In Search of the Optimal Retirement Planning Strategy

In his October 18 post What Is The Optimal Shape of Retirement Planning—Curve, Triangle or Rectangle? Michael Kitces did an excellent job of summarizing the evolution of retirement planning strategies and discussing the benefits and limitations of the three different strategies identified in his post.  The inspiration for Mr. Kitces’ post is a fine article by Patrick Collins and Francois Gadenne entitled The Shapes of Retirement Planning—Are You a Curve, a Triangle, or a Rectangle?  In our post today, we will briefly highlight some of the discussion in these articles and encourage you to read these thought-provoking pieces.

Collins/Gadenne Article

In their article, Messrs. Collins and Gadenne employ three very clever geometric metaphors to describe the three general types of retirement planning strategies currently used by financial advisors.  They encourage advisors to consider employing the more holistic household balance sheet approach, the rectangle shape, that considers all of a household’s present and future assets and spending liabilities to determine a funded status or a current spending budget.  According to these gentlemen, “This article is a call to advisors to expand beyond asset allocation pie charts and Sharpe ratio values to diagnose feasibility of goal funding and monitor the plan’s performance by helping clients ask and answer the following questions:

• Do I have enough to do what I’d like?
• How likely is it that my plan will remain sustainable under future economic environments?
• What is my capacity to meet the unknown or unexpected?”

While we have not developed a full understanding of the planning strategy they proposed, it is clear to us that it has a lot in common with our rectangularly-shaped Actuarial Approach, as both approaches employ balance sheet comparisons of an individual’s or household’s assets and spending liabilities.

Michael Kitces Post

In his post, Mr. Kitces deftly summarizes the three Collins/Gadenne geometric metaphors and his understanding of the benefits and limitations of employing each type of retirement planning strategy.  In response to his question “What is the optimal shape of retirement planning?” Mr. Kitces concludes that the best approach for retirement planning may involve incorporating elements from all three shapes.

Our Take

We support the Collins/Gadenne endorsement of what we consider to be the use of basic actuarial principles in the personal financial planning process.  We believe employing these principles will not only better meet the needs of clients of financial advisors, but also reduce financial advisor fiduciary liability.  At the same time, however, we also support Mr. Kitces’ conclusion that an optimal consulting approach may very well involve elements from different approaches.  It is exactly for this reason that we suggested in our Advisor Perspective article (originally entitled “Give Your Clients Another Data Point Each Year to Help Them Make Better Financial Decisions”) that financial advisors supplement their client consulting (i.e., not necessarily replace what they are doing) with calculation and explanation of the client’s Actuarial Budget Benchmark (ABB).

Mr. Kitces is critical of the sensitivity of the rectangle approach to the use of different discount rate assumptions to determine present values of assets and spending liabilities.  He indicates:

• that there is little agreement on the appropriate discount rate to use,
• “nothing on the household balance sheet directly conveys the greater risk that is inherent in assuming a higher discount rate”, and
• “two advisors using the same rectangle approach may still come up with substantively different conclusions and recommendations about whether the prospective retiree is on track!”

It is exactly for these reasons that we advocate using basic financial economic principles and annuity based pricing assumptions to develop the client’s ABB.  Use of these assumptions provides a mark-to-market comparison of the client’s assets and liabilities under the Actuarial Approach and significantly mitigates the concerns raised by Mr. Kitces.

Are There Better Spending Budget Calculators Out There Than Our Actuarial Budget Calculators?

We occasionally hear that the Excel workbooks that we make available in our website to help individuals and couples perform the present value calculations required by the Basic Actuarial Equation, are inferior to other free retirement calculators available on the Internet.  Depending on what you are specifically looking to accomplish, this can be a valid comment.  Our Excel Actuarial Budget Calculator (ABC) workbooks are clearly not the most sophisticated or sexiest personal planning spreadsheets around and are not designed to replace all the tasks generally performed by a financial advisor.  Readers interested in kicking the tires on other retirement calculators may find Mr. Darrow Kirkpatrick’s website that rates “The Best Retirement Calculators” to be of interest.  In full disclosure, our ABCs do not make the author’s curated list, and we have not compared our spreadsheets with all the calculators on Mr. Kirkpatrick’s list.

Despite being omitted from Mr. Kirkpatrick’s list, we believe that using our ABC spreadsheets with our recommended assumptions (or using the Basic Actuarial Equation directly) can provide you (or if you are a financial advisor, your clients) with important data points to help with personal financial planning.  Since we have not compared our spreadsheets with every other calculator in the universe, we can’t say for sure that our spreadsheets are better than every other free calculator available on the Internet for every conceivable purpose.  In this post, we will outline some of the common criticisms of our spreadsheets and respond to them, as well as discuss some of the things our spreadsheets can do that we don’t generally see in other calculators, and other reasons why we prefer our approach.

Common Criticisms of the ABC Spreadsheets and Responses

Deterministic Assumptions.  The most common criticism of our spreadsheets we hear is that they utilize a deterministic (or average) investment return assumption that ignores the individual’s actual or desired asset mix.  Many retirement calculators incorporate Monte Carlo modeling and require input of the individual’s asset allocation information.  This enables these calculators to provide a measure of volatility of the proposed asset mix and a probability of success of meeting specific retirement goals based on the assumptions used for the model.

