Modeling Deviations from Assumed Future Experience

We here at How Much Can I Afford to Spend advocate the use of three basic actuarial principles to help you develop a reasonable spending budget and enhance your personal financial planning.  We refer to the combination of these basic principles as “The Actuarial Approach.”  As discussed in Misperception #5 of our five common misperceptions post of November 6, 2017, many people tend to confuse the Excel workbooks that we provide to facilitate the present value calculations required under the Basic Actuarial Equation with the more general Actuarial Approach/process.  

The Actuarial Approach/Process

• Principle #1--Matching Assets and Spending Liabilities 
• Principle #2—Annual valuations 
• Principle #3—Modeling deviations from assumed experience to mitigate risks
  

The first principle involves making assumptions about the future and matching your assets and your liabilities (calculated based on those assumptions) to help you develop a financial plan and a reasonable spending budget for the current year; the second involves periodically making adjustments in your plan and spending budget to reflect experience as it emerges, and the third involves preparing yourself in the event your assumptions about the future turn out to be wrong.  When taken together, this actuarial process provides a much more powerful personal financial planning tool than our simple Excel spreadsheets. 

This post will focus on applying the third principle—modeling deviations from assumed experience, a principle graphically described by boxing legend Mike Tyson when asked if he was concerned about Evander Holyfield and his fight plan.  Mike’s now famous response was, “Everyone has a plan until they get punched in the mouth.”  In this post, we will encourage you to “stress test” your financial plan with some “what if” analysis for the purpose of determining the potential negative implications of being wrong about the assumptions used in your plan, and the actions you may wish to consider now or in the future to mitigate these potential negative implications.

The Assumptions Used in Your Plan Will Be Wrong

As discussed in our post of September 22, 2015, “Retirement Planning in an Uncertain World—Part 2”, there are many possible reasons why forecasts made today will be wrong (deviate from expected results) in the future.  These reasons include:

• Differences between actual and assumed investment returns 
• Differences between actual and assumed longevity 
• Differences between actual and assumed spending 
• Differences between actual and assumed sources of income, and 
• Differences between actual and assumed rates of inflation
  

In fact, every assumption you make in developing your financial plan and current spending budget may turn out to be wrong to some degree.  And while we want you to sleep well at night, and we don’t want you to be overly-paranoid about the future, we do believe that a reasonable amount of risk assessment and risk mitigation can be helpful in facilitating achievement of your long-term financial goals.

Differences Between Actual and Assumed Longevity

Since our last post included an example of determining a spending budget for John and Mary, we are going to continue that example and start with stress testing their lifetime planning period (LPP) assumptions.  You should refer to this previous post for the calculation details.  As you may recall from that example, John and Mary went to the Actuaries Longevity Illustrator and the planning horizon section on the results page told them that the 25% chance (or probability) of survival was 29 years for John, 37 years for Mary, 37 years for “either alive” and 26 years for “both alive.”  Based on these and other recommended assumptions used for developing their Actuarial Budget Benchmark (ABB), they developed a current year spending budget of $77,893. 

The LPP assumptions they used for their plan may turn out to be about right, too long or too short for one or both of them.   To stress test the LPP assumptions for the potential impact of being too long, we recommend that John and Mary look at the estimated effect on their spending budget assuming one of the couple (in this example, John) dies immediately.   Because John elected a 50% Joint and Survivor form of annuity payment and because he has a $100,000 life insurance policy, Mary would receive $100,000 in proceeds from the insurance policy and would receive $1,300 per month under John’s pension upon John’s assumed demise.   Based on her age (60), she would also be eligible for a survivor’s benefit from Social Security equal to 71.5% of John’s ($2,000 per month) benefit, which would be payable until she elected to receive the benefit based on her own Social Security earnings.   For this purpose, Mary assumes that she will commence her benefit based on her earnings at age 70 and will receive her survivor’s benefit from John for 10 years.  She therefore goes to our Present Value Calculator V 1.1 to determine the present value of $17,160 ($1,430 per month) payable annually for 10 years and increasing by 2% per year.  She enters the resulting present value of $157,486 in C (7) of the ABC for Single Retiree workbook together with other relevant data and assumptions to estimate her spending budget assuming John’s immediate demise. 

The screen shot below shows the entries Mary makes into the ABC for Single Retirees to develop an estimated spending budget of $53,505, or about 69% of the $77,893 spending budget anticipated for the couple while both alive.  This amount is a little bit higher than their desire to have about a 33% decrease in spending upon the first death within the couple, so while Mary wouldn’t be overjoyed if John passed away this year, she is reasonably comfortable with the financial consequences. 

