Saturday, August 20, 2016

Planning for Constant Real-Dollar Spending in Retirement — Is It Setting the Bar Too High? Part II

This post is a follow-up to my post of March 31 of this year in which I encouraged you (or your financial advisor) to use the Budget by Expense-Type Tab of the Actuarial Budget Calculator to develop a reasonable spending budget that more closely meets your spending objectives with respect to the various types of expenses you expect to incur in the future.

Initial Spending Budget

Developing an initial spending budget using the Actuarial Approach is a two-step process:
  • The first step in the process is to determine the total present value of the assets you have to spend.  This present value includes your current liquid assets, the present value of your Social Security benefits, the present value of your defined benefit plan benefits, the present value of any annuity income you may have, the present value of non-liquid assets you may own that you plan to sell in the future, the present value of rental income from properties you may own, the present value of future wages you may earn, etc. 
  • The second step in the process is to determine how you want to spread this total present value of assets over your expected payout period.
The result, Current Year's Total Actuarial Spending Budget based on annual desired increase (shown in row 42 of the Input Tab of the Actuarial Budget Calculator spreadsheet), shows this year’s actuarially determined spending budget:
  • if you decide to spread the total present value of your assets, less Desired amount of savings remaining at death (input in row 33), over 
  • the Expected payout period (input in row 29), based on the assumption that future spending budgets will increase each year by the Annual desired increase in future budget amounts percentage (input in row 31).
If the same assumption is input for the Annual desired increase in future budget amounts (in row 31) as is input for Expected annual rate of inflation (in row 35), you are essentially planning for constant real-dollar spending throughout your retirement:
  • assuming all the assumptions input in the spreadsheet (including the mortality assumption) are exactly realized (and unchanged), and 
  • your actual spending exactly matches your spending budget each year.
We know, however, that all of the assumptions you input in our spreadsheet won’t be exactly realized (and/or unchanged) each year, and your actual spending will probably not be exactly equal to your spending budget.  That is why we added the 5-year Projection Tab, so that you could see how variations in investment returns and actual spending could affect your future spending budgets.

We also know that not all of your future expenses are likely to increase at the same rate, which is why we added the Budget by Expense-Type Tab to the spreadsheet.  This tab gives you the ability to spread the present value of your assets (which is also equal to the present value of your future spending budgets) between five different types of expense:

  • long-term care 
  • unexpected 
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
and to make different future increase assumptions for these expenses:
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
This is one of the many benefits of using the Actuarial Approach that you just don’t get with many other approaches — the flexibility to decide how you want to budget the spending of your retirement assets.

Planning for Constant vs. Decreasing Real-Dollar Spending

And the foregoing brings us to the inspiration for today’s post (with my apologies for taking so long to get here).

Three of retirement researcher Wade Pfau’s recent articles,

note that average spending appears to decrease consistently during retirement, until individuals become quite old, at which time their expenses (mostly health-related) increase.  Therefore, according to Dr. Pfau and other researchers, “Suggesting that retirees should plan for constant inflation-adjusted spending may overestimate the required retirement savings that many households will require for a successful retirement.”  Stated in another way, this research appears to support some degree of “front-loading” of the early years’ real-dollar spending budgets, relative to later years (i.e., larger early year budgets than later year budgets, measured in real dollars).  In his “Smile” article, Dr. Pfau cites research from David Blanchett that shows that real-dollar spending for a retiree whose initial spending is about $100,000 is expected to decrease by about 1% per year until the retiree reaches her early 80s, at which time health-related expenses will tend to increase real-dollar spending.

While I agree that non-essential expenses are likely to decrease in real dollars as we age in retirement, I also agree with Dr. Pfau that other types of expenses in retirement are likely to remain constant in real dollars or even increase.  It is for this reason that I recommended different rates of assumed increases for
  • essential non-health (ENH) expenses, 
  • essential health (EH) expenses and 
  • non-essential (NE) expenses
for determining 2016 spending budgets in my post of December 21 of last year.

It is important to note, however, that if we assume:

  • essential non-health (ENH) expenses will increase with inflation in the future, 
  • essential health (EH) expenses will increase faster than general inflation and 
  • non-essential (NE) expenses will increase at a rate less than inflation,
then the expected rate of increase or decrease in the total real-dollar spending budget will depend on the relative levels of these three separate budget components.

The larger the portion of the spending budget that is represented by non-essential expenses (using different rates of assumed increases for essential non-health (ENH) expenses, essential health (EH) expenses and non-essential (NE) expenses), the greater the annual decrease expected in future real-dollar total spending budgets.