By comparison, the recommended assumptions used to calculate the Actuarial Budget Benchmark (ABB), using either our spreadsheets or the Basic Actuarial Equation, are consistent with the financial economics principle that the cost of retirement (in this instance) is not a function of individual’s asset mix, but rather is determined by the “defeasance cost” of the individual’s spending liability.  For this purpose, we recommend assumptions approximately consistent with those used to price immediate life annuities (annuity based pricing).  And while we don’t provide users with probabilities of success (or failure), we stress that the Actuarial Approach requires periodic adjustments, at least annually, to keep spending plans on track to meet retirement goals.

Since our focus is determining how much one can afford to spend each year, and not how to invest one’s assets, and we subscribe to the financial economics theory that spending levels should not necessarily be a function of how assets are invested, our spreadsheets are indeed silent with respect to asset mix.  We understand that this may be heretical to some financial advisors.   For this reason, we suggest that financial advisors or others may wish to consider supplementing whatever they are currently doing with the Actuarial Budget Benchmark (ABB) to provide clients with a relatively low risk “data point” to help them with their spending decisions as discussed in our post of May 10, 2017.   It is also important to note here that we don’t advocate any specific investment strategy, and while we use annuity based pricing to determine the cost of retirement, we don’t necessarily advocate investment in annuities.

Pre-tax Calculations.  Our spreadsheets develop a pre-tax spending budget that considers taxes to be just another expense to be covered by the spending budget.   This bothers some people who point out that assets have potentially different tax treatment when they are distributed, and this difference should be considered in an “accurate” model.  For pre-retirement planning, it will be necessary for individuals to manually reflect adjust their target spending after retirement to reflect these differences.  We don’t see this as a big issue.

Longevity and Social Security Information.  We ask users to gather relevant data on expected lifetime planning periods (LPP) from the Actuaries Longevity Illustrator (http://www.longevityillustrator.org/) and expected Social Security benefits from the Social Security Quick Calculator (https://www.ssa.gov/oact/quickcalc/), rather than building these calculations into the spreadsheet.  Unfortunately, it is just not practical to build these calculations into our spreadsheets.

Positive Aspects of Our Spreadsheets That We Don’t Generally Find in Other Calculators:

• Our spreadsheets are reasonably transparent and user-friendly and don’t involve black-box assumptions relative to asset returns
• We have a 5 Year Projection tab that enables users to model different experience with respect to investment returns and actual spending
• Our ABC for Retirees has a Budget by Expense Type tab that enables the user to make different assumptions for various types of expenses
• Our spreadsheet permits users to shape spending by making different assumptions about future increases in spending budgets or by treating certain expenses as “non-recurring” vs. “recurring”
• Our spreadsheets are Excel spreadsheets which you download so that information you input safely resides on your computer, not on the web, and
• We utilize basic actuarial principles

Conclusion

Are our ABC spreadsheets the best free retirement calculators available on the internet?  Probably not for everyone and not for every purpose, but we believe they are quite robust and can be useful tools for those we call “Intelligent Numbers People” (INPs).  If our readers have suggestions for improving our spreadsheets please forward them to us.  We are currently in the process of developing an ABC for Retired Couples that will more accurately calculate spending budgets for couples.  We hope to have this spreadsheet available in the next few months in time for 2018 calendar year budgeting, although it is unlikely to have all the tabs included in our ABC for Retirees workbook.

We note that some of the perceived limitations of our spreadsheets don’t necessarily apply if you are not using our spreadsheets but are using the Basic Actuarial Equation instead.  If you are using the Basic Actuarial Equation, you can use Monte Carlo modeling and you can make your calculations as complicated and sophisticated as you desire.  It is important to keep in mind, however, that it may not be worth your time and considerable effort to develop a more sophisticated model just to determine a spending budget that you may consult only once a year.

Nice Review of The Actuarial Approach in The Globe and Mail

Thanks to Ian McGugan, reporter with The Globe and Mail’s Report on Business, for his complementary review of the Actuarial Approach in his article of October 3, 2017.  And even though we tend to be a little too U.S. centric in our posts, it is important to note that the Actuarial Approach will work just fine for our nice neighbors up north.

Better Budgeting with the IRS RMD Table?

In his recent Advisor Perspectives article, Joe Tomlinson touts the benefits of using a “variable” or “dynamic” strategic withdrawal plan (SWP) like the “endowment SWP” rather than a “fixed” SWP like the 4% Rule.   According to Mr. Tomlinson, “The general superiority of variable over fixed withdrawals applies regardless of the type of [investment] sequence.”  Under an endowment SWP (for example, x% of each year’s accumulated savings), withdrawals may fluctuate from year to year based on actual investment performance or actual spending for the previous year, while under a fixed SWP, withdrawals are not based on actual investment performance or actual spending, and are generally just increased from one year to the next by inflation (with the hope that the money doesn’t run out).  There are, of course, many hybrid SWPs that combine elements of both approaches and/or smooth the individual’s withdrawals from year to year.

