thinking that just because retirement experts refer to an approach as a “safe withdrawal rate” approach that it is necessarily safe or without risk.
For the umpteenth time, I will summarize some of the major downsides using a safe withdrawal rate approach:
- It doesn’t coordinate with other sources of income (particularly fixed dollar sources like pensions)
- It ignores certain types of expenses such as long-term care expenses, other unexpected expenses and bequest motives.
- It doesn’t distinguish between different types of future expenses, so there is no ability to assume different rates of future increases for different types of expenses and no ability to consider variations in the retiree’s aversion to risk for different types of expenses.
- It is designed to “draw-down” accumulated savings; not be part of a “bigger picture” spending budget
- It is a “set and forget” strategy that requires faith that future investment experience will duplicate historical investment experience (or adjusted historical investment experience).
- It assumes that each year’s retiree spending will exactly equal the safe withdrawal amount.
- It assumes that the retiree will invest at least 50% of accumulated savings in equities and maintain at least this percentage in equities throughout retirement.
- It contains no adjustment mechanisms to keep future spending on track if investments fail to earn rates assumed in the model (or investments earn more than assumed) or if actual spending deviates from the safe withdrawal amounts.
Roberta enters her information and the recommended assumptions for 2016 into the Actuarial Budget Calculator. It tells her that the present value of her assets are $1,540,623 and when reduced by the present value of the amount she wants to leave to her daughter leaves a present value of her future spending budgets of $1,487,223.
Roberta then goes to the “Budget by Expense Type” tab. She inputs $100,000 as her reserve for future long-term care expenses (using the methodology described in our January 12, 2016 post, assuming 4.5% future annual cost increases and reflecting only 60% of the expected present value since other expenses will be reduced if and when Roberta enters a long-term care facility). She also enters $50,000 for the present value of her unexpected expenses.
She determines her 2016 non-medical essential expenses to be about $40,000 per year and she believes those expenses will stay relatively constant in real dollar terms in future years, so she enters the recommended inflation assumption of 2.5% per annum for the expected increase for this expense type. The total present value budget attributable to her current and future non-medical essential expenses is $919,494. She enters $6,000 for essential medical expenses with a 4.5% future increase assumption giving her a total present value budget for this item of $180,000. This leaves her with a $229,728 total spending budget for non-essential, discretionary expenses. She decides that she can live with the same dollar amount of non-essential expenses each year, so she inputs a 0% increase assumption for this item, giving her a 2016 non-essential spending budget of $13,966.
Roberta’s total spending budget determined using the Actuarial Approach (excluding any amounts attributable to long-term care or unexpected expenses) is $59,496. Note that this amount is $504 less than the sum she expects to receive during 2016 from Social Security and her pension. Thus, under the Actuarial Approach, in order to meet her spending objectives on an expected basis throughout her retirement, she must actually save $504 of her 2016 pension (or Social Security) in addition to spending $0 from her accumulated savings. By comparison, the 4% Rule would tell her to go ahead and spend $16,000 of her accumulated savings in 2016 in addition to her pension and Social Security.
The Actuarial Approach (and the Budget by Expense Tab) also tells Roberta approximately how much of the present value of her assets are dedicated to each expense type. If she is more concerned about her essential expense budgets, for example, she can choose to invest assets dedicated to those budgets more conservatively than assets dedicated to non-essential expenses. Or, at the end of 2016, she can transfer assets from one expense-type budget to another depending on actual experience during the year.
Most importantly, the Actuarial Approach tells Roberta where she stands each year depending on her actual spending and actual investment performance. Roberta can always choose to smooth her budgets or spending from year to year, but she doesn’t have to rely on blind faith in historical investment results (or restrict actual spending) to develop a reasonable spending budget each and every year of her retirement.
Because of all the unknowns involved, determining a spending budget can sometimes be more art than science. If you a greater than average risk taker, you can always spend more of the present value of your assets now rather than later (with the risk that you may have to spend less later). However, don’t be misled into thinking that just because retirement experts refer to an approach as a “safe withdrawal rate” approach that it is necessarily safe or without risk.
Thursday, April 21, 2016
Use the Logical “Big Picture” Retirement Budget Setting Alternative
Dirk Cotton has once again hit the nail on the head in his recent blog post when he said, “The details of retirement financial planning are easier to understand once you imagine the big picture and can see what the pieces are and how they fit together. It's easy to get stuck in the weeds. Most retirement literature, unfortunately, doesn’t start with the big picture. It often jumps right into asset allocations or sustainable withdrawal rates.”