Examples using James and Michael

Let’s take a look at two different retirees to illustrate this point.  Both James and Michael are:

  • 65-year old males 
  • with $20,000 annual Social Security benefits, 
  • a $10,000 annual pension benefit, 
  • no other sources of retirement income and 
  • no bequest motive.
The only difference between James and Michael is their accumulated savings:
  • James has accumulated savings of $500,000 and 
  • Michael has accumulated savings of $1,000,000.
Both retirees use the Actuarial Budget Calculator to develop their spending budget for this year and our recommended assumptions of:
  • 4.5% discount rate 
  • 2.5% inflation 
  • expected retirement period equal to age 95 minus attained age or life expectancy if greater.
Under these assumptions, the present value of assets are:
  • $1,129,966 for James, and 
  • $500,000 higher, or $1,629,966 for Michael’s.
If these present values are spread over their expected retirement periods as a constant real-dollar amount (increasing each year at the same 2.5% annual rate assumed for inflation), their spending budgets for this year would be:
  • $49,156 for James 
  • $70,907 for Michael.
Examples Using Budget by Expense-Type Tab

Both James and Michael have determined their expenses as:

  • essential non-health (ENH) expenses for the upcoming year are $30,000 
  • essential health (EH) expenses are $7,000 
  • essential non-health (ENH) expenses will increase by inflation in the future (2.5% as stated above) 
  • essential health (EH) expenses will increase by inflation (2.5%) plus 1.5%, or 4.0% 
  • non-essential (NE) expenses will remain constant in nominal dollars
For the sake of simplicity, we are going to assume that both have separately set up sufficient reserves for long-term care expenses and unexpected expenses.

If instead of planning for constant real-dollar spending, these retirees use the Budget by Expense-Type Tab of the spreadsheet and the increase assumptions for each budget expense type discussed above,

  • James will develop a total spending budget for this year of $51,351 (or about 4.5% greater than his constant dollar spending budget), while 
  • Michael’s total spending budget would be $80,725, (or about 13.8% higher than his constant dollar spending budget).
The reason for the different rates of increase is that non-essential (NE) expenses represent a much larger proportion of James’ total spending budget than for Michael’s.


The following two charts illustrate this concept by showing expected real-dollar budget components and total spending budgets for the two retirees by age, if all assumptions are realized.

click to enlarge

click to enlarge

It is important to note that we show expected budget components and totals only until age 90.  This is because real-dollar spending budgets developed as the sum of these three budget components under the Actuarial Approach are expected to decrease significantly once the retiree’s current age plus life expectancy starts to exceed age 95.  At that time, however, the retiree presumably has long-term care and unexpected expense reserves to dip into.

Over the 25-year period from age 65 to age 90, James’ expected total real-dollar spending budget decreases by about .25% per year, while Michael’s total real-dollar spending budget decreases by about 1% per year.  Thus, the results for Michael are very close to the results for the average retiree with initial income of $100,000 noted by David Blanchett.  However, it is important to look at your own situation to determine what is appropriate for you.

Saturday, July 30, 2016

Retired Actuary Calls for Actuarial Profession to Advocate True Social Security Sustainability

This post is a follow-up to several of my recent posts on Social Security financing.  It is a call to my profession to fulfill its mission and vision by advocating adoption of a basic actuarial principle for Social Security:  ensuring sustainability of the program through automatic maintenance of the actuarial balance between expected system assets and liabilities on a going-forward basis. 


The American Academy of Actuaries is the public voice of the actuarial profession on public policy issues.   In its June, 2016 Issue Brief, An Actuarial Perspective on the 2016 Social Security Trustees Report, the Social Security committee of the Academy said, “The Social Security Committee believes that any modification to the Social Security system should include sustainable solvency as a primary goal.”  The issue brief goes on to define this term as follows:

Sustainable solvency means the program is not expected to deplete reserves any time in the 75-year projection period, and trust fund ratios are expected to finish the 75-year projection period on a stable or upward trend.”  This is essentially the same definition used by the Social Security actuaries, who are a little more precise and talk about Sustainable Solvency “under a given set of assumptions.”  This is an important distinction because sustainable solvency depends to a significant degree on exact realization of assumptions made about the next 75 years.

The concept of Sustainable Solvency was developed by the Social Security actuaries to address the problem of unrecognized deficits after the end of the 75-year projection period.  This concept did not exist at the time of the 1983 amendments, as discussed on our post of May 17, 2016, “What went wrong with the 1983 Social Security Fix?” when Congress supposedly “solved” the program’s financial problems for the next 75-years by reducing the 75-year actuarial deficit in existence at that time to zero.  Note, however, that with the additional requirement with respect to the trend at the end of the 75-year projection period, Sustainable Solvency is essentially the same as the 75-year actuarial balance requirement used in the 1983 Amendments.

As part of the annual Trustee’s report, the Social Security actuaries perform an actuarial valuation of the program by comparing program assets with program liabilities under various sets of assumptions about the future.  The most publicized results of these actuarial valuations are the expected trust fund exhaustion date and the 75-year actuarial deficit under the Intermediate (or best estimate) assumptions.  For many years now the Trustees and the actuarial profession has been using the results of these valuations to encourage Congress to act sooner rather than later to bring the program back into actuarial balance under the Intermediate set of assumptions.  For example, the Academy’s most recent Issue Brief said, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.”