In addition to advocating variable SWPs over fixed SWPs to mitigate sequence of return risk, Mr. Tomlinson’s research demonstrates that the IRS Required Minimum Distribution (RMD) SWP improves retirement outcomes over a flat percentage endowment SWP.  He indicates that this is accomplished “in very approximate terms… by dividing savings by expected remaining life.” He notes, “One can attempt exact calculations using an appropriate actuarial table and assumed investment returns, or a simpler approach is to rely on the IRS requires [sic] minimum distribution (RMD) tables.”

The Actuarial Approach we recommend in this website, which is also a variable approach, uses the more “exact actuarial calculations” referred to by Mr. Tomlinson; that is, it uses the present value of the future lifetime planning period with desired annual future increases.  And while the IRS RMD SWP may be a tad simpler than the Actuarial Approach, we believe that doing the more exact actuarial calculations is definitely worthwhile and can improve retirement outcomes even more.  This is why our website tagline reads, “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”  The following paragraphs discuss why we believe you or your financial advisor may be making a mistake using the “simpler” IRS RMD SWP advocated by Mr. Tomlinson to determine your spending budget in retirement or to determine when you should retire or how much you should be saving for retirement.  Our reasons may be summarized as:

• The IRS RMD SWP is quite conservative 
• SWPs frequently do not coordinate well with other sources of retirement income 
• SWPs generally do not adequately recognize non-recurring expenses in retirement and do not anticipate different rates of increase in future recurring expenses 
• SWPs generally don’t permit “budget shaping” to meet individual retirement goals, and 
• SWPs generally don’t do a particularly good job of helping you with pre-retirement planning
  

The IRS RMD SWP is quite conservative

The IRS didn’t design its Required Minimum Distribution table to be used as a spending budget tool for retirees.  The rules were designed to force retirees with pre-tax accumulations in qualified defined contribution plans and IRAs to take distributions from these plans so that the government could collect their income taxes.  And by the way, just because you are required under these rules to make minimum withdrawals, you aren’t required to spend the money when you do.   Determining how much you can afford to spend each year is an entirely different matter.

Because the required minimum distribution under the IRS RMD rules are determined assuming a 0% real discount rate and a very conservative mortality table, the distribution periods in the IRS tables produce lower withdrawals at every age than the more exact Actuarial Approach.

The following chart compares real dollar spending under:

• the IRS RMD rules vs. 
• the Actuarial Approach

We used the same person in Mr. Tomlinson’s straightforward example (female age 65 with $1,000,000 in accumulated savings and a Social Security benefit of $30,000 per year), and we assumed exact realization in the future of our current Actuarial Budget Benchmark recommended assumptions (4% investment return assumption, 2% inflation, 31-year lifetime planning period and 2% annual desired increases in future spending budgets).  We also ignored, as Mr. Tomlinson did, long-term care costs, unexpected expenses and bequest motives, and we assumed, as Mr. Tomlinson did, that the hypothetical person would spend exactly her spending budget each year (at the beginning of each year).   For ages prior to 70, we assumed a 3.5% per year annual rate of withdrawal under the IRS RMD SWP.

click to enlarge

The chart shows that the hypothetical female’s total spending budget is consistently higher in real dollar terms under the Actuarial Approach than under the IRS RMD approach. Yes, we understand that it is highly unlikely that the assumptions about the future that we made to develop this chart will be exactly realized every year for the next 25 years.   But, that is not the point here.  The point is to illustrate the clear relationship between the two lines, as both of these approaches are variable approaches and, absent any smoothing, these two lines will move up and down in tandem with actual investment performance.  Under these assumptions for the future, the hypothetical person’s accumulated savings at the end of her 89th year are $716,896 under the IRS RMD approach as compared with $243,171 under the Actuarial Approach.  Therefore, if one of her goals is to maximize retirement income and not leave significant bequests, as Mr. Tomlinson indicated, she would be much better off using the Actuarial Approach.  

The chart also shows that for much of her expected period of retirement, her spending is expected to increase in real dollar terms under the IRS RMD approach as she ages under the assumptions selected.  Such increases in real dollar spending may also not be consistent with her retirement goals.  She may desire a more level (or even front-loaded) expected spending pattern.

SWPs frequently do not coordinate well with other sources of retirement income

Retirement spending goals generally involve how much you can afford to spend, not how to “tap” your accumulated savings.  SWPs in general and the IRS RMD approach specifically are concerned only with how to tap your accumulated savings and not the bigger picture of your total spending.   As we have discussed many times, (most recently in our post of August 8, 2017), SWPs may not work very well if you have other sources of income that aren’t paid for the entire duration of retirement (like part-time employment or QLACs) or are not paid in a manner consistent with your desired future increases in spending budgets (like fixed dollar pension benefits or life annuity payments).   For couples, other sources of income may commence or cease at different times.  In these instances, you may not be able to develop a reasonable spending budget by simply adding other sources of income for the year to the SWP amount for that year.  To smooth out these discontinuities and produce a more reasonable spending budget, the Actuarial Approach takes the present value of income from other sources and spreads it over the individual’s (or couple’s) future lifetime using the same spreading factor (and same desired increases) used to spread your accumulated savings.  Therefore, if you like how the Actuarial Approach spreads your accumulated savings, you will love how it spreads the present value of your income from other sources to develop a more reasonable spending budget.

