Tuesday, August 8, 2017

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

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

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

  • Convince you to buy lifetime income products from insurance companies 
  • Advise you on the best way to invest your assets 
  • Influence public policy to encourage plan sponsors or financial institutions to offer “lifetime income” options from qualified defined contribution plans or IRA’s 
  • Refine existing research relating to retirement, or 
  • Develop the optimal Systematic Withdrawal Plan (SWP) so that withdrawals under such plan may be added to other sources of lifetime income.
We are disappointed that the major actuarial organizations in the U.S. appear to be more focused on advocating the cobbling together of various lifetime income “solutions” (including lifetime income insurance products and SWPs) than advocating the use of basic actuarial principles to help individuals achieve their spending goals.  The American Academy of Actuaries (AAA) actually sponsors a Lifetime Income Initiative which claims, “The Academy has identified lifetime income as a top public policy issue and strongly supports initiatives that will lead to more widespread use of lifetime income options.”

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


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

  • Betty would like to maximize her Social Security benefits 
  • Neither would like to become a burden on their daughter 
  • They don’t want to outlive their assets 
  • The would like to earmark $20,000 per year in real dollar spending for the next 20 years for travelling expenses, as they are quite interested in travelling while they are able to do so. 
  • They desire relatively constant real dollar non-travel spending from year to year while they both are alive, with about 2/3rds of such real dollar spending to continue after the death of the first spouse.
  • They plan to use about 1/2 of their existing home equity to finance recurring expenses, leaving the other half to finance expected long-term care costs.  They understand that they may have to downsize or take some other action during retirement to extract home equity assets. 
  • They establish an initial reserve for unexpected non-recurring expenses of $100,000. 
  • They have no desire to establish a separate reserve to fund a bequest motive for their daughter.  They understand that it is likely that some assets will remain for this purpose at the second death of the couple.
Bill’s assets:
  • Bill has commenced his Social Security benefit of $20,000 per annum 
  • Bill has a QLAC (deferred annuity contract) that will pay $20,000 per annum for his life, commencing at age 85
Betty’s assets:
  • Betty estimates (by using the Social Security Quick Calculator) that her Social Security benefit will be about $35,000 per annum if it commences at age 70 
  • Betty has a pension benefit that will pay her $12,000 per annum for her life, commencing at age 65
Joint assets:
  • The couple has combined accumulated savings (pre-tax and post-tax) equal to $1,000,000 
  • The couple estimates that the equity in their home is currently $600,000, with no mortgage.

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

  • 4% annual discount rate 
  • 2% annual rate of inflation 
  • Using the Actuaries Longevity Illustrator and a probability of survival of 25%, they determine that:
o    Bill’s lifetime planning period is 29 years,
o    Betty’s is 42 years, 
o    the expected period at least one of them alive is 42 years and
o    expected period both are alive is 27 years.
  • The couple expects their home equity will increase at 4% per annum, the same rate of annual increase as assumed for their other investments. 
  • The calculations of the present values in the table below can be duplicated using either our ABC (Retiree) or Present Value Calculator spreadsheets.
Actuarial Balance Sheet

Here is Bill and Betty’s Actuarial Balance Sheet

(click to enlarge)

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

Spending Budgets

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

  • non-travelling recurring spending of $71,599 ($1,946,707 ÷ 27.1890), plus 
  • their travelling budget for the year of $20,000, 
  • for a total spending budget for this year of $91,599.
If all assumptions are realized in the future, Bill and Betty’s spending budget is expected to increase each year with inflation for the first 20 years, after which it would be expected to drop to $71,599 (when their 20-year temporary travelling budget expires) in real dollars until Bill’s expected time of death, at which it would be expected to drop to $47,733 (2/3rds of $71,599) in real dollars.

“Sum of Sources” approach

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

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

Final Words

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

Thursday, August 3, 2017

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

This week, the American Academy of Actuaries (AAA) released An Actuarial Perspective on the 2017 Social Security Trustees Report.  Their primary recommendations were:
  • “Social Security’s financial soundness should be addressed now”, and
  • “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be”
And while these recommendations appear to be non-controversial, this post will discuss the one big problem we have with the AAA’s actuarial perspective as well as several smaller concerns.


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

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

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

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

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

Smaller Concerns in the Issue Brief

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

Adoption date of reform changes vs. effective date of changes

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

Giving Baby Boomers adequate time to adjust?