The Actuarial Approach advocated in this website is a big picture approach that is based on the simple concept of matching total retirement assets with total retirement liabilities. As discussed in previous posts, the basic actuarial equation used to determine a retiree’s annual spending budget under the Actuarial Approach is:
Market value of Investments + Present Value of Future Retirement Income = Present value of future spending budgets + Present value of amounts left to Heirs
where the present value of future retirement income includes income from all sources, such as Social Security, pensions, annuities, rental income, future home sales, etc. The left hand side of the equation represents a retiree’s total assets while the right hand side of the equation represents the retiree’s total liabilities for future spending.
What does this basic actuarial equation tell us? It tells us that the total amount a retiree can afford to spend in retirement is a function of how much assets (investments plus present value of future retirement income) the retiree has accumulated. Well, of course, this conclusion is obvious, right? You can’t spend what you don’t have. On the other hand, a simple (and perhaps even an obvious) solution is often the best solution.
The basic actuarial equation also tells us that for a given set of assumptions relative to investment return and longevity, the answer to how much one can afford to spend each year is a function of 1) how much assets you have and 2) how you want to spread those assets over the period of your retirement (and after your retirement). You can spread the present value of future spending budgets as a constant real dollar amount, as a decreasing real dollar amount, as an increasing real dollar amount or in some other manner. Also, you can (and probably should) develop separate spending budgets for different expense types, such as expected long-term care costs, unexpected expenses, essential expenses and non-essential expenses. And there is nothing that says that you have to assume the same rate of future increase in these expense types when deciding how to allocate the present value of future budgets for these expenses between current and future years.
An important aspect of the Actuarial Approach is that the retiree (or the retiree’s financial advisor) should go through this exercise of balancing the retiree’s assets and liabilities each year to re-determinine the new spending budget that will make the balance equation work and satisfy the retiree’s spending objectives.
There are some individuals who don’t like that spending budgets may vary from year to year under the Actuarial Approach as a result of a number of factors (such as deviations of actual from assumed investment experience, changes in assumptions, deviations in actual spending from assumed, etc.). They prefer a constant real dollar withdrawal from investments from year to year. First of all, spending the same real dollar amount from a pool of risky assets for every year of retirement is a pipe dream for the reasons I have enumerated in many prior posts. Secondly, safe withdrawal rate strategies are not “Big Picture” strategies as they generally ignore other sources of retirement income and rarely focus on all expenses the retiree can expect. Finally, there is nothing in the Actuarial Approach that prohibits retirees from smoothing spending budgets determined under the Actuarial Approach. Alternatively, they can smooth actual spending or even use a combination of a safe withdrawal rate and the actuarial approach. The important considerations when deciding to smooth under any of these options, however, is to know how far off the actuarially balanced reservation you have strayed so that you can plan the steps necessary to get spending back on track.
Bottom Line: Don’t just tap your investments with a “small picture” safe withdrawal rate approach that may be based on overly optimistic assumptions about expected future rates of investment return. Develop a Big Picture spending budget based on all your assets and liabilities and sound (but relatively simple) actuarial principles.
The Actuarial Approach advocated in this website is a big picture approach that is based on the simple concept of matching total retirement assets with total retirement liabilities. As discussed in previous posts, the basic actuarial equation used to determine a retiree’s annual spending budget under the Actuarial Approach is:
Market value of Investments + Present Value of Future Retirement Income = Present value of future spending budgets + Present value of amounts left to Heirs
where the present value of future retirement income includes income from all sources, such as Social Security, pensions, annuities, rental income, future home sales, etc. The left hand side of the equation represents a retiree’s total assets while the right hand side of the equation represents the retiree’s total liabilities for future spending.
What does this basic actuarial equation tell us? It tells us that the total amount a retiree can afford to spend in retirement is a function of how much assets (investments plus present value of future retirement income) the retiree has accumulated. Well, of course, this conclusion is obvious, right? You can’t spend what you don’t have. On the other hand, a simple (and perhaps even an obvious) solution is often the best solution.
