Another Example of Why You Want to Use the Actuarial Approach

In this post we are going to revisit our hypothetical retiree, Mike, whom we talked about in our posts of April 16, 2015 and February 25, 2015.  As you may recall, Mike is a single 65 year-old male retiree who is eligible to receive a Social Security benefit of $16,800 per annum and he also has accumulated savings of $750,000 but no other sources of retirement income.   As we saw in the previous posts, if Mike uses the Excluding Social Security spreadsheet from this website and the recommended assumptions (and no amount to be left to heirs), he will develop an initial spending budget of $49,427 ($16,800 from Social Security plus a $32,627 withdrawal from his accumulated savings).  If all the recommended assumptions are unchanged and exactly realized each year in the future and Mike spends exactly his spending budget each year, his spending budget would be expected to remain constant in real dollar terms until he reaches about age 90.  If he survives past age 90, his spending budget would be expected to decline somewhat as his age plus his life expectancy starts to exceed 95 (under the mortality assumptions in the 2012 Society of Actuaries Individual Annuitant mortality table with 1% projection). 

Here is Mike’s Actuarial Balance Sheet as of his 65th birthday for this base case.  Present values are determined using the recommended spreadsheet assumptions (4.5% discount rate, 2.5% inflation increases and death at age 95)

(click to enlarge)

As indicated in the previous posts, Mike is not pleased with his spending budget and he has looked at a number of alternatives to increase early year spending.  Mike knows that his life expectancy is 23 years under the Society of Actuaries mortality table.  Therefore, he knows that assuming a 30-year payout period is likely to be conservative and leave money unspent upon his death.   He also knows, however, that if he uses his life expectancy as the expected payout period, his spending budgets will decline in future years as life expectancy does not decrease by one year for each year that a retiree ages (see our post of December 3, 2014 for a graph of this effect).  Mike is also aware of experts who say that many retirees spend less in real dollar terms as they age.  So, Mike feels that there is some conservatism built into the recommended assumptions that he can exploit to increase his near-term spending budgets. 

Mike’s first step is to see how much his essential spending is.  He determines that his essential spending needs are about $40,000 per year.  With respect to his essential spending, however, Mike feels that it is important to be conservative both with respect to the expected payment period of 30 years and with respect to the desire to maintain constant purchasing power.  With a little playing around with the Excluding Social Security spreadsheet and QLAC purchase rates from Immediateannuities.com, Mike sees that if he designates $415,000 of his accumulated savings to essential spending, his entire Social Security benefit and spends $70,000 to purchase a deferred annuity starting at age 85 (with no benefit for death prior to that age), he can generate an initial essential spending budget of $40,074 ($16,800 from Social Security plus $23,274 from accumulated savings) that is expected to remain constant in real dollars over the next 30 years. 

This leaves Mike with $265,000 in accumulated savings ($750,000 - $415,000 dedicated to essential spending - $70,000 for purchase of the QLAC).  With respect to this $265,000 that he has decided to dedicate to non-essential spending, Mike is more willing to front-load this spending.  He decides that he will target his spending over his remaining life expectancy (not 30 years) and he will not build in any increases for future inflation.  Using the Excluding Social Security spreadsheet, he enters 23 for expected payout and 0% for desired increases due to inflation.   This gives him an initial non-essential spending budget of $17,924 and a total initial spending budget of $57,998 ($40,074 essential plus $17,924 non-essential).  This spending budget is approximately 17% higher than his base spending budget 0f $49,427.

Mike knows that his total spending budget will decline in real terms from year to year if all assumptions are realized.  In fact, he estimates that his non-essential spending budget will only be about $5,100 in real dollar terms at age 89.
Here is Mike’s Revised Actuarial Balance Sheet reflecting purchase of the QLAC.  

(click to enlarge)

It is important to note that even though Mike only spent $70,000 for the QLAC, the present value of benefits expected to be received under that contract is about $120,000 as Mike is assuming that he will live until age 95 (not his life expectancy assumed by the insurance company).  Thus, from a pure budget perspective (and not necessarily from an investment perspective), the purchase of the QLAC is a smart move.   He is using the mortality premium from the insurance contract to more cheaply fund future essential expenses than he can with his accumulated savings. 