SWPs like the IRS RMD approach don’t consider your non-recurring expenses and they don’t anticipate different rates of increases for different types of expenses.
Retirement experts constantly bombard us with admonitions to be sure to worry about increasing health-care costs, unexpected expenses and long-term care costs when we do our retirement planning.  Despite these admonitions, SWPs like the IRS RMD approach generally focus only on your recurring spending in retirement and not these non-recurring expense items.  By comparison, these items are addressed directly using the Actuarial Approach.

SWPs generally don’t permit “budget shaping” to meet individual spending goals

As discussed in our previous two posts, the Actuarial Approach can be used to shape your spending budget to better meet your spending needs in retirement.  For example, you can “front-load” your travel expenses by treating them as non-recurring, or you can plan on decreasing spending budgets in real dollars as you age consistent with the “go-go, slow-go and no-go” phases of retirement noted by many retirement researchers.

SWPs don’t do a particularly good job of helping with pre-retirement planning

Unlike SWPs that focus on helping you tap your savings after retirement, the same basic principles used in the Actuarial Approach can help you plan for your retirement.  It can be used to develop a spending/savings budget consistent with your retirement goals and keep you on track as experience deviates from your assumptions.

Conclusion

While the IRS RMD SWP may be a better approach than the 4% Rule and other fixed SWPs for purposes of “tapping your savings”, neither of these SWPs can hold a candle to the Actuarial Approach in terms of helping you develop a reasonable spending budget and make other financial decisions.  Unfortunately, financial planning is relatively complex and not always adequately addressed by simple rule of thumb approaches.  We encourage you to utilize the basic actuarial principles inherent in the Actuarial Approach and do the number crunching necessary to obtain the right answer for you based on your specific situation and your specific financial goals.

We have no problem with Mr. Tomlinson’s suggestion that fund companies keep the IRS RMD rules in mind when developing managed payout options for their clients (particularly those with tax qualified accounts.  We firmly believe, however, that financial advisors can do a much better job for their clients by employing the more “exact actuarial calculations” inherent in the Actuarial Approach rather than by using IRS RMD tables.

Front-Loading Your Spending Budget by Treating Travel Expenses as a Non-Recurring Expense

After our last post, we received several questions on what we meant (and what would be involved) when we suggested that retirees might wish to consider treating certain expenses as non-recurring to “front-load” their spending budgets.  This post will present an example that might be helpful in explaining this particular “budget-shaping” approach. 

Example

Mary is a 65-year old with $500,000 in accumulated savings and she is receiving a Social Security benefit of $2,000 per month.  For simplicity purposes, let's assume these are her only two sources of income and her only expected non-recurring expense is $50,000 of unexpected expenses.  Using the Actuarial Budget Calculator for Retirees (ABC) and our recommended assumptions (4% discount rate, 2% inflation, 2% desired increases and 31 years LPP), Mary develops an annual recurring real dollar spending budget of $43,135.  This amount is equal to the present value of her future spending budgets of $1,014,425 divided by the present value of her future years with desired increases of 23.5177.  If all assumptions are realized in the future, Mary expects her spending budget to remain at this level in real dollars throughout her period of retirement. 

Mary has determined that her non-travel essential expenses are about $38,000 per year.  The spending budget that she has developed in the paragraph above therefore only leaves her with about $5,100 as an annual travel budget.  Based on her understanding of the “go-go, slow-go and no-go” stages of retirement, she understands that she may not have the same desire to travel when she becomes older, and she decides to consider “front-loading” her desired travel expenses over a limited period rather than spreading them equally over the remainder of her life.

So, let's assume that Mary decides that she is going to travel until she is 80 (15 years) and she would like to spend $10,000 per year in real dollars for travel each of those 15 years.  Since she does not anticipate traveling every year of her retirement, she treats her traveling expenses as a non-recurring expense rather than one that will last until she dies.  Using our Present Value Calculator spreadsheet, she determines the present value of her future traveling expenses to be $131,397 and enters this amount in the ABC along with the $50,000 present value she has budgeted for unexpected expenses.  This reduces her recurring non-travel budget to $37,547, but her total real-dollar travel and non-travel budgets for this year (and the next 14 years are expected to be $47,547 ($10,000 plus $37,547), or about 10% higher than her initial “non-front-loaded” spending budget.  All things being equal, however, she expects her real dollar total spending budget under this “front-loaded” approach for ages after 79 will only be $37,547 in real dollars, or about 13% less than the non-front-loaded budget.   Since this amount is a little bit more than her expected non-travel essential expenses, she considers this alternative front-loaded budget shaping approach as a possible way to go.  If Mary decided that a travel budget of $10,000 per annum may still not be sufficient to satisfy her desired travel plans, she could look at a higher travel budget and shorter travel period as another alternative. 

The graph below illustrates Mary’s choice, again assuming all assumptions made about the future are exactly realized. 

(click to enlarge)

Conclusion

The graph illustrates the general rule of spending in retirement that we refer to frequently in our blog:  You can spend it now or you (or your heirs) can spend it later.   There is no free lunch.  If you want a higher spending budget in retirement, you either need to increase your assets (for example, Mary could take a part-time job) or you can increase the risk that your spending will decrease in the future in real dollars by front-loading your current spending.