(click to enlarge)

John can also examine what effect on his budget would be if Mary were to pass away this year.  The important result of looking at the possibility of earlier than expected deaths is the effect such death could have on the spending budget of the survivor.   If, for example, John had not elected a 50% joint and survivor form of annuity and/or did not have a life insurance policy, John’s early demise could have a significantly negative effect on Mary’s spending budget.  If that were the case, the couple could mitigate this potential negative impact by deciding to either buy some life insurance protection for John or buy annuity income based on Mary’s life.

John and Mary could also look at the potential implications of living longer than the assumed LPPs they used for planning purposes by re-determining their spending budget assuming even longer LPPs.  For example, instead of using the 25% probability of survival from the Actuaries Longevity Illustrator, they could use the LPPs based on a 10% probability and re-determine the additional present values of the benefits payable to Mary after John’s revised age of demise.  In this case, the impact on their spending budget would be fairly minimal.

Additional stress testing of the longevity assumptions can also be accomplished by assuming different health assumptions for one or both of the couple, assuming one or both is a smoker or by assuming one or both is X number of years older or younger than their actual age. 

Differences Between Actual and Assumed Investment Return and Actual and Assumed Spending

We have provided 5-year projection tabs in our ABC’s for single retirees and post-retirees to enable you to model the approximate impact on your spending budget of deviations from these assumptions.  As discussed in the overview tabs of the ABCs for retired and pre-retired couples, if you are a couple, you can use the single versions of the ABC’s to approximately model these variations.  Stress testing these assumptions can provide helpful information for developing investment and spending strategies, such as the possibility of establishing a robust Rainy-Day Fund.  Given the current equity market, it may be prudent to model the impact on your spending budget of a significant correction in the equity markets in the near future. 

Differences Between Actual and Assumed Sources of Income

If a significant portion of your assets is expected to come from one or two sources, you may wish to stress test your assumptions about receiving this income.  For example, if you are not yet retired, a significant source of your expected income may be your future expected employment income or your Social Security benefit.  Sources of income may also be lost or diminished in the event of death or divorce.  Also, many individuals expect to tap into their home equity or other sources to fund their retirement expenses.  If the potential loss or diminishment of these sources of income significantly reduces your expected spending, you may wish to consider taking steps to better protect these sources of income through insurance, through alternative investment strategies or you may wish to adjust your spending strategy to be more conservative.

Differences Between Actual and Assumed Inflation

While rates of inflation have been at historical low levels in recent years, it is certainly possible that higher rates may emerge in the future.  You may wish to stress test this assumption as well to help you make choices between investments that may or may not be inflation sensitive.

Conclusion

This website encourages you to think like an actuary and use basic actuarial principles in addition to what you are currently doing when it comes to your own personal financial planning.  In addition to making assumptions about the future and periodically balancing your assets with your spending liabilities, we encourage you to periodically stress-test important planning assumptions you make so that you can possibly mitigate negative outcomes if actual future experience punches you in the mouth. 

Survivor Payments Anticipated After First Death Within the Couple

Almost immediately after releasing our new Actuarial Budget Calculators for couples, we began to receive questions on how to handle payments anticipated after the first death within the couple.  Such payments could occur, for example, if

• One or both of the couple have a joint and survivor form of life annuity, 
• One of the spouses is eligible for a larger monthly benefit from Social Security or Canada Pension Plan upon the first death within the couple, or 
• One of the spouses may receive a lump sum or annuity upon death from a life insurance policy.
  

At this time, we don’t plan to modify our simple spreadsheets to calculate the present value of these various types of survivor benefits.

However, in this post, we will address how you can estimate the additional present values of these survivor payments using the Present Value Calculator spreadsheet, and then add the calculated present values to the “present value of other sources of income” input item in the ABC spreadsheets, to refine the calculation of your current spending budget.

We will use the following example of the retired couple of John and Mary and our ABC for Retired Couples to illustrate how this calculation could be done.

Example

Assume the following information for John and Mary:

• John is age 65 and Mary is age 60 and are both retired. 
• Neither of the couple has part-time employment income. 
• John has a monthly Social Security benefit of $2,000 that he is currently receiving and Mary anticipates receiving a Social Security benefit of $2,800 per month payable in future dollars when she reaches age 70. 
• John also has a pension benefit of $2,600 per month which is payable for his life with 50% of his benefit ($1,300 per month) payable to Mary after his death as long as she lives. 
• He also has a paid-up life insurance policy that will pay Mary $100,000 when he dies. 
• Mary has no lifetime income benefits other than her Social Security and she has no life insurance. 
• Because Mary has significant Social Security benefits on her own, she does not expect her Social Security benefit to change on John’s death. 
• They have accumulated savings of $500,000. 
• They also have equity in their home, but they have decided such equity will be used to cover any long-term care costs they may incur. 
• They assume unexpected expenses with a present value of $75,000 and expenses on final death of $100,000 in today’s dollars.
  

