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Developing a reasonable spending budget for clients who are near or in retirement is an actuarial problem. As such, it requires an actuarial solution. But, you don’t need to be an actuary to solve your client’s problem.
All you need are some consulting skills, number-crunching abilities and the proper tools and processes. This article will point you toward those tools and processes and tell you why you and your clients will benefit from using what I call “The Actuarial Approach” for determining spending budgets.
I’m a retired pension actuary with over 35 years of experience working at consulting actuarial firms. When I retired a little over five years ago, I started a website to help retirees determine how much of their non-annuitized assets they can afford to spend each year as part of the overall process of developing a reasonable spending budget. Here is a link to the website.
On the website, you will find several explanations of The Actuarial Approach, two simple spreadsheets (one for general use and one for a retiree who wants to defer commencement of Social Security benefits) and a Blogspot that contains periodic posts from me on various decumulation topics. You will notice in my bio that I justifiably claim to have no expertise in either investing or financial planning and that I receive no direct or indirect compensation from any activities associated with the blog or website.
Survey says: Most financial advisors not using math and science
In a survey by Russell Investments published last fall, 234 financial advisors were asked how they develop spending budgets for clients who are approaching or in retirement. A quarter responded that they based their approach on levels of pre-retirement spending; 22% indicated that they used a rule of thumb like the 4% rule; 19% indicated that they used some variation of the bucket strategy; 16% indicated that they compared assets with future liabilities and 18% indicated some other approach. The survey concluded that not enough advisors were using "math and science" to develop spending budgets for their clients.
Advisors should be periodically comparing the client's assets with the client's liabilities, in a similar way actuaries measure the funded status of pension plans. The authors said that while using a rule of thumb is easy to understand, “it doesn’t account for a client’s individual circumstances.” Thank you, Russell Investments, for your indirect plug for the Actuarial Approach.
The Actuarial Approach
The Actuarial Approach indeed uses “math and science” to develop spending budgets by periodically (generally annually) aligning the retiree’s assets (accumulated savings, Social Security and other sources of retirement income such as pension benefits or annuities) with the retiree’s liabilities (the present value of future spending needs). While this sounds complicated, it is easily accomplished by entering a few data items and assumptions in one of the two spreadsheets that reside on my website.
While the Actuarial Approach can be used to produce a total spending budget for the year, I encourage advisors to break their client’s total budget into several component parts or categories, such as non-health-related essential expenses, essential health-related expenses, non-essential expenses, bequests or other end-of-life expenses and emergency expenses. Clients may have different expectations for these separate categories (in terms of expected length of payment or expected/desired rate of future increase) that may affect current budgets and investment strategies.
The Actuarial Approach is mathematically equivalent in certain limited situations to the Annually Recalculated Virtual Annuity (ARVA) approach, discussed in Laurence B. Siegel’s Advisor Perspectives March 31, 2015 article. But the Actuarial Approach is a much more powerful and useful approach as discussed below.
Why you should use the Actuarial Approach
Here are four reasons to use the Actuarial Approach:
- It will make you a better advisor by being better able to meet the needs of your client. Your clients are all different. They have different characteristics and objectives. They deserve better consulting from you than off-the-shelf rules of thumb that don’t consider their objectives. To be a good advisor/consultant, you need to sit down with your client and determine your client’s goals with respect to maximization of lifetime income, wealth transfer, expected patterns of future expenses, desired flexibility in spending, desired stability in spending, risk tolerance for large decreases or increases, etc. These discussions will naturally lead to different investment/withdrawal strategies for the various expense categories discussed above.
- It is the only approach that properly coordinates withdrawals from savings with fixed income payable from pensions and annuities. If your client has a fixed-dollar pension income or income from single premium immediate annuities (SPIAs) or deferred income annuities, you can’t recommend the same withdrawal approaches that you recommend for clients that don’t have those assets and expect to accomplish the client’s long-term goals.
- It is very flexible. While I provide recommended assumptions, these assumptions can be changed to make spending budgets more or less conservative, consistent with client goals.
- It is free and readily available on my website.
Example
In my blog post on June 7, 2015, I provided an example of how a hypothetical retiree named Mary could develop a reasonable spending budget that meets her goals, including a specific goal to be more conservative with respect to withdrawal of funds and the investment of assets supporting her essential expenses.