Could Mike use a conservative approach for his essential spending and a less conservative approach for his non-essential spending and still obtain his desired increased spending budget with the 4% Rule, any safe withdrawal rate rule, or the Guyton decision rules?  Not bloody likely.  That is why smart retirees and their financial advisors should chooose the Actuarial Approach rather than some “simple” rule of thumb. 

The Actuarial Approach—Periodic Matching of a Retiree’s Assets and Liabilities

As I said in my previous post, any spending approach that does not periodically match a retiree’s assets with her liabilities runs a significant risk of failing to achieve the retiree’s spending objectives.   What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.

This post will illustrate, with an example, the matching of assets and liabilities achieved by the Actuarial Approach advocated in this website. 

Let’s assume that we have a hypothetical retiree named Mary who is age 65.  She has $1,000,000 in accumulated savings, a fixed dollar pension of $15,000 per year, a Social Security benefit of $20,000 per year and no other sources of income.  She has determined that her essential expenses in retirement will be about $50,000 per year.   Since believes that these essential expenses will stay reasonably constant in real dollar terms from year to year.   She would also like to leave around $500,000 (in future dollars) to her daughter at her death or have that money available for long-term care or extra medical bills if needed.  She also believes that she will need something like $100,000 for unexpected expenses not included in her essential expense budget, such as purchases of new automobiles or gifts to her daughter. 

Mary goes to the “Excluding Social Security” spreadsheet to see how much of her accumulated savings it will take, together with her pension and her Social Security benefit to cover her $50,000 annual real dollar essential expense budget and still leave her with $500,000 at her expected death.  She enters $600,000 in accumulated savings, $15,000 in annual pension, $500,000 to be left to heirs at death and the recommended assumptions (including a desired annual increase rate applicable to future budgets attributable to savings and pension of 2.5% per annum).  The resulting spending budget when Social Security is added is $51,401.  Since this is close to her estimate of essential expenses she decides she will dedicate $600,000 of her accumulated savings to her “essential expenses” budget along with her pension and her Social Security benefits.  She may even invest these essential expense assets differently than her other accumulated savings. 

To cover unexpected expenses, Mary dedicates $100,000 of her assets to this budget item.  Since she feels that the amount she desires to leave to her daughter at her death can serve several purposes, Mary does not feel it is necessary to dedicate additional assets to cover rising health costs or long-term care expenses.  Finally, Mary wishes to travel early in her retirement and have an active social life.  She dedicates her remaining $300,000 of accumulated savings toward non-essential spending but she wishes to front-load this budget item.  Therefore, she enters $300,000 in the Excluding Social Security spreadsheet with 0% increase in the annual desired increase.  The result for the first year is a non-essential spending budget of $17,624.  Mary knows that this budget item will not increase in nominal terms from year to year and therefore will represent a declining real spending budget as she ages.

Mary’s first year spending budget is $69,025 (a total of $51,401 from Social Security, her pension and her essential assets) plus $17,624 from her non-essential assets.   The exhibit below shows Mary’s Actuarial Balance Sheet as of her date of retirement.  The present values are based on the recommended assumptions and results from the Excluding Social Security spreadsheet. 

Click to enlarge

Mary will revisit her spending budget thought process at the beginning of each new year.  She will use the Excluding Social Security spreadsheet and enter new data and new assumptions.  Investment experience may deviate from the assumptions she used.  Her spending may deviate from her budget.  Assumptions may be changed.  Her objectives and liabilities may change (or she may refine what is essential and what is not essential).  If she continues to use the Actuarial Approach, she has the flexibility to make informed adjustments in her budgets.  Each year, she will balance her assets and her liabilities.  If she uses the recommended smoothing algorithm, assets and liabilities may not be perfectly matched, but she knows that the match will be close enough. 