It is also important to note that assumptions made about the future will not be exactly realized.  For example, as you age, your lifetime planning period plus your age may increase (your expected age at death).  All things being equal, an increase in your expected age at death will result in an “actuarial loss” that will decrease your real dollar annual spending budget.  Therefore, it is critical to revisit one’s spending budget annually to reflect actual experience, actual spending and any changes in your desired spending goals.  Things change.  Budgeting your spending should not be a “one and done” process.

Are You Over-Estimating Your Future Retirement Spending Needs?

In this post, we will focus on the future estimated spending liabilities (right-hand side) of the Basic Actuarial Equation, which is frequently shown in this website and is advocated by us to develop your spending budget.

Accumulated Savings

+

PV Income from Other Sources

=

PV Future Non-Recurring Expenses

+

PV Future Recurring Annual Spending Budgets

 
If you over-estimate your future spending liabilities, you run the risk of underspending today.  If you under-estimate your future spending liabilities, you run the risk of overspending today.  Clearly, the more “conservative” strategy is to over-estimate your future spending liabilities and spend less today.  On the other hand, if you are too conservative, you may be denying yourself the lifestyle you really want to enjoy today and may be unintentionally increasing the amount you ultimately leave to your heirs.  This is perhaps one of the most difficult trade-offs that you (possibly with the help of your financial advisor) will have to face in your financial planning.

We will address this important trade-off first for pre-retirees who may be considering retirement, and then for both pre-retirees and retirees.

Pre-retirees Considering Retirement

Some retirement “experts” tell us that we need to replace 70% - 80% of our pre-retirement gross income to enjoy the same lifestyle after retirement as before.  Other experts tell that we need to accumulate savings of 10 times or more of our pre-retirement gross pay to retire at age 67.  These “rules of thumb” frequently over-state post-retirement spending liabilities, particularly if, just prior to retirement, the individual (or couple) has been:

• saving significant amounts, 
• making large mortgage payments, or 
• making large education payments
  

Since these types of expenditures are frequently not required throughout the entire period of retirement, it will generally not be required to consider them as recurring expenses to be replaced in retirement.  For this reason, we encourage pre-retirees to compare expected recurring spending budgets in retirement with expected recurring spending (in real dollar terms) just prior to retirement for retirement planning purposes.

The table below shows a distribution of mean spending by age and spending category.  The source of this data was the 2015 Consumer Expenditure Survey (table 1300) prepared by the U.S. Department of Labor Bureau of Labor Statistics.

click to enlarge

The first take-away from this table is that total mean spending decreases with age.  Mean spending (including taxes) for individuals (family units) age 65 - 74 of $54,465 was about 78% of mean spending for those age 55 - 64 ($70,059).

The second take-away from this table is that much of the decrease in mean spending between these two age groups may be explained from spending reductions generally associated with retirement:

• Reduced FICA taxes 
• Reduced taxes, and 
• Reduced work-related expenses, including savings for retirement
  

This data suggests that a better target for an initial spending budget in retirement will be about 80% - 85% of one’s pre-retirement spending levels, if your goal is to approximately replace your pre-retirement living standards.  Therefore, you may wish to categorize your spending in a manner similar to that shown in the Consumer Expenditure Survey (CES) table for purposes of determining a more reasonable spending target and determining whether you can afford to retire.

The third key point from this table is that spending appears to decrease in real terms as we age after retirement.  This leads us to the next section, which discusses several approaches you can consider (either before or after retirement) to possibly avoid over-estimating your spending needs in retirement, when using the Actuarial Budget Calculator (ABC) or the Actuarial Approach to develop your spending budget.  These approaches are all designed to increase current spending budgets.  You should be aware, however, that increasing current spending budgets may also decrease future spending budgets, all things being equal, so these approaches should be considered more as “Budget Shaping” approaches.

Budget Shaping Approaches to Avoid Over-Estimating Your Spending Needs

Assuming Decreasing Real Dollar Spending

The CES survey data above and data from other surveys suggest that spending does not keep pace with inflation as we age.  While certain types of expenses may remain constant in real dollars, or even increase (like healthcare), total real dollar spending appears to decline with age.  Therefore, when using the ABC to develop your spending budget, you may wish to consider inputting a lower rate for “desired increase in future budgets” than you input for “expected rate of inflation.”

Use a Less Conservative Lifetime Planning Period (LPP)

For the Actuarial Budget Benchmark (ABB), we recommend using a lifetime planning period (LPP) developed using the 25% probability of survival from the Planning Horizon section of the Actuaries Longevity Illustrator assuming excellent health, non-smoker mortality.  If you are aware of health issues (or you are a smoker), you may wish to use average health or a shorter, more realistic, LPP to develop your spending budget.

Treat Certain Expenses as Non-Recurring

Many retirees want to travel and have that as one of their spending goals in retirement.  However, you may not want to travel as much when you are in your 80s as when you first retire.  Rather than plan on the same level of travel each year of your retirement (by spreading these expenses over your entire LPP), you should consider setting up a non-recurring expense reserve for travel that you plan to exhaust over a period shorter than your LPP.  You should consider doing this for other types of expenses that you do not anticipate lasting your entire retirement, such as mortgage payments that you intend to pay off before you die.