The basic actuarial equation also tells us that for a given set of assumptions relative to investment return and longevity, the answer to how much one can afford to spend each year is a function of 1) how much assets you have and 2) how you want to spread those assets over the period of your retirement (and after your retirement). You can spread the present value of future spending budgets as a constant real dollar amount, as a decreasing real dollar amount, as an increasing real dollar amount or in some other manner. Also, you can (and probably should) develop separate spending budgets for different expense types, such as expected long-term care costs, unexpected expenses, essential expenses and non-essential expenses. And there is nothing that says that you have to assume the same rate of future increase in these expense types when deciding how to allocate the present value of future budgets for these expenses between current and future years.
An important aspect of the Actuarial Approach is that the retiree (or the retiree’s financial advisor) should go through this exercise of balancing the retiree’s assets and liabilities each year to re-determinine the new spending budget that will make the balance equation work and satisfy the retiree’s spending objectives.
There are some individuals who don’t like that spending budgets may vary from year to year under the Actuarial Approach as a result of a number of factors (such as deviations of actual from assumed investment experience, changes in assumptions, deviations in actual spending from assumed, etc.). They prefer a constant real dollar withdrawal from investments from year to year. First of all, spending the same real dollar amount from a pool of risky assets for every year of retirement is a pipe dream for the reasons I have enumerated in many prior posts. Secondly, safe withdrawal rate strategies are not “Big Picture” strategies as they generally ignore other sources of retirement income and rarely focus on all expenses the retiree can expect. Finally, there is nothing in the Actuarial Approach that prohibits retirees from smoothing spending budgets determined under the Actuarial Approach. Alternatively, they can smooth actual spending or even use a combination of a safe withdrawal rate and the actuarial approach. The important considerations when deciding to smooth under any of these options, however, is to know how far off the actuarially balanced reservation you have strayed so that you can plan the steps necessary to get spending back on track.
Bottom Line: Don’t just tap your investments with a “small picture” safe withdrawal rate approach that may be based on overly optimistic assumptions about expected future rates of investment return. Develop a Big Picture spending budget based on all your assets and liabilities and sound (but relatively simple) actuarial principles.
Wednesday, April 20, 2016
Determining the Retirement Income Strategy that is Best for You is Not Necessarily an Easy Task
Last week, as part of his continuous effort to challenge financial advisors to provide better service to their clients, Michael Kitces shared an interesting blogpost entitled, How DO You Measure Which Retirement Income Strategy Is Best? In his post, he examined possible “best” strategies for a 65-year old couple “trying to decide how much to spend for a 30-year retirement from their $1,000,000 portfolio, and how that portfolio should be invested.” He looked at three possible strategies:
A) Spend an inflation-adjusting $30,000/year from the portfolio, by putting 90% of it into an immediate annuity and keeping the other 10% in cash reserves
B) Spend an inflation-adjusting $45,000/year from the portfolio, and invest it 50/50 in stocks and bonds
C) Spend an inflation-adjusting $60,000/year from the portfolio, and invest it 100% in stocks
Making assumptions about future inflation (3%) and expected returns on cash (3%), intermediate bonds (5%) and stocks (10%) and relevant standard deviations and correlations (undisclosed) for Monte Carlo projections, Michael determined which of the three strategies was “best” based on eight possible ways to measure the outcomes (including three levels of how risk-averse the retiree is). His analysis is summarized nicely in a chart. Michael concludes that “careful thought about how a strategy will be evaluated is actually an essential aspect of the process in crafting financial planning recommendations.”
Kudos to Michael for suggesting such an approach. I worry, however, about how comprehensive and meaningful the process would be in actual practice. The results are very much dependent on the assumptions made for future expected returns of the various asset classes. Projections of future experience that are based on poor assumptions will yield poor results. How would the results change, for example, if instead of assuming a 7% expected risk premium for stocks, Michael had assumed “only” 4%? If current annuity purchase rates are used for the most conservative options, expected future returns should properly reflect current economic conditions as well to make sure that comparisons are “apples to apples.” Perhaps a more comprehensive process would involve several charts illustrating variations in expected assumptions (a suggestion that I would also make for Monte Carlo simulations in general).
As Michael points out, the situation is further complicated by the fact that “most clients have multiple and complex goals and preferences.” Certainly, many retirees may have different risk preferences for different types of budget expenses (essential vs. non-essential for example), so the strategies examined may have to be more complicated than the three examined by Michael in his example. In addition, the existence of other sources of retirement income can further complicate the analysis as can funding for long-term care and unexpected expenses.