Mary knows that she has to crunch a few more numbers under the Actuarial Approach than she would have to under the 4% withdrawal rule or some other variation of this rule, but Mary feels much more comfortable with the control she has over her spending budget using this much more sophisticated (and not that much more complicated) approach.  Mary also finds comfort in the fact that the approach she is using is consistent with basic actuarial principles and is not just some simple rule of thumb approach.  

Want to Really Take the Guess-Work Out of Your Retirement Spending Budget?

Once again we read in the popular press about the 4% Rule and the tinkering that will be necessary to make this rule (or some form of this rule) possibly work in retirement.   In his May 13, 2015 article, 4 Reasons Why the 4% Rule Isn’t a Hard and Fast Rule, David Ning tells us that spending needs to be adjusted in retirement.  His “hard and fast” advice for doing this is that “you will be tempted to spend more in bull markets” and “you should decrease spending in bear markets.”  In her May 8 article in The New York Times, New Math for Retirees and the 4% Withdrawal Rule, Tara Siegel Bernard quotes several industry experts with various opinions about the 4% rule and different adjustments that might make the rule work.  The experts in this area continue their search (using their Monte Carlo modeling) for a Holy Grail spending rule to replace the now-suspect 4% Rule.  So, what is a poor retiree to do now without a clear, simple spending rule of thumb?

Sorry folks, but a retiree’s budget problem is basically an actuarial problem that requires an actuarial solution.  The retiree (or the retiree’s advisor) needs to periodically match the retiree’s assets with her liabilities.  What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.  Any simple spending rule of thumb that doesn’t attempt to match these assets and liabilities (and most common approaches don’t) runs a significant risk of not meeting the retiree’s spending objectives.

Ok, we’ll does this actuarial solution come in the form of a simple rule of thumb like the 4% Rule?  No.  It doesn’t.   And while periodically matching assets and liabilities requires some number crunching, the Actuarial Approach and spreadsheets set forth in this website do most of the work for you.  The process is relatively straightforward and doesn’t require you to be an actuary.

As we said in our post of August 2, 2014, Are You “Most People”?, the Actuarial Approach is not for everyone.  It for someone who wants more than a questionable simple rule of thumb who is willing to do a little number crunching for the purpose of taking the guess-work out of developing a reasonable spending budget.

Brief Explanation of How to Use the Actuarial Approach, Revised

The June, 2014 explanation of how to use the Actuarial Approach has been revised to incorporate necessary adjustments to the general process for those retirees who want to “front-load” their spending budgets instead of developing a spending budget that is expected to remain constant in real dollar terms from year to year.  Here is a link to the revised explanation.

16th Annual Transamerica Retirement Survey of Workers

The Transamerica Center for Retirement Study has released its annual survey of workers of all ages on the subject of retirement, entitled Retirement Throughout the Ages: Expectations and Preparations of American Workers. This survey provides lots of interesting information, and the Center uses this information to make recommendations to workers, employers and policymakers (pages 18, 19 and 20). 

Consistent with results from prior years, "outliving my savings and investments" was cited by workers of all ages as their most frequently cited fear (page 31).  Of course, addressing this fear by developing a reasonable spending budget in retirement is what this website is all about.

Of particular interest to me, in light of my previous post about the need to strengthen Social Security financing, were the results shown on page 36--that 47% of surveyed individuals in their 60s reported that Social Security will be their primary source of income in retirement and the results shown on page 32 that many individuals are concerned about the future of Social Security. But, despite these fairly disturbing results, the Center's Recommendations to Policymakers fail to mention any action to fix Social Security at all. As I said in my previous post, I believe the first step toward increasing workers' retirement outlook in the future should be to make sure that Social Security, the foundation of retirement security for most Americans, is solid. 

A Better Financing Approach for Social Security

In my post of March 1, 2015, I briefly discussed Social Security’s financial problem. In this post, I will once again mount my steed and tilt at the Social Security financing windmills by advocating adoption of a more actuarial approach to solving the problem. Readers who desire more background on the problem, the confusion resulting from the different approaches used to measure the size of the problem, how the problem came about and how Canada solved a similar problem can read my article in the May/June issue of Contingencies Magazine, the magazine for the actuarial profession.
  