Mary is a 65-year old single female retiree with $1,000,000 in accumulated savings, a fixed-dollar pension benefit of $15,000 per year and a Social Security benefit of $20,000 per year. Mary has determined that her essential expenses are $50,000 per year (including $7,000 attributable to medical expenses and prescription drugs). She wants to leave $500,000 to her daughter upon her death or have that money available for long-term care or other expenses near the end of her life. She also wants to set aside $100,000 of her accumulated savings for unexpected expenses.
Mary expects her future medical expenses to increase by inflation plus 2% and she anticipates that these expenses will be payable for 30 years, the recommended planning period under the Actuarial Approach. Mary expects her non-medical essential expenses to increase by inflation each year, and she also plans to incur these expenses for 30 years. With respect to non-essential expenses, Mary is comfortable assuming that these expenses will not increase with inflation in the future and will be based on her current life expectancy (24 years). She realizes that this desired pattern will produce a lower non-essential expense budget (in both real and nominal terms) for her as she ages if all assumptions are realized.
Mary wants to be conservative with respect to the funding of her essential expenses, so she decides to buy a SPIA that gives her another $13,000 in annual payments. This annuity costs her $205,629 at current annuity prices and leaves her with remaining accumulated assets of $794,371 ($1,000,000 - $205,629). She will allocate $7,000 of this annuity to essential non-health related expenses and $6,000 to essential health related expenses. Number crunching under the Actuarial Approach Mary uses the “excluding Social Security” spreadsheet available on my website to determine that $107,500 of her accumulated savings plus a $6,000 per year fixed income annuity is expected to give her an annual spending budget of $6,988 per year increasing by 4.5% per year for the next 30 years. This is close to her $7,000 per year estimate of health related expenses that she expects to increase by inflation (assumed to be 2.5% per annum) plus 2% each year. Mary uses the spreadsheet again to solve for how much of her accumulated savings she will need to cover her non-health related essential expenses and her bequest motive/long-term care reserve. Her spending target for this calculation is about $23,000 (to which she will add her Social Security benefit of $20,000). She enters $22,000 for the fixed annuity ($15,000 pension plus the $7,000 recently purchased annuity allocated to non-health essential expenses), the recommended assumptions and $500,000 payable to heirs. She determines that $288,000 of her accumulated savings will give her a constant real-dollar spending budget of $23,012 annually for the next 30 years, to which she will add her Social Security benefit of $20,000 per year to give her an expected non-health essential real dollar budget of $43,012 per year (and $500,000 to her heir) if all assumptions are realized and Mary spends exactly her budgeted amount each year. Mary also establishes a separate budget account for unexpected expenses in the amount of $100,000. After budgeting for her future health related expenses, her non-health related essential expenses (including the desired amount to be left to her heir) and her future unexpected expenses, Mary has $298,871 of accumulated savings left ($794,371 - $107,500 - $288,000 - $100,000) for her non-essential expense budget. She enters that amount in the spreadsheet with a 24-year payout period and 0% annual increases (and the other recommended assumptions) to develop a non-essential spending budget for her first year of retirement of $19,730. Her total spending budget for her first year of retirement, then, is $69,730 plus whatever amount she decides to spend from her unexpected budget account. Assuming no withdrawals from her unexpected budget account, her $69,730 budget for her first year of retirement comes from the following sources:
- Social Security: $20,000
- Pension: $15,000
- Life Annuity: $13,000
- Savings: $21,730
- Total: $69,730
The total amount Mary expects to withdraw from her accumulated savings of $21,730 represents 2.74% of her accumulated assets of $794,371, but only 0.35% of her non-health essential accumulated savings account, only 0.92% of her health budget accumulated savings account and 6.60% of her non-essential spending accumulated savings account. By comparison, Siegel’s ARVA and most other popular withdrawal strategies apply the same algorithm to Mary’s total accumulated savings and ignore her pension and life annuity. They would suggest that Mary withdraw a certain amount or percentage from accumulated savings in addition to amounts she expects to receive from her pension, annuity and Social Security. This amount or percentage would generally result in too much being withdrawn from Mary’s essential budget accounts and too little withdrawn from her non-essential budget account to meet her specific spending objectives.
The bottom line for advisors
Don’t just recommend that your clients “tap their savings.” Help them develop a reasonable spending budget that works with your recommended investment strategy to meet their needs in retirement.
Ken Steiner is a retired actuary with a website entitled, "How Much Can I Afford to Spend in Retirement?"
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