Spending After First Spouse Death

If you are married, you should consider what will happen to sources of income and spending after the death of your spouse (assuming you survive).  Some expenses may remain constant and some may be reduced.  We discussed how to adjust assets and spending liabilities to reflect different expected LPPs for married couples in our post of July 4, 2017.  It would not be unreasonable, however, to assume that recurring expenses drop by one-third after the first death.

Assume Lower Non-Recurring Costs

As we have previously discussed, if you are spending the budget determined under the Actuarial Approach and you are increasing your LPP as you age to determine such budget, it is likely that you will die with assets remaining.  As a result, you may be “doubling up” to a certain degree, by inputting a specific level of desired amount remaining at the end of the LPP.  Additionally, you may have other plans for near end of life care so that you may not want to build a large reserve for long-term care.

Use a Higher Discount Rate

If you believe that your investments will consistently achieve higher returns than those inherent in insurance company annuities with no additional risk, you can assume a higher discount rate than we recommend.  Unlike the items mentioned above, however, we are less enthusiastic about this option.

Conclusion

We are fine if you want to be conservative in estimating your future spending needs.  If you are still working, enjoy your job and have no trouble getting out of bed in the morning to go to work, we encourage you to keep working even if you might be able to afford to retire.  As we have indicated in previous posts, we estimate that an individual’s annual recurring retirement spending budget will generally increase by almost 10% for each year additional year of employment.  On the other hand, if you just can’t wait to retire, you might consider some of the Budget Shaping alternatives discussed above, to see if your retirement goals can be accomplished using somewhat more realistic assumptions about future spending needs.

By the way, if you are working and determine that you still can’t afford to retire even after trying some of the approaches above, we encourage you to increase your pre-retirement savings until it hurts.  Doing so has a double benefit.  It simultaneously increases your assets and decreases your post-retirement spending target.
We are also fine if you are already retired and just want to be more conservative in your spending.  We aren’t trying to push anyone to spend more now rather than later.  We are all about encouraging you to develop a reasonable spending budget that considers your specific situation and spending goals.  If you believe your current spending plan is not meeting your goals, however, you may wish to consider one or more of the Budget Shaping approaches discussed above.

Feel free to discuss meeting your spending goals with your financial advisor by applying these approaches, but don’t be terribly surprised if his or her planning software doesn’t handle some of them adequately.  You may also find it difficult to accomplish your spending goals if you use approaches that “cobble together” sources of lifetime income and involve strategic withdrawal plans (SWPs), like the 4% Rule or the Required Minimum Distribution (RMD) approach, as these approaches generally aren’t very flexible.  By comparison, if you are willing to do a little number crunching and are willing to live with the potential consequences of being a little less conservative, the Actuarial Approach can help you tailor your spending plans to better meet your anticipated spending needs and goals.

Happy Budget Shaping!

Budgeting to Meet Your Spending Goals in Retirement vs. Cobbling Together Sources of “Lifetime Income”

This post is a follow up to our post of April 9, 2017, The Whole is Greater than the Sum of its Parts (and several other of our previous posts) where we maintained that using the Actuarial Approach advocated in this website is superior to summing up sources of lifetime income (Sum of the Sources) for developing a reasonable spending budget designed to achieve your spending goals in retirement.  This post will include a “real world” example that we believe will demonstrate why it is worthwhile to spend the extra half hour to crunch your numbers using the Actuarial Approach, rather than to rely on a Sum of the Sources approach.

We at How Much Can I Afford to Spend are retired pension actuaries, not insurance company actuaries, academic retirement researchers, financial advisors, or investment advisors.  Our primary mission is to provide you (or your financial advisor) with an actuarial framework that can be used to develop an annual spending budget that reflects your specific situation and your lifetime spending goals.  It is not our mission to:

• Convince you to buy lifetime income products from insurance companies 
• Advise you on the best way to invest your assets 
• Influence public policy to encourage plan sponsors or financial institutions to offer “lifetime income” options from qualified defined contribution plans or IRA’s 
• Refine existing research relating to retirement, or 
• Develop the optimal Systematic Withdrawal Plan (SWP) so that withdrawals under such plan may be added to other sources of lifetime income.
  

We are disappointed that the major actuarial organizations in the U.S. appear to be more focused on advocating the cobbling together of various lifetime income “solutions” (including lifetime income insurance products and SWPs) than advocating the use of basic actuarial principles to help individuals achieve their spending goals.  The American Academy of Actuaries (AAA) actually sponsors a Lifetime Income Initiative which claims, “The Academy has identified lifetime income as a top public policy issue and strongly supports initiatives that will lead to more widespread use of lifetime income options.”

We will be the first to admit that the actuarial calculations required to develop a reasonable spending budget, that reflects your specific situation and that is consistent with your goals, can be somewhat complicated.  For this reason, we have tried to make these calculations a little bit simpler by developing our Actuarial Budget Calculators (ABC).  Sometimes, however, your personal situation may not be adequately handled by the ABC.  In these situations, we recommend that you go back to the basics and apply the Basic Actuarial Equation to develop your spending budget.  The following is an example of such a calculation.