Briefly, the 1983 Amendments to Social Security solved the financial problem that existed at that time, which was measured using the 75-year Actuarial Balance. This measurement is still around today and is widely quoted in the press as representing the size of the problem that needs to be solved today, but it was defective as a measure of the size of the problem in 1983, and it remains defective today. The 75-year Actuarial Balance calculation fails to reflect the future deficits expected after the end of the 75-year projection period.  For this reason, the Social Security actuaries have proposed a stronger measure they refer to as “Sustainable Solvency” which would also require, at the time of a measurement, that trust fund ratios at the end of the 75 year projection period be expected to remain stable or on an upward trend. Unlike the 75-year Actuarial Balance calculation, the stronger requirement for Sustainable Solvency is not well quantified in the annual Trustee’s Report and therefore, it tends to get ignored when discussing reform options. 

As noted in the article, Canada faced a similar financing problem with The Canada Pension Plan and implemented sweeping reforms in 1997. These reforms included self-sustaining provisions (automatic adjustments) to safeguard desired levels of funding, which resulted in Sustainable Solvency not only at the time of adoption of the changes, but also provided a mechanism for maintaining Sustainable Solvency in the future. I call this even stronger requirement, “Self-Sustaining Sustainable Solvency.” Actuaries, who work with the concept of automatic adjustments every day, may simply call this approach “actuarial financing.” I believe that the approach adopted in Canada provides a good blue-print for similar action in the U.S. 

From time to time, we hear someone call for a national conversation on retirement in light of the retirement “crisis” in this country. Without a doubt, the first step in addressing this issue has to be making sure that Social Security, the foundation of retirement security for most Americans, is solid. I believe adoption of actuarial financing for Social Security is important for keeping that foundation strong for the future. 

I want to thank Jean-Claude Menard, Chief Actuary for The Canada Pension Plan, for his thoughtful comments on an initial draft of the article and for his patience with me in explaining the process used in Canada. 

Regarding the Don Quixote reference above, this is not the first time that I have advocated consideration of a more actuarial approach for Social Security financing (anticipating a tax rate expected to remain level indefinitely). Back in 1982 when the National Commission on Social Security Reform was working on what would become the 1983 Amendments, I wrote a paper that was subsequently published in the 1983 Transactions of Society of Actuaries entitled, “A Better Financial Approach for Social Security.” While this paper may be available from the SoA library, it is very difficult to find (and probably worth a lot of money).  If you are interested in reading my thoughts on Social Security financing from around that time, a staff member of the Conference of Consulting Actuaries was able to provide me with a pdf version of the transcript of my paper and presentation, “Social Security--There Will Be No Long-Term Solvency With Pay-As-You-Financing” from a 1984 meeting of what was then the Conference of Actuaries in Public Practice. 

Revisiting the Guyton Decision Rules

To err is human, and I am very human.  In this post I will issue not one but two corrections of errors made in prior posts.

In our post of April 18, 2015, we showed a graph that compared the expected pattern of future spending budgets for a hypothetical age 65 male retiree who buys a fixed income annuity (Single Premium Income Annuity, or SPIA) under the Actuarial Approach (assuming desired increases in the annual budget equal to the assumed future annual rate of inflation) with budgets produced using the Guyton Decision Rules.  Budget amounts shown were total budgets, including Social Security, payments from the annuity and withdrawals from accumulated savings. 

Subsequent to the April 18th post, I received a nice note from Dr. Wade Pfau indicating that I appeared to have incorrectly applied the Guyton Decision Rules in the example.  Instead of increasing the prior year’s budget with inflation (the preliminary withdrawal amount for the year), the Guyton Decision Rules impose a 10% reduction in the withdrawal amount for a year in which the preliminary withdrawal amount divided by accumulated savings at the beginning of the relevant year exceeds 120% of the initial withdrawal rate.  Mr. Guyton refers to this decision rule as the “capital preservation rule.”  I correctly applied this reduction, but I was unaware, however, that this capital preservation rule is not applied if the retiree is “within 15 years of the maximum planning age.”