When reform proposals are now submitted to the Social Security actuaries for scoring, the Social Security actuaries determine whether such proposals meet the requirements for Sustainable Solvency based on the Intermediate assumptions used in the most recent Trustee’s Report.  For example, as discussed in our post of June 16, 2016, The Bipartisan Policy Center’s Commission on Retirement Security and Personal Savings Report got very excited when the Social Security Actuaries indicated that their Social Security proposals met the requirements for Sustainable Solvency.  Their report erroneously concluded “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…”  These statements were erroneous because they were based on the premise that all of the Intermediate assumptions used in the 2015 OASDI Trustees report would be exactly realized in the future, which we know won’t occur.

As discussed in our post of June 16, it is foolish to believe that assumptions made by Social Security actuaries today will be accurate over the next 75 years, so a claim of Sustainable Solvency is shaky at best and potentially misleading. No sound actuarial process proclaims solvency for a period of 75 years without anticipating making periodic adjustments in future years as experience emerges. 

Truly Sustainable Solution

The common sense solution to providing true Social Security sustainability is to require that the system automatically be placed in actuarial balance on a periodic basis in the future, as is the case for all sound actuarial processes.  For example, current law could be changed to require the program’s tax rate be automatically changed effective for the year following an actuarial valuation that shows the program has fallen out of actuarial balance by 5% or more.  Congress could, of course, take other actions to bring the program back into actuarial balance rather than have the automatic tax rate increase (or decrease) take effect.

As an example of how this automatic process might work, let’s look back at the 1983 Amendments, which were supposed to fix the system for 75 years.  In 1989 (which by the way, was just 6 years after the 1983 Amendments), the system went out of long-term actuarial balance (as that term was defined at the time using a 5% threshold).   If the proposed automatic adjustment had been in place at the time, a small tax increase would have been required to bring the program back into actuarial balance.  Additional tax increases would also have been required in subsequent years, unless Congress took other actions.  If no benefit reductions were adopted during this period, today we would have a higher tax rate but no impending significant reductions to consider. 

Reasons Why the Profession Should Endorse this Solution

Here are some of the reasons why the actuarial profession should advocate in favor of this solution:

  • The solution is consistent with the expressed mission statement of the American Academy of Actuaries “to serve the public and the United States actuarial profession.”  
  • It is consistent with the Academy’s vision statement that “financial systems in the United States be sound and sustainable…”  
  • According to the Academy’s 2015 Public White Paper, Sustainability in American Financial Security Programs, “The American public relies on the promises made under many different financial security programs—whether they are public programs like Social Security and Medicare or offered through the private sector such as employer-sponsored pension plans or insurance products. The public must have confidence that these programs can be sustained and continue to meet their goals.”  I believe adoption of the proposed solution would increase public confidence in the system. 
  • The proposed solution is consistent with the Academy’s Social Insurance Committee’s belief that, “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be.”  Clearly, frequent automatic adjustments would involve earlier implementation and would be less disruptive than infrequent, more disruptive reforms. 
  • The proposed solution is consistent with the Academy’s public policy objective “to address pressing issues that require or would benefit by the sound application of actuarial principles.”  If current law already provided for such automatic adjustments, I can’t imagine that the profession would support legislation to eliminate them.  So, why the reluctance to endorse them? 
  • Endorsement of this solution is an opportunity to enhance the profession’s public image.  Conversely, failure to endorse this solution increases the possibility of damaging the profession’s reputation.   The reputational risk involved with Social Security financing may be even greater than the risk associated with performing actuarial valuations for public pension plans.

Sustainable solvency as defined by the profession and Social Security actuaries is a misnomer and is potentially misleading.  It is based on exact realization of assumptions made for the next 75 years that will not come true.   True system sustainability can be achieved through periodic adjustments to maintain the system’s actuarial balance as actual experience emerges.

The 1983 Amendments failed to provide us with system sustainability, and we are looking at significant reform proposals as a result.  This time around, however, the changes should result in a more sustainable program on which the American public can truly depend.   It is time for us to remember the old proverb, “fool me once, shame on you; fool me twice, shame on me.”  We shouldn’t just accept a reform “fix” that is similar to the “fix” adopted in 1983.  For this reason, I call on the actuarial profession to step up its game and advocate true system sustainability through automatic periodic adjustments to keep the program in actuarial balance on a going forward basis.