Example

Data and Goals
Bill and Betty are a married couple who have retired and both are in relatively good health.  Bill is age 65 and has already commenced his Social Security benefit.  Betty is age 55.  They have a daughter.  Their financial goals include:

• Betty would like to maximize her Social Security benefits 
• Neither would like to become a burden on their daughter 
• They don’t want to outlive their assets 
• The would like to earmark $20,000 per year in real dollar spending for the next 20 years for travelling expenses, as they are quite interested in travelling while they are able to do so. 
• They desire relatively constant real dollar non-travel spending from year to year while they both are alive, with about 2/3rds of such real dollar spending to continue after the death of the first spouse.
• They plan to use about 1/2 of their existing home equity to finance recurring expenses, leaving the other half to finance expected long-term care costs.  They understand that they may have to downsize or take some other action during retirement to extract home equity assets. 
• They establish an initial reserve for unexpected non-recurring expenses of $100,000. 
• They have no desire to establish a separate reserve to fund a bequest motive for their daughter.  They understand that it is likely that some assets will remain for this purpose at the second death of the couple.
  

Bill’s assets:

• Bill has commenced his Social Security benefit of $20,000 per annum 
• Bill has a QLAC (deferred annuity contract) that will pay $20,000 per annum for his life, commencing at age 85
  

Betty’s assets:

• Betty estimates (by using the Social Security Quick Calculator) that her Social Security benefit will be about $35,000 per annum if it commences at age 70 
• Betty has a pension benefit that will pay her $12,000 per annum for her life, commencing at age 65
  

Joint assets:

• The couple has combined accumulated savings (pre-tax and post-tax) equal to $1,000,000 
• The couple estimates that the equity in their home is currently $600,000, with no mortgage.
  

Assumptions:

For present value calculations, Bill, Betty and their financial advisor have selected:

• 4% annual discount rate 
• 2% annual rate of inflation 
• Using the Actuaries Longevity Illustrator and a probability of survival of 25%, they determine that:

o    Bill’s lifetime planning period is 29 years,
o    Betty’s is 42 years, 
o    the expected period at least one of them alive is 42 years and
o    expected period both are alive is 27 years.

• The couple expects their home equity will increase at 4% per annum, the same rate of annual increase as assumed for their other investments. 
• The calculations of the present values in the table below can be duplicated using either our ABC (Retiree) or Present Value Calculator spreadsheets.
  

Actuarial Balance Sheet

Here is Bill and Betty’s Actuarial Balance Sheet

(click to enlarge)

The left-hand side of the Actuarial Balance Sheet shows the present value of Bill and Betty’s assets, and the right-hand side shows the present value of their spending liabilities.  Note that the total of the present value of their assets (the left-hand side) must equal the present value of their spending liabilities (the right-hand side).  The present value of Bill and Betty’s future recurring spending budgets ($1,946,707) is the balancing item that makes the totals equal (balance).

Spending Budgets

The final step in developing Bill and Betty’s first year spending budget is to divide the present value of their future recurring spending budgets shown above ($1,946,707) by the present value of their future years of life, based on the assumption that the spending budgets will increase by inflation of 2% per year until the first death, at which time real dollar spending budgets will be reduced by a third.  The calculation of this present value of future years (27.1890) is discussed in our post of July 4, 2017.  The resulting budget is the sum of:

• non-travelling recurring spending of $71,599 ($1,946,707 ÷ 27.1890), plus 
• their travelling budget for the year of $20,000, 
• for a total spending budget for this year of $91,599.

If all assumptions are realized in the future, Bill and Betty’s spending budget is expected to increase each year with inflation for the first 20 years, after which it would be expected to drop to $71,599 (when their 20-year temporary travelling budget expires) in real dollars until Bill’s expected time of death, at which it would be expected to drop to $47,733 (2/3rds of $71,599) in real dollars.

“Sum of Sources” approach

By comparison, if they had used the “Sum of Sources” approach and used the 4% Rule for their SWP, their initial total spending budget would have been only $60,000 (Bill’s $20,000 Social Security benefit plus 4% of their accumulated savings of $1,000,000).  Of course, when Betty’s Social Security, Betty’s pension and Bill’s QLAC actually kick in, their spending budget under this Sum of Sources approach would be much higher in real dollar terms.  By that time, however, it might be too late for Bill and Betty to enjoy the travelling they so desired.  By using the Actuarial Approach, they increased their initial spending budget by almost 53% and, on an expected basis, satisfied all of their spending goals.

Note that if Bill and Betty’s spending goals included relatively constant real dollar non-travel spending on “essential expenses” (which they estimated to be $45,000 per annum while they are both alive) and declining real dollar spending on non-essential expenses (inflation minus 1% per year), their first-year spending budget could have been increased to $96,091, or about 60% greater than under the Sum of the Sources approach.

Final Words

You only get one attempt at enjoying your retirement.  There is no opportunity for a “do-over.”  This is why we believe it is important for you to spend a little bit more time and use basic actuarial principles to develop a reasonable plan (and spending budget) that is consistent with your spending goals rather than cobbling together sources of lifetime income.

The American Academy of Actuaries Stumbles on Social Security “Sustainable Solvency”

This week, the American Academy of Actuaries (AAA) released An Actuarial Perspective on the 2017 Social Security Trustees Report.  Their primary recommendations were:

• “Social Security’s financial soundness should be addressed now”, and
• “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be”

And while these recommendations appear to be non-controversial, this post will discuss the one big problem we have with the AAA’s actuarial perspective as well as several smaller concerns.