Assumptions:  John and Mary use the assumptions we recommend to calculate their Actuarial Budget Benchmark (ABB) to determine their 2018 recurring spending budget.  These assumptions include:

• 4% discount rate 
• 2% assumed rate of inflation 
• 2% annual increases in their future desired spending budget 
• 33% decrease in the spending budget upon the first death within the couple
  

They go to the Actuaries Longevity Illustrator and enter their birthdates, their genders, “no smoking” and “excellent general health” on the first page of this tool.  The planning horizon section on the results page tells them that the 25% chance (or probability) of survival is 29 years for John, 37 years for Mary, 37 years for “either alive” and 26 years for “both alive.”

To reflect the anticipated death benefits payable to Mary after John’s assumed death in the current year’s spending budget, they need to add the present value of the anticipated death benefits payable to Mary after John’s death in PV Other sources of income item C(26) of the ABC for Retired Couple workbook.  To obtain these present values, they go to our Present Value Calculator V. 1.1 spreadsheet and enter the following items:

For Mary’s expected pension benefits after John’s death (which based on the planning horizon assumptions is expected to occur after 29 years):

• $15,600 for “p” (which is twelve times the monthly amount Mary would receive: 12 X $1,300 per month) 
• 29 years of deferral for “t” 
• 8 years of payment for “n” (which is the difference between Mary’s assumed planning years until her demise of 37 minus John’s assumed planning years until his demise of 29) 
• 4% for “i” 
• 0% for “k.
  

This produces a present value of $35,025, as shown in I(15).

The present value of John’s life insurance policy is $32,065, and is determined by entering:

• $100,000 for “p” 
• 29 years for “t” 
• 0 years of payment 
• 4% for “t” 
• 0% for “k.
  

(click to enlarge)

The screen shot above shows the amounts that John and Mary enter into the Input portion of the Inputs & Results tab of the ABC for Retired Couples and the results. 

Note that the additional present value of $67,090 inserted in C(26) produces a 3.4% increase in John and Mary’s current spending budget (from $75,298 to $77,893).   This relatively small increase is a function of assuming relatively long lifetime planning periods for budget setting purposes.  The value of these benefits would, of course, be much greater if John were to die in the near future.  Also note that if John were entitled to benefits after Mary’s death, there would be no additional present value of such benefits, as under the planning assumptions, John is assumed to pre-decease Mary.

While we recommend assuming relatively long lifetime planning periods for budget development, it is also important to periodically determine the effect on spending budgets if assumptions about the future are not realized.  In John and Mary’s case, the earlier than expected death of either individual would probably not significantly negatively affect the budget of the surviving individual, but this is something that other couples should examine.

We will address the assessment of risks (that assumptions will not be realized in the future) in our next post.

Five Common Misperceptions About Using the Actuarial Approach for Personal Financial Planning

When you propose something different, you can expect that not everyone is going to fully appreciate or understand your position.   We at How Much Can I Afford to Spend advocate using basic actuarial and financial economic principles to help individuals (and their financial advisors) develop reasonable spending budgets and make better personal financial decisions.  Because we are actuaries and not financial advisors or academics and because what we advocate differs somewhat from approaches advocated by industry “experts” or described in articles contained in well-established personal financial planning literature, we experience a fair amount of misunderstanding of what we propose.   Most of this misunderstanding comes in the form of individuals erroneously describing what we are advocating and the associated deficiencies of what they think we are advocating.   We have found that the majority of these misperceptions have come from individuals who:

• Have never read the explanations of the Actuarial Approach provided in our website, 
• Have never tried to apply the basic principles endorsed, 
• Have different agendas to pursue or 
• Some combination of the above items.
  

In this post, we will respond to some of the more common misperceptions we hear about the Actuarial Approach, and we will encourage individuals and their financial advisors to try to ignore these misperceptions, try to be a little more open-minded about this new approach and actually try to apply the basic actuarial principles endorsed by us as a supplement to what they are currently doing.  To repeat the tagline from Alka Seltzer commercials from the early 1970s; we believe you should, “Try it, you’ll like it.”

Misperception #1—We advocate conservative investments. 