Graph #1 below corrects the graph provided in the April 18th post by ceasing application of Mr. Guyton’s capital preservation rule at age 80.   I will also add a warning to my post of July 3, 2014 cautioning those who may visit that post that the graph shown is not based on a correct interpretation of the Guyton Decision Rules.

Graph 1 (click to enlarge)

Dr. Pfau also indicated that since many retirees like higher real dollar spending early in retirement, it wasn’t so obvious to him that the constant spending budget produced under the Actuarial Approach was more desirable.  I’m was actually a little surprised to hear this from Dr. Pfau, as most withdrawal strategies appear to have constant real dollar spending as an objective, and I was somewhat curious as what there was about buying a fixed income annuity that would significantly change someone’s spending objective.  But, be that as it may, as indicated in my previous post, it is easy to change the shape of expected future real dollar budgets under the Actuarial Approach to satisfy a retiree’s objectives.  For example, Graph #2 shows expected future real dollar spending budgets if the same hypothetical retiree makes the conscious decision to front-load his spending budget by inputting 0% desired increases in the portion of his total spending budget attributable to accumulated savings and annuity payments (the Social Security component of his spending budget would still be expected to increase by the inflation assumption of 2.5% per annum).

Graph 2 (click to enlarge)

While the spending budgets shown in Graph 2 for the two approaches are close, the important distinction between the two approaches is that the decision to front-load under the Actuarial Approach is a conscious one where the retiree is fully aware of the out-year implications if future experience is close to assumed experience on average (and the retiree is aware that he has made a commitment not to give himself inflation increases in future years, at least with respect to the portion of his spending budget attributable to the annuity and withdrawals).  The same cannot be said if he uses the Guyton Decision Rules because the retiree doesn’t know what the assumptions for future experience are under that approach.

Even though ceasing application of Guyton’s capital preservation rule when the retiree is within 15 years of the maximum planning age may improve the Guyton’s Decision Rules, I am still not a fan of them.  They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy.   As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive.  If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed.   For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement).  If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions).  After the 15th year, there are no cut backs, but there is a risk of running out of money.  Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.”  Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives.  Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities (the present value of the future expected/desired withdrawals and annuity payments) under a reasonable set of assumptions about the future.

As a further illustration of how the Guyton Rules fail to coordinate with other fixed income sources of retirement income, Graph #3 shows expected future real dollar spending budgets for our hypothetical retiree under the assumption that instead of buying the immediate annuity at 65 (SPIA), he spends $150,000 of his accumulated savings on a deferred income annuity (DIA) with benefits commencing at age 80.  According to today’s Immediateannuities.com website, he would be eligible to receive payments of $40,776 for life starting at age 80 (and nothing if he dies prior to age 80) for a premium of $150,000.  Using the Excluding Social Security spreadsheet on this site and inputting the recommended assumptions, $850,000 in accumulated assets ($1,000,000 minus the $150,000 used to purchase the DIA), $40,776 in deferred annuity payments and 16 years as the deferred annuity commencement year [Note, since the retiree in this instance is age 65 in year 1, he is assumed to reach age 80 in year 16, 15 years later.  This is correction #2 of this post as I myself haGraph 1 (click to enlarge)ve made the mistake of inputting 15 years for a deferred annuity starting at age 80 or twenty years for a deferred annuity starting at age 85 for a 65 year old retiree in prior posts discussing deferred annuities/QLACs].  Finally, this graph also assumes that the retiree makes the decision to front-load spending in the same manner as for Graph #2 by inputting 0% desired increases in future spending budgets attributable to the annuity and withdrawals from accumulated savings.  

Graph #3 (click to enlarge)

Graph #3 shows that the Actuarial Approach produces an expected total spending budget pattern that is comparable to the pattern it produced in Graph #2, while the expected spending budget pattern produced by the Guyton Spending Rules under these assumptions doesn’t appear to be consistent with the retiree’s front loaded spending objectives.