Finally, even if simple strategies are chosen, care should be taken to make sure that they represent potentially best strategies. For example, if I go to annuityquickquote.com, I get a quote of $555 per month per $100,000 premium for a 65-year old male payable as a fixed dollar immediate 15-year certain and life annuity and a quote of $502 per month per $100,000 premium for a 65-year old female payable as a fixed dollar immediate 15-year certain and life annuity. If I split Michael’s $900,000 premium equally for the husband and the wife, I’m looking at total annual payments from the contracts of $57,078 as long as both the husband and wife are alive. Using the Actuarial Budget Calculator spreadsheet from this website and inputting $100,000 invested in cash (and Michael’s 3% assumptions for expected return on cash and desired future increases to adjust for expected inflation), I come up with a total amount spendable in the first year of retirement of $41,774. (Note that in order to provide inflation increases throughout the 30 period of retirement, a significant portion of initial year’s annuity payments would have to be saved). This strategy would provide about 39% higher benefits than Michael’s Strategy A. I would imagine that this strategy would fare better under Michael’s comparisons than Strategy A.
While I believe that Michael chose these three strategies to illustrate how his process night work, I become skeptical when someone tells me that I can spend 33% more in retirement if I simply increase my investment in equities from 50% to 100% (Strategy C vs. Strategy B). Unless you are very conservative with your investments, I recommend that you assume about the same rate of future investment return that is “baked” into insurance company life annuity pricing, as this is approximately the discount rate at which you can “settle” your future budget liabilities. My rational for making this recommendation is that while you might expect to achieve higher rates of investment return by investing in riskier assets, you are taking on more risk, and this increased risk tends to counterbalance the positive effect of higher expected returns when it comes to determining how much of your assets you can afford to spend.
FYI, you can use the Actuarial Budget Calculator to determine that the future deterministic real rate of investment return implied by Michael’s Strategy B is about 2.3% per annum, while the future deterministic real rate of investment return implied by Strategy C is about 4.8%.
A) Spend an inflation-adjusting $30,000/year from the portfolio, by putting 90% of it into an immediate annuity and keeping the other 10% in cash reserves
B) Spend an inflation-adjusting $45,000/year from the portfolio, and invest it 50/50 in stocks and bonds
C) Spend an inflation-adjusting $60,000/year from the portfolio, and invest it 100% in stocks
Making assumptions about future inflation (3%) and expected returns on cash (3%), intermediate bonds (5%) and stocks (10%) and relevant standard deviations and correlations (undisclosed) for Monte Carlo projections, Michael determined which of the three strategies was “best” based on eight possible ways to measure the outcomes (including three levels of how risk-averse the retiree is). His analysis is summarized nicely in a chart. Michael concludes that “careful thought about how a strategy will be evaluated is actually an essential aspect of the process in crafting financial planning recommendations.”
Kudos to Michael for suggesting such an approach. I worry, however, about how comprehensive and meaningful the process would be in actual practice. The results are very much dependent on the assumptions made for future expected returns of the various asset classes. Projections of future experience that are based on poor assumptions will yield poor results. How would the results change, for example, if instead of assuming a 7% expected risk premium for stocks, Michael had assumed “only” 4%? If current annuity purchase rates are used for the most conservative options, expected future returns should properly reflect current economic conditions as well to make sure that comparisons are “apples to apples.” Perhaps a more comprehensive process would involve several charts illustrating variations in expected assumptions (a suggestion that I would also make for Monte Carlo simulations in general).
As Michael points out, the situation is further complicated by the fact that “most clients have multiple and complex goals and preferences.” Certainly, many retirees may have different risk preferences for different types of budget expenses (essential vs. non-essential for example), so the strategies examined may have to be more complicated than the three examined by Michael in his example. In addition, the existence of other sources of retirement income can further complicate the analysis as can funding for long-term care and unexpected expenses.
Finally, even if simple strategies are chosen, care should be taken to make sure that they represent potentially best strategies. For example, if I go to annuityquickquote.com, I get a quote of $555 per month per $100,000 premium for a 65-year old male payable as a fixed dollar immediate 15-year certain and life annuity and a quote of $502 per month per $100,000 premium for a 65-year old female payable as a fixed dollar immediate 15-year certain and life annuity. If I split Michael’s $900,000 premium equally for the husband and the wife, I’m looking at total annual payments from the contracts of $57,078 as long as both the husband and wife are alive. Using the Actuarial Budget Calculator spreadsheet from this website and inputting $100,000 invested in cash (and Michael’s 3% assumptions for expected return on cash and desired future increases to adjust for expected inflation), I come up with a total amount spendable in the first year of retirement of $41,774. (Note that in order to provide inflation increases throughout the 30 period of retirement, a significant portion of initial year’s annuity payments would have to be saved). This strategy would provide about 39% higher benefits than Michael’s Strategy A. I would imagine that this strategy would fare better under Michael’s comparisons than Strategy A.