Background

In our post of November 23, 2016, we asked the question of why the AAA was painting such a rosy picture of Social Security’s financial problems with its Social Security Game.  In response to our post, we were contacted by the Pension Fellow of the AAA to discuss our concerns about the “Game.”  We suggested some caveat language be added to the Game to avoid potentially misleading the public.  In response, on December 8 of last year the AAA added the following caveat language to the Game:

“The following should be noted when interpreting results from the Social Security Game:

• The 75-year actuarial balance calculation used in the game does not consider significant revenue shortfalls expected to occur after the end of the 75-year projection period, and thus possible solutions illustrated in this game are generally not sufficient to achieve “sustainable solvency,” a concept discussed in the Trustees Report. 
• The possible solutions assume immediate adoption of System changes, rather than gradual implementation. If changes to the System are gradually implemented, the required increases in tax revenue or benefit decreases will need to be larger than noted in the game to achieve actuarial balance. 
• The success of reforms will depend on how well actual future experience compares with the assumptions made by the trustees and the Social Security actuaries. There is no mechanism in current Social Security law to maintain the program’s actuarial balance once it has been achieved. Thus, there can be no guarantee that the System’s long-term problem will be “solved” for any specific length of time by enacting various system changes.”
  

The Big Problem—Sustainable Solvency

The major problem we have with the recently released AAA actuarial perspective is their call for Congress to adopt a solution that will “ensure the sustainable solvency of Social Security.”  The concept of “Sustainable Solvency” was developed by the Office of the Actuary after the 1983 Amendments to the System in an attempt to correct the serious deficiency in the 75-year actuarial balance calculation discussed in the first caveat bullet above.  While this was a move in the right direction, the name of this concept is potentially misleading, as it conflicts with common language usage and the AAA’s own definitions of “sustainability” and “solvency” included in its Sustainability in American Financial Security Programs White Paper.  The condition of “Sustainable Solvency” developed by the SSA actuaries is based on exact realization of assumptions made today about the next 75 years.  Therefore, the System could meet the conditions for “Sustainable Solvency” this year, but not next year.  As noted in the third caveat bullet above, there exists no mechanism in current Social Security law to maintain actuarial balance (or Sustainable Solvency) over time.  Therefore, a condition of Sustainable Solvency achieved at the time of eventual System reform will not guarantee or “ensure” sustainable solvency for any specific period of time, and the AAA’s call for implementation of a solution “to ensure sustainable solvency of Social Security” is, in our opinion, potentially misleading to the public, Congress and other intended users of the AAA’s Issue Brief.

We would like to see the AAA recommend adoption of mechanisms to maintain the System’s actuarial balance (or the condition of Sustainable Solvency) over time.  Adjustments for experience gains and losses is a fundamental actuarial concept that actuaries generally use to keep financial security systems solvent and sustainable.  We are not sure why the AAA is reluctant to make such a recommendation for Social Security.   However, if it is reluctant to do so, it should, at a minimum, take reasonable steps to make sure the public and Congress appreciate the limitations of not having such mechanisms. 

Smaller Concerns in the Issue Brief

We have several other smaller concerns about this AAA Issue Brief, in no particular order:

Adoption date of reform changes vs. effective date of changes

We believe the Issue Brief could be clearer about the implications of when reform changes are adopted vs. when they become effective.  The longer the delay in the effective date, the more significant the changes needed to achieve actuarial balance or the condition of sustainable solvency as of the reform date.   This is clearly stated in the middle paragraph on page 5 of this year’s Trustee’s Report but not adequately addressed in the AAA Issue Brief.

Giving Baby Boomers adequate time to adjust?

The Issue Brief implies that something should be done to address the Baby Boom bulge at the same time it argues that prompt action will enable affected individuals to modify their plans in response to changes in the System.  It isn’t clear to us how these AAA recommendations would work for Baby Boomers who are close to retirement or who have already retired. 

Significant changes on the horizon—What’s the big deal?

We are now looking at significant reform changes.  For some reason, the AAA wants to tell us that when the System was last amended in 1983, the SSA actuaries knew about the deficiency in the 75-year Actuarial Balance calculation, so “more than 30 years later it should come as no surprise that large and growing actuarial deficits are now projected at the end of the long-range projection period.”  We note that the System went out of close actuarial balance in 1990, just 7 years after adoption of the 1983 Amendments and that no actions have been taken since that time to place the System back into actuarial balance.  We find the Academy’s 30 year reference to be confusing, and the tone of this paragraph is inconsistent with the AAA’s expressed desire to improve public trust in the System. 

Conclusion

It will not be an easy task for Congress to make the significant changes necessary to bring the System into a condition of “Sustainable Solvency.”  And without additional changes in the law to maintain this condition over time, it is unlikely that the condition of sustainable solvency will persist indefinitely.  We believe the public and Congress would be better served by adopting automatic adjustment mechanisms normally found in most financial security systems, but if these mechanisms are not adopted, the public and Congress need to fully understand the limitations of the actuarial term “sustainable solvency.”