Expected Real Dollar Spending Budget Shaping

As indicated in previous posts, retirees and their financial advisors can use the Actuarial Approach to provide different patterns of future expected real dollar spending budgets.  If the user of the "Excluding Social Security" spreadsheet on this website inputs the recommended assumptions and sets the desired increase in payments equal to the inflation assumption, annual future budgets (including Social Security) are expected to remain constant in real dollar terms from year to year until the retiree reaches almost age 90  (when age plus life expectancy starts to exceed 95) if all assumptions are realized, assumptions are not changed and actual spending exactly equals budgeted spending.  As discussed in our previous post,  unlike under many other withdrawal strategies, this is true under the Actuarial Approach even if the retiree has other fixed dollar sources of retirement income such as pension income or immediate or deferred annuity income. 

There is a school of thought that says that spending generally declines in real terms as we age.  See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject.  In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption.   In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used.  Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate. 

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter.  While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis.  Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem. 

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater.  I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive.  For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase.  In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%).  He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget.  In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%).  After 10 years, he will just use 1.5% (assumed inflation minus 1%).  In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above.  For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.   
     
The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter).  The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year).  While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).  

(click to enlarge)

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later.  If you want to "front-load" your spending, you can do this in several ways.  You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement.  The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income.  You should also have a sense of what the out-year implications may be of a decision to front-load your spending.  I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard.  If you aren't using the Actuarial Approach and you/your financial advisor aren't  adequately addressing these issues, you may wish to consider switching to the Actuarial Approach.  At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.   

Your Withdrawal Strategy Should be Coordinated with Other Sources of Fixed Retirement Income

If you have accumulated savings and a fixed dollar pension benefit or life annuity, your accumulated savings need to do double duty when it comes to maintaining a constant real dollar annual spending budget in retirement.  Your accumulated savings need to 1) fund inflation increases on the portion of your spending budget attributable to your accumulated savings and 2) fund inflation increases on the portion of your spending budget attributable to the fixed dollar pension or life annuity.  If you have fixed dollar sources of retirement income, the withdrawal strategy you use needs to be adjusted to perform this double duty or you will find that your annual spending budget will likely decrease over time as a result of inflation.  The higher the rate of future inflation and the larger percentage of your spending budget attributable to fixed dollar income, the bigger this potential problem will be. 

The standard withdrawal strategies like the 4% rule, any safe withdrawal rate rule, the Required Minimum Distribution (RMD) rule, or any of the variations of these rules, were not designed to coordinate with other fixed dollar sources of income.  I was therefore surprised to read that when asked in a recent Barron’s article which spending strategy has the most potential, Dr. Wade Pfau said,

“I’m leaning toward some combination of an income annuity and a method used by [Cornerstone Wealth Advisors’] Jonathan Guyton, whose model I simulated. It’s a complicated set of rules but adjusts spending based on the market, limiting the fluctuations in the withdrawal amount to only 10%, and only when absolutely necessary.”

I was not at all surprised that Dr. Pfau advocated purchase of an annuity as an investment strategy that mitigates longevity risk and enable retirees to be somewhat more aggressive with respect to investment of their remaining assets.  I was, however, surprised that Dr. Pfau advocated using the Guyton Rules for determining withdrawals from the remaining assets.  First of all, I am not that impressed with the Guyton Rules (which are basically a variation of the safe withdrawal rule approach).  Secondly, and more importantly, the Guyton rules fail to coordinate with a fixed income annuity to provide constant spending budgets in retirement.  See my post of July 3, 2014 for my cautions about using the Guyton Rules even if a retiree has no fixed income retirement sources of income.   

The graph below shows total spending budgets for a hypothetical 65 year old male retiree with $1,000,000 in accumulated savings and a $20,000 per year Social Security benefit.  Let’s assume the retiree decides to follow Dr. Pfau’s suggestion and determines that his essential income level is about $50,000.  Therefore, he decides to purchase an immediate fixed income annuity of $30,000 per year (to supplement his Social Security benefit of $20,000 per year).  At current annuity purchase rates, this purchase is expected to cost him $458,716 ($545 of monthly benefit per each $100,000) leaving him $541,284 in accumulated savings.  
 