While I believe that Michael chose these three strategies to illustrate how his process night work, I become skeptical when someone tells me that I can spend 33% more in retirement if I simply increase my investment in equities from 50% to 100% (Strategy C vs. Strategy B). Unless you are very conservative with your investments, I recommend that you assume about the same rate of future investment return that is “baked” into insurance company life annuity pricing, as this is approximately the discount rate at which you can “settle” your future budget liabilities. My rational for making this recommendation is that while you might expect to achieve higher rates of investment return by investing in riskier assets, you are taking on more risk, and this increased risk tends to counterbalance the positive effect of higher expected returns when it comes to determining how much of your assets you can afford to spend.
FYI, you can use the Actuarial Budget Calculator to determine that the future deterministic real rate of investment return implied by Michael’s Strategy B is about 2.3% per annum, while the future deterministic real rate of investment return implied by Strategy C is about 4.8%.
Saturday, April 2, 2016
You Can Do Better Than the IRS Required Minimum Distribution (RMD) Rules for Your Withdrawal Strategy
A number of financial experts tout the benefits of using the same IRS Publication 590 life expectancy factors required for determining required minimum distributions from qualified plans for the purpose of determining annual spending withdrawals from accumulated savings in retirement. They argue that these factors are readily available, reflect remaining life expectancy, generally must be applied (for RMD purposes) in each year beginning with the year a retiree reaches age 70.5 and are conservative.
In his March 31 article, Henry K. “Bud” Hebeler sets forth seven essentials in retirement planning that do-it-yourself planners should not ignore. I am in total agreement with the first 6 essentials and the first part of the seventh. In this post, however, I’m going to take issue with the last few sentences of Bud’s article.
Even casual readers of this blog will know that I’m not a big fan of any withdrawal strategy that doesn’t properly coordinate with other sources of retirement income to produce a reasonable spending budget. As I have discussed in prior posts, the RMD approach will generally not work very well for a retiree who has other fixed dollar sources of retirement income [pensions, immediate or deferred annuities] and who desires to have relatively constant dollar spending throughout retirement. I did, however, give kudos to Henry “Bud” Hebeler in our March 26 post for developing an adjustment to apply to fixed dollar pension benefits/annuities so that he could add withdrawals determined the RMD approach and still develop a reasonable spending budget. Notwithstanding the existence of Bud’s fixed dollar adjustment (which would be appropriate to use with any rule of thumb approach), I believe the RMD approach is just too conservative for most retirees.
The table below shows rates of withdrawal by age for the RMD approach vs. the Actuarial Approach using recommended assumptions for discount rate, inflation rate and expected period of retirement. Note that the withdrawal rates shown for the Actuarial Approach were developed by assuming no fixed dollar pensions/annuities exist and assuming no bequest motive to facilitate an “apples to apples” comparison of withdrawal rates.
The first column shows withdrawal rates by age under the RMD approach. These rates are obtained by dividing 1 by the life expectancy from the IRS Publication 590 tables. The second column shows withdrawal rates under the Actuarial Approach under our current recommended assumptions (4.5% discount rate, 2.5% inflation and period of retirement equal to 95-attained age or life expectancy if greater). The withdrawal rates in the second column are designed to produce constant real-dollar withdrawals at least until about age 90 (after which time real-dollar withdrawals would be expected to decline somewhat from year to year) if the recommended assumptions are exactly realized. As can be seen in the table above, the RMD withdrawal rates are consistently significantly lower than the rates using the Actuarial Approach. The primary reason for this is that instead of assuming a 2% real discount rate (4.5% - 2.5%), the RMD approach effectively assumes a 0% real discount rate. The net effect, then, of using RMD withdrawal rates would be to back-load real dollar spending to later years of retirement under the recommended assumptions.