Tuesday, July 26, 2016

“It’s Simply Common Sense” to Develop Your Spending Budget in Retirement by Carefully Considering How to Deploy All the Retirement Assets You Own

In his most recent CBS MoneyWatch article, my friend and fellow actuary Steve Vernon reminds us that home rich/cash poor Americans can use their home equity to fund their retirement.  He discusses various ways this can be done, including downsizing and reverse home mortgages.  He concludes his article by saying, “It's simply common sense to carefully consider how to deploy all the retirement assets you own.”  Well, thank you very much, Steve, because careful consideration of how to deploy all the retirement assets you own is what the Actuarial Approach for developing a reasonable spending budget is all about.

The basic concept of the Actuarial Budget Calculator spreadsheet provided in this website is to match your retirement assets (including the present value of future Social Security benefits, pension benefits and future sales of other assets) with the present value of your future spending budgets and the present value of your bequest motive (called Desired Amount of Savings Remaining at Death in our spreadsheet).  And don’t be frightened by the fact that the calculations involve present values; our Actuarial Budget Calculator spreadsheet does them for you.

Before I give an example of how you can use the Actuarial Budget Calculator spreadsheet to “deploy” your home equity, I would like to, once again,point out that even though it may be common sense to deploy all your assets to meet your retirement spending objectives, you generally won’t find much discussion of how to accomplish this with rule of thumb withdrawal approaches such as the 4% Rule or other safe withdrawal rate approaches.  What you do hear with those approaches is something like, “trust us, based on complicated Monte Carlo modeling, if you invest your accumulated savings at least 50% in equities, you will have a 95% chance of not running out of money.”  On the other hand, with the Actuarial Approach, you develop a reasonable spending budget based on your best estimates of future experience and your financial situation.

Recently one of my readers wanted to know how to determine a reasonable spending budget during a period of time prior to commencing his Social Security benefit recognizing, that he had a fair amount of equity in his home in addition to a fair amount of more liquid accumulated savings.  I’m going to change his fact situation somewhat for simplicity sake.  Let’s assume that

“David” is age 65,
no longer working,
has $500,000 of liquid accumulated assets,
$400,000 of equity in his home, and
he projects his Social Security benefit will be $30,000 per year when he commences it at age 70 (in 5 years).

David believes that, in about 15 years, he will downsize his house to a condominium and,at that time, he will be able to pull out about 50% of his equity.  He wants to use what he can pull out when he downsizes to increase his current spending budget.  David wants to use the remaining 50% of his equity for long-term care costs when he no longer can live by himself in his condominium. Thus, David estimates the present value of the equity he will be able to pull out of his current home when he downsizes to a condominium at $200,000 (half of the $400,000 of equity in his home).  David assumes that his home equity will increase by 4.5% per year, the same assumption he makes for investment return on his more liquid accumulated savings.

Using the Actuarial Budget Calculator, David enters

$500,000 in accumulated savings,
$30,000 in Social Security benefits commencing in 5 years,
$200,000 as the present value of other sources of income and
the recommended assumptions (4.5% investment return, 2.5% inflation and 30- year retirement period).
He has no bequest motive.
Since we are going to use the Budget by Expense tab and look at the components of David's spending budget, we don't need to make an assumption about the desired increase in David's total spending budget in the input tab.

The present value of David’s retirement assets under these input items and assumptions is $1,181,925 (plus the 50% remaining equity that is assumed to cover David’s long-term care costs).

David assumes:

$50,000 for the present value of unexpected expenses,
$35,000 increasing with inflation for essential non-health expenses and
$7,000 increasing with inflation plus 2% for essential health costs.

He then goes to the Budget by Expense-type Tab of the spreadsheet and budgets

$0 for long-term care costs (because they are to be covered by his condominium equity), and the three assumptions above.

This leaves him with $117,367 for the present value of his non-essential expenses, which he decides to spread over his expected retirement as the same constant dollar per year, giving him a current year non-essential spending budget of $6,895 and a total current year spending budget of $48,895.  Note that because he is not currently receiving Social Security benefits, this amount must come entirely from his liquid accumulated savings and represents about 9.8% of his current liquid assets.

While a 9.8% withdrawal from David’s liquid assets is relatively high, he knows that withdrawals from his liquid assets will decrease when he starts collecting his increased Social Security benefit and he also knows that if he runs low on his liquid assets, he can choose to downsize his home earlier than planned to take out some of his equity.  He also knows that his situation will change each year and he will have to revisit his calculations annually to make necessary adjustments.

Had he been advised to use the 4% Rule, there is no telling what portion of his liquid accumulated savings David would have decided to spend.  $20,000 (= .04 x $500,000)?  $20,000 plus the amount of the Social Security benefit he could have received if he wasn’t deferring?  Something more than this based on his knowledge that he has a fair amount of home equity?

With the Actuarial Approach, David has set aside money for long-term care, future unexpected expenses, future essential expenses and future non-essential expenses.   This is the real benefit to David of doing a little number crunching rather than blindly relying on some rule of thumb approach.