(click to enlarge)

 
The retiree uses the Guyton Rules to determine withdrawals from his accumulated savings with a beginning withdrawal rate of 5.5%.  In the first year, his total spending budget is $79,771 (.055 X $541,284 = $29,771 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security).  Under the Actuarial Approach and the current recommended assumptions, his initial spending budget would be $65,762 ($15,762 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security), assuming no amounts to be left to heirs. 

Let’s further assume that actual future experience is exactly follows the recommended assumptions—4.5% annual investment return and 2.5% inflation (and exactly the budget amount is spent each year).  Under these assumptions, the Actuarial Approach produces a constant real dollar budget of $65,762 per year while the spending budget under the Guyton Rules plus annuity approach produces a declining real dollar budget from year to year.  In fact the real dollar spending budget expected under these assumptions at age 89 is only about 61% of the initial spending budget.  As noted above, this decline could be worse for higher levels of inflation or for strategies involving a higher relative portion of the budget being used to purchase the fixed income annuity. 

Most withdrawal strategies for situations that don’t involve fixed sources of retirement income have constant real dollar income throughout retirement as an objective.  It doesn’t make sense to me to change that objective just because you add fixed dollar retirement income.   At the very least, retirees should be made aware of this potential inconsistency. 

Dr. Pfau has many readers of his blog (many, many times the number who visit this site) and has published many fine articles.   He is a revered academic scholar in the retirement area.   In light of his influence, I encourage him to “lean” away from using the Guyton Rules (or any other approach that does not reasonably coordinate with the fixed income annuity) when fixed dollar annuity/pension benefits are present in a retiree’s portfolio.    

Delaying Commencement of Social Security vs. Buying a QLAC—Which Is the Better Strategy?

May 28, 2015 Note: This post has been revised to correct some minor errors.

There is no shortage of articles out there advocating delaying commencement of Social Security as a no-brainer strategy to increase spending in retirement.  Several experts have indicated that delaying commencement of Social Security is hands down the best long-term investment money can buy. These articles encourage individuals who have retired to spend what may be a significant portion of their accumulated savings during the period of deferral in order to collect a much larger Social Security benefit down the road (typically at age 70). While I have agreed in prior posts (see the post of August 9, 2014 for example) that this deferral strategy can increase annual retiree spending budgets, it does come with its own set of risks and does not always live up to the hype used to sell it. In this post, I will compare the Social Security deferral strategy to the strategy of using roughly the same amount of accumulated savings to purchase a Qualified Longevity Annuity Contract (QLAC), which I have also discussed in prior posts (see the post of February 25, 2015 for an example).

In our post of February 25, 2015, we took a look at a hypothetical retiree, Mike, a single 65-year old male with a 401(k)/IRA balance of $750,000 and a potential Social Security benefit payable immediately of $16,800 per year.  Using the Excluding Social Security spreadsheet in this website and the recommended assumptions, Mike developed a first year spending budget of $49,427. Using the Social Security Bridge spreadsheet and the same assumptions, Mike determines that if he defers commencement of Social Security until age 70, his Social Security benefit will increase to about $26,880, and his spending budget, starting at age 65 and remaining constant in real dollars for the next 29 years, will increase from $49,427 to $51,412, an increase of $1,985 per year. He also determines that he must effectively spend a present value of $114,329 of his 401(k)/IRA balance in order to implement this strategy.