Not true.  We don’t advocate any specific investment strategy.  Yes, we do recommend using assumptions consistent with annuity-based pricing to develop your Actuarial Budget Benchmark (ABB), but we believe determining the cost of your spending liabilities for this purpose is a separate issue from the issue of how best to invest your assets to accomplish your financial goals.  The ABB is a budget developed using basic financial economic principles by comparing the market value of your assets with the approximate market value of your spending liabilities (i.e., the theoretical cost of purchasing currently available insurance annuity contracts to cover your future spending).

There are plenty of good reasons why you may or may not want to invest all or part of your assets in liability-driven investments (like annuities) or in more risky assets (like equities).  We aren’t going to list those reasons here.  We leave the decision of how best to invest your assets to meet your financial goals up to you with possible assistance from your financial advisor. 

We acknowledge that the basic financial economics principle that the cost of future spending liabilities may be determined independently of the client’s investment mix is almost heretical within the financial advisor community.  This community frequently concludes that client spending may be increased, within limits, by increasing the client’s investment risk; a result generally obtained by assuming historical real rates of return and variances will continue in the future.   We counter this general conclusion by pointing to the problems created by public pension plan actuaries who similarly assumed plan contributions could be reduced simply by increasing investment risk, and to recent Actuarial Standards Board considerations requiring actuaries to disclose a low-investment risk liability in actuarial reports for public pension plans as a way to quantify the extra risk assumed by the plan sponsor (and taxpayers) resulting from the plan’s investment policy (similar in concept to what we advocate with our ABB calculation).

Misperception #2—We advocate conservative spending.

Not true.  We don’t tell you how much you should spend each year.  The amount you spend each year is your business (or your and your spouse’s business).  We tell you how much you can afford to spend this year to meet your financial goals based on your financial situation and the assumptions you make about the future.   If you use our recommended assumptions to calculate your ABB, you are calculating a current year spending budget based on a relatively low investment-risk strategy.  Yes, this approach should produce a reasonably conservative spending budget.  But, you don’t have to spend your ABB.  The purpose of the ABB is to gauge how conservative or aggressive your current spending strategy is.   Armed with this benchmark, you can choose the level of spending with which you are comfortable, and just as important, you can monitor how aggressive your spending is each year by annually comparing it with your annually revised ABB.

In our posts, we have discussed many ways that you can spend more aggressively by front-loading your spending.  Several ways to do this without increasing your investment risk include:

• Assuming declining future real dollar future spending budgets, 
• Assuming decreases in the spending budget upon the first death within a couple, or 
• Treating some expenses (such as travel expenses) as non-recurring and thus not spreading them over your entire expected longevity planning period.
  

Misperception #3—We advocate using a deterministic assumption model rather than a stochastic model

Partly untrue.  While the simple Excel workbooks that we make available on our website to facilitate the present value calculations required under the general asset/liability matching model we advocate use deterministic assumptions, this doesn’t mean that our general individual model (the Basic Actuarial Equation) can’t accommodate stochastic modeling.  Since we provide you with an ABB based on basic financial economics principles and don’t claim to provide you with the maximum amount of income that can be provided at a specified probability of success based on assumptions with respect to expected returns and variances associated with various types of investments, we don’t feel a need to complicate our simple models with unnecessary stochastic modeling.   Unlike black-box stochastic models, our models are relatively transparent when deterministic assumptions are used, and unlike stochastic models, our process anticipates periodic future valuations to adjust for future experience that will inevitably differ from assumed experience.

Misperception #4—We advocate using only the Actuarial Approach to determine a reasonable spending budget

Not true.  As discussed in our post of April 20, 2017 and as discussed above, we recommend that you consider your ABB as another “data point” to be used in making your spending decisions.   Thus, we recommend that you use this calculation in combination with, and not in lieu of, other budgeting approaches you may be using that you find to be helpful.

Misperception #5—The Actuarial Approach is either too simple, not as sophisticated as Monte Carlo modeling and therefore inferior or it is too complicated for average individuals to use. 

Partly untrue.  As discussed above, quite a few people tend to conflate the Excel workbooks that we provide to facilitate the present value calculations required under the Basic Actuarial Equation with the more general process we refer to as The Actuarial Approach.  The Actuarial Approach involves using three basic actuarial principles:

1. Use of a generalized individual model that compares assets with liabilities (The Basic Actuarial Equation), 
2. Annual valuations to keep spending on track to meet financial goals, and 
3. Modeling of deviations in assumed experience to assess risk and assist financial planning
   

When taken together, these principles are much more powerful personal financial budgeting tools and concepts than our simple Excel spreadsheets. 