The final two columns of this table, show withdrawal rates for males and females using the 2% real discount rate but instead of assuming death occurs at 95, these columns assume death occurs at the end of life expectancy determined using the 2012 SoA Individual Annuity Mortality Table with 1% mortality improvement (a link to which may be found in our Other Calculators and Tools section). Also shown in these columns in parentheses are the remaining life expectancies for applicable ages.
While Mr. Hebeler indicates that every year you live your life expectancy grows, this is technically not an accurate statement. As can be seen from the table, your life expectancy decreases as you age, but your expected age at death (i.e., the sum of your age and your life expectancy) does increase. This is probably what Bud intended to say. Using your life expectancy as your expected period of retirement produces higher withdrawal rates than the age 95 approach, all things being equal, but as you age this results in declining real dollar withdrawals if all other assumptions are realized. Therefore, unless you consciously want to front-load real dollar spending earlier in your retirement, we recommend planning to live until age 95. We also recommend that you avoid using the RMD approach (with possible necessary adjustments of fixed dollar pensions, etc.) and just stick with the Actuarial Approach.
In his March 31 article, Henry K. “Bud” Hebeler sets forth seven essentials in retirement planning that do-it-yourself planners should not ignore. I am in total agreement with the first 6 essentials and the first part of the seventh. In this post, however, I’m going to take issue with the last few sentences of Bud’s article.
Even casual readers of this blog will know that I’m not a big fan of any withdrawal strategy that doesn’t properly coordinate with other sources of retirement income to produce a reasonable spending budget. As I have discussed in prior posts, the RMD approach will generally not work very well for a retiree who has other fixed dollar sources of retirement income [pensions, immediate or deferred annuities] and who desires to have relatively constant dollar spending throughout retirement. I did, however, give kudos to Henry “Bud” Hebeler in our March 26 post for developing an adjustment to apply to fixed dollar pension benefits/annuities so that he could add withdrawals determined the RMD approach and still develop a reasonable spending budget. Notwithstanding the existence of Bud’s fixed dollar adjustment (which would be appropriate to use with any rule of thumb approach), I believe the RMD approach is just too conservative for most retirees.
The table below shows rates of withdrawal by age for the RMD approach vs. the Actuarial Approach using recommended assumptions for discount rate, inflation rate and expected period of retirement. Note that the withdrawal rates shown for the Actuarial Approach were developed by assuming no fixed dollar pensions/annuities exist and assuming no bequest motive to facilitate an “apples to apples” comparison of withdrawal rates.
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The first column shows withdrawal rates by age under the RMD approach. These rates are obtained by dividing 1 by the life expectancy from the IRS Publication 590 tables. The second column shows withdrawal rates under the Actuarial Approach under our current recommended assumptions (4.5% discount rate, 2.5% inflation and period of retirement equal to 95-attained age or life expectancy if greater). The withdrawal rates in the second column are designed to produce constant real-dollar withdrawals at least until about age 90 (after which time real-dollar withdrawals would be expected to decline somewhat from year to year) if the recommended assumptions are exactly realized. As can be seen in the table above, the RMD withdrawal rates are consistently significantly lower than the rates using the Actuarial Approach. The primary reason for this is that instead of assuming a 2% real discount rate (4.5% - 2.5%), the RMD approach effectively assumes a 0% real discount rate. The net effect, then, of using RMD withdrawal rates would be to back-load real dollar spending to later years of retirement under the recommended assumptions.
The final two columns of this table, show withdrawal rates for males and females using the 2% real discount rate but instead of assuming death occurs at 95, these columns assume death occurs at the end of life expectancy determined using the 2012 SoA Individual Annuity Mortality Table with 1% mortality improvement (a link to which may be found in our Other Calculators and Tools section). Also shown in these columns in parentheses are the remaining life expectancies for applicable ages.
While Mr. Hebeler indicates that every year you live your life expectancy grows, this is technically not an accurate statement. As can be seen from the table, your life expectancy decreases as you age, but your expected age at death (i.e., the sum of your age and your life expectancy) does increase. This is probably what Bud intended to say. Using your life expectancy as your expected period of retirement produces higher withdrawal rates than the age 95 approach, all things being equal, but as you age this results in declining real dollar withdrawals if all other assumptions are realized. Therefore, unless you consciously want to front-load real dollar spending earlier in your retirement, we recommend planning to live until age 95. We also recommend that you avoid using the RMD approach (with possible necessary adjustments of fixed dollar pensions, etc.) and just stick with the Actuarial Approach.
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