Yesterday Mike went to Immediateannuities.com to check out the amount of annual payments he could receive under a deferred annuity contract commencing at age 85 (with no death benefit) with a premium of $114,329 (the same cost as the Social Security deferral strategy). The website said that his annual benefits commencing at age 85 would be almost $60,000.  Mike is a little bit skeptical of this result as it is significantly higher than the benefit amount shown on this website just a couple of months ago. He knows that the QLAC market is not yet robust, but he decides to see what the effect on his spending budget would be if he spent $114,329 on a QLAC that gave him a benefit of $52,000 (not $60,000) starting at age 85. So he enters $635,671 ($750,000 - $114,329) as accumulated assets, an annual deferred benefit of $52,000 starting in 20 years (by entering 21 in the spreadsheet) and the recommended assumptions. The Excluding Social Security spreadsheet tells him that his spending budget under these input items would be $35,409 to which he adds his non-deferred age 65 Social Security benefit of $16,800 to get a spending budget of $52,209, or $2,782 higher than his base spending budget and $797 higher than the Social Security deferral strategy spending budget. So, based on realization of all the assumptions in these spreadsheet calculations (and the slightly lower assumption for the QLAC benefit payable at age 85), the QLAC strategy appears to be the better strategy for Mike.

But, not so fast here. We know that future experience will deviate from our assumptions. Future interest rates will change, future investment returns will not be 4.5% per annum, future inflation will not be 2.5% each year, Social Security benefits may be reduced, QLAC pricing may become more robust, etc.  There is a great deal of uncertainty about the future that makes comparison of these two approaches difficult.

Both strategies involve generation of mortality credits by virtue of mortality risk pooling that you don’t get when you self-insure.  These mortality credits are used to pay larger benefits to individuals who live longer (the winners, if you will) and come from payments not made to individuals who die earlier (for lack of a better term, the losers). The bet inherent in both of these strategies is won only if the individual lives longer than average. The QLAC strategy is a bigger bet in this regard than the Social Security deferral strategy with a potentially bigger mortality credit payoff for those who live past age 85. This larger mortality credit is the reason the QLAC approach appears to be the better strategy for Mike under the spreadsheet assumptions.

On the other hand, Social Security provides survivor benefits and inflation protection not provided by the QLAC. If annual inflation is 4.5% rather than 2.5%, the Social Security deferral strategy becomes the better strategy (in terms of increasing the spending budget) as QLAC payments are fixed and Social Security benefits are indexed to inflation (under current law).

There is another hand, however, with Social Security. To digress a little here, this reminds me of the old actuary joke about the actuary who used the phrase, “on the other hand” so frequently in explaining the plusses and minuses of different approaches that her client asked her firm to replace her with a “one-handed” actuary. Anyway, like it or not, there is nothing in the current Social Security law that prevents Congress from changing Social Security law with negative effects on individuals, even those who may have elected to defer commencement of benefits. As I indicated in my post of March 1, 2015, Social Security actuaries predict that benefit payments will have to be reduced by about 23% across the board if no action is taken by Congress prior to 2033. There are experts who say that the Social Security deferral approach is still a good option even if benefits are reduced by 23%.  Of course, there is nothing that guarantees the reduction will be 23% across the board. It is possible that Congress could decide that the benefits payable to retirees with lower levels of retirement income should be protected.  In that event, reductions for more affluent retirees would have to be greater than 23%. Just yesterday, for example, Chris Christie made headlines by proposing to phase out Social Security benefits for those with retirement incomes in excess of $80,000. So an individual who chooses the Social Security deferral strategy needs to be aware that there is a possibility that future Social Security benefits could be reduced or eliminated, thus negatively affecting the expected benefits of the deferral strategy, even for individuals with greater than average longevity. 

As discussed above, the QLAC market is not yet robust. There are far too few insurers in the market at this point. In addition, if you believe that interest rates are going to rise in the future, now may not be the best time to purchase a product which essentially combines long-term bond investments with mortality credits. Higher future real interest rates will favor the QLAC strategy (assuming purchase takes place in the future) relative to the Social Security deferral strategy unless the law is changed to increase actuarial adjustments for benefit deferral.

Bottom line: Both the Social Security deferral strategy and the QLAC strategy can be used to increase retiree spending budgets. The strategy that is more effective in this regard will depend on what actually happens in the future.  Not knowing what the future holds, it is just too difficult for me to proclaim a “no-brainer” winner at this time. I do believe that both strategies are worthy of consideration by retirees and/or their financial advisors, and that those interested in pursuing the QLAC strategy should keep a watchful eye on QLAC pricing in the months ahead.