We will admit that the calculations required by the Actuarial Approach may unfortunately be beyond the comprehension of many individuals today.  That is why we have targeted Intelligent Numbers People (INP) in our communications.

Conclusion

No one (not even actuaries or financial advisors) knows what your investments will earn in the future and no one knows how long you (or your spouse) will live.   In fact, what we do know is that whatever assumptions we make about the future will be wrong, and future adjustments to spending plans will likely be required.  These unknowns make spending budgeting a difficult task.  Many stochastic models use historical experience to forecast future investment performance, and many clients rely on these models (and their questionably precise probability of success calculations) to make complex financial decisions regarding investments and spending.  We have concerns about stochastic models that promise higher levels of spending without properly quantifying the additional risk.  We also have concerns about blindly relying on the results of these models, particularly over extended periods of time without adjustment.   And while no one knows what future investments will earn, we do know how much insurance companies are currently charging to provide income for life based on life annuity quotes.  We believe that this “known” market pricing information can be useful in developing a low-investment-risk Actuarial Budget Benchmark that you can use in combination with the other approaches you are using to make better financial decisions.

Unlike others who may encourage you to use a specific budgeting approach, we have no financial stake in the decision you make.  We won’t benefit financially if you decide to buy annuities or invest in equities or use the Actuarial Approach.  We receive no direct or indirect income from advertising or hits to our site.   Despite having to occasionally address these misperceptions and live with the baffling lack of support from our own profession, we remain passionate about recommending the same basic actuarial principles that we applied in our work as actuaries to help INPs make better financial decisions.

We encourage you to try to keep an open mind with respect to using the Actuarial Approach and give it a try rather than rejecting it out of hand simply because of misperceptions you may have heard or read about it.

We Have Two New Actuarial Budget Calculator (ABC) Workbooks for Couples

Our website is all about using basic actuarial principles to help you (or your financial advisor) develop a reasonable spending budget designed to meet your personal financial objectives.  The first actuarial principle of personal financial planning (and budget development) involves balancing your assets with your spending liabilities.  Our readers are quite familiar with the Basic Actuarial Equation shown below, where assets are the items on the left-hand side of the equation and spending liabilities are the items on the right-hand side of the equation.

Accumulated Savings

+

PV Income from Other Sources

=

PV Future Non-Recurring Expenses

+

PV Future Recurring Annual Spending Budgets

Note that if you are comfortable performing the present value calculations and math required by the Basic Actuarial Equation, you may not need to use our Excel workbooks at all.  The ABC workbooks that we make available on our website have been designed to simplify these present value and math calculations, but may not be as robust in all situations as the results that can be obtained from directly applying the basic principle to your specific fact situation.   

Our previous ABCs for Retirees and Pre-Retirees involved using a single Lifetime Planning Period (LPP) to estimate the present values of income from other sources and the present value of certain future non-recurring expenses and recurring annual spending budgets.  This single LPP assumption made the calculations easier, but not as accurate, as the calculations required for a couple.  We discussed the complications involved in couple’s budgeting in our post of July 4, 2017.  After that post, we decided to create separate workbooks for retired couples and pre-retired couples.  The new workbooks are the result of that decision. 

Instead of using one LPP for a couple, the new ABC couple’s workbooks use four LPPs:  one for each person in the couple, one for the LPP while either person is expected to be alive and one for the LPP while both persons are expected to be alive.  These four LPPs may be obtained from the “Planning Horizon” section of the Actuaries Longevity Illustrator.  In addition to these additional LPPs, the new Couple’s workbooks require entry of the percentage decrease in the couple’s desired recurring spending budget upon the first death within the couple.

The new workbooks are titled, “ABC for Retiree Couples” and “ABC for Pre-Retiree Couples.” The original single LPP workbooks still reside in our website (with the new workbooks) in our “Spreadsheets” section and have been relabeled as “ABC for Single Retirees” and “ABC for Single Pre-Retirees.”

As part of the process of developing the new couple’s workbooks and renaming the old workbooks, we have updated the overview tab material describing each workbook.   We encourage you to read this material to obtain a better understanding of the workbooks.

We wanted to make these new workbooks available to you in time for your 2018 calendar year budgeting, and we encourage you to “kick the tires” on them.  We hope you will like the changes.  If you like the workbooks, please recommend them to other “intelligent numbers people.”  If you think they can be improved, please pass along your recommended changes to us as we are always interested in your feedback.

Happy Budgeting from all of us at How Much Can I Afford to Spend.

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.