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

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

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


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

Friday, July 28, 2017

Got “Lumps” in Your Sources of Income or Your Expenses? Smooth Them Out with the Actuarial Approach

Ever notice when you are reading about the best way to spend down your invested assets in retirement how most retirement researchers or retirement experts will demonstrate how well their Systematic Withdrawal Plan (SWP) works by assuming:
  • Sources of retirement income will commence at the same time and will generally only involve Social Security and withdrawals under the SWP 
  • Any other sources of income will commence at the same time, will be paid for life and will generally increase with inflation 
  • Expenses in retirement will be smooth from year to year and will generally increase with inflation 
  • Individuals or couples will develop their annual spending budget by summing their retirement income sources (sum of the sources) each year and will spend exactly this amount every year, and 
  • The family unit’s goal is to have a recurring spending budget (and actual spending) that remains constant in Real Dollars for as long as they live.
For many individuals and couples, these just aren’t realistic assumptions, and application of the expert’s SWP can lead to undesired consequences under more real-world situations.  Amazingly, however, these potential problems don’t seem to stop the retirement researchers from continuing to tout the 4% Rule, the Required Minimum Distribution (RMD) Rule, some variation of these rules or some other rule of thumb SWP as the best way to spend down your assets.  We have previously discussed the potential shortcomings associated with SWPs and “sum-of-the-sources” budgeting if sources of income aren’t “smooth” throughout retirement (most recently in our post of April 9, 2017).  This post will focus on the problems associated with using SWPs that can also occur if expenses in retirement are expected to be “lumpy,” and how the Actuarial Approach can be used to smooth out such lumpy expenses, just as it works to smooth out lumpy sources of income.

How do lumpy expenses affect your annual recurring spending budget?

It is just kind of silly to assume that your expenses are going to remain constant in Real Dollars from year to year.  At some point during your retirement, you or your spouse is going to decide that your house needs a new roof, the kitchen needs to be remodeled, you need one or more new cars, etc.  As the old saying goes, “Expenses Happen.”  And these larger expenses are unlikely to fit into your recurring annual expense budget.  This is why we suggest that you establish reserves for unexpected expenses and other non-recurring expenses (in addition to your reserves for Long-Term Care and bequest motives, and general Rainy Day Funds to dip into if your investments perform poorly).  To the extent that these expenses are covered by reserves for this purpose, there may be no effect on your annual recurring spending budget (although you may have to build the reserves up again for the next unexpected expense, and this could reduce your annual recurring spending budget).

Sometimes these larger expenses, such as home improvements, can be considered as investments that increase (or do not decrease) the total value of your assets.  In this event, the diminution of your accumulated savings may be totally or partially offset by the increase in your home value, and depending on how you plan to use your home to finance your retirement, you may not have to experience a reduction in your annual recurring spending budget by incurring this type of expense.

Other expenses, for which you have established no reserves or that don’t increase the value of some other asset you own, are just large expenses, and you will have to decide whether they are “recurring” or “non-recurring.”  If you can’t (or don’t want to) absorb them entirely in this year’s recurring spending budget), then your assets will be reduced and your next year’s recurring spending budget may be reduced, just as it may be with any asset loss.
You may expect to incur some temporary, but not permanently, expenses over several years.  For example, you may have temporary family loans/support, plans to travel over a defined period of time or remaining mortgage payments when you retire.  As illustrated in the example below, you may wish to establish non-recurring expense reserves for these types of expenses, rather than have them significantly affect short-term and long-term annual recurring spending budgets.

Finally, research has shown that retirees tend to spend less in Real Dollar terms as they age.  If you are comfortable with developing a more “front-loaded” spending budget, you can use the Actuarial Approach to “smoothly” reflect this reality.


Let’s assume we have a retired 65-year old female with:

  • $500,000 in accumulated savings 
  • a Social Security benefit of $20,000 per annum payable immediately 
  • four years left on her home mortgage at $24,000 per annum that she does not want to pay-off early.
For calculation simplicity, let’s also assume that she inputs $0 for
  • bequest motive, 
  • PV Long-Term care costs 
  • PV unexpected expenses

She desires to have constant Real Dollar recurring spending in retirement.  However, she establishes a reserve to pay off her current mortgage of $96,602.

Using the Actuarial Budget Calculator and our recommended assumptions, she determines her annual recurring spending budget for this year to be $37,408.  If all her assumptions about the future are realized, this will be her Real Dollar recurring spending budget for her first year of retirement and for the rest of her life.  If she actually spends this amount plus the $24,000 of mortgage payments from her non-recurring fund, she will spend a total of $61,408.  By comparison, if she used the 4% Rule and didn’t set up a separate mortgage payment reserve, her total spending for her first year would be limited to $40,000, and would be expected to remain at this Real Dollar level throughout her retirement.  In her first year of retirement, however, her non-mortgage spending would only be about $16,000, compared with non-mortgage real dollar spending of $40,000 after her mortgage is paid off.


If you live in the real world where sources of income and expenses may not always follow the simplifying assumptions made by retirement researchers, we encourage you (or your financial advisor) to use the Actuarial Approach to develop a more reasonable recurring spending budget.  Even if your situation is consistent with the assumptions above, we still encourage you to become familiar with and apply our Actuarial Budget Calculators.