|An Actuarial Primer for Developing a Retirement Spending Budget |
By Ken Steiner, FSA
You got the watch, the hearty handshake, and, if you were conscientious, a decent retirement nest egg to manage. Now what?
A financially successful retirement requires planning for two phases: saving and spending. While several useful Internet applications can help you figure out how much to save for retirement, there are few tools for managing spending once you get there. Some financial planners recommend withdrawing somewhere in the neighborhood of 3%-6% of your accumulated savings each year, but these “rule-of-thumb” spending strategies may not be right for your circumstances or consistent with your objectives.
As employers have switched from traditional defined benefit (DB) plans (which generally pay out benefits in a lifetime income option) to 401(k) and other account-based plans (which typically pay out only lump sums), more and more people are facing a choice at retirement:
• Use the 401(k) balance or other accumulated savings to purchase a life annuity (or other lifetime income insurance product) from an insurance company;
• Self-insure their retirement—invest accumulated savings (including lump sums payable from DB plans) and withdraw a prudent amount annually.
Self-insuring offers several advantages, including greater liquidity, more flexibility, the potential for a higher income, and the possibility of leaving an inheritance. The disadvantages include a risk of running out of money and a less predictable, and possibly lower, annual income. But by using the actuarial process described below—and with reasonable assumptions—it’s possible to better manage these financial risks.
The overwhelming majority of people choose to self-insure their own retirement rather than buy a life annuity. Given a choice between a lump sum and a life annuity with the same expected value, most DB plan participants opt for the lump sum. I’m not going to attempt to settle the question of which is best, but rather to suggest a rational approach for those who choose to self-insure.
So you’ve retired (or are about to). How will you replace your salary? You might be eligible for Social Security or a lifetime income option from a DB plan, but I’ll assume you’ll be relying on your accumulated assets (Individual Retirement Accounts and investments in various stocks, bonds, or mutual funds) to supplement these sources.
Self-insuring your retirement means assuming responsibility for investing your assets, perhaps for the rest of your life (aka investment risk). If your investments fall short, you could run out of money or need to scale back. If your investments outperform your expectations, you’ll be in much better financial shape (unless you’re worried about leaving too much money to your heirs).
Choosing to self-insure also entails longevity risk, meaning that your retirement assets need to last as long as you (or your significant other) do. While most of us hope for a long life, greater longevity requires more financial resources. Women tend to live longer than men, so they generally pay higher premiums for lifetime income products than their same-age male counterparts.
Most people prefer their retirement income to be steady rather than feast and famine. But if you self-insure, your annual income might vary along with the market and other conditions. I’ll call this income volatility risk.
Your withdrawal strategy might be too optimistic or too pessimistic. For example, you might decide it would be fun to spend your retirement money on a boat. Not purchasing an annuity (or choosing the lump sum option from a DB plan) gives you more flexibility, but it also offers more opportunities to exercise bad, or at least financially unsound, judgment. Being overly cautious can cause problems as well. Retirees who worry about outliving their retirement assets often spend too little, denying themselves an enjoyable retirement. The risk of taking out too much or too little each year is what I’ll call withdrawal strategy risk.
Lifetime income products can essentially eliminate all of these risks. Of course, an insurance company (or pension plan sponsor) could go out of business and fail to honor its annuity promise. While such defaults are extremely rare, they can happen. In those unhappy circumstances, your annuity may be fully or partially protected by state insurance guarantee agencies (or the Pension Benefit Guaranty Corporation).
Finally, almost all retirees are subject to inflation risk. Social Security payments generally keep pace with inflation. Most lifetime income insurance products don’t, although some life insurance companies offer life annuities with payouts that increase from year to year. If you self-insure, you will need to consider how future inflation will affect your spendable income needs.
Becoming Your Own Pension Actuary
Professional actuaries help life insurance companies, businesses and other organizations manage risks, including those described above. If you decide to self-insure your retirement income, whether you consciously think about it or not, you’ll need to perform many actuarial functions. Luckily, you won’t need to study and pass a lot of pension actuarial exams to successfully manage the risks associated with self-insuring your retirement. You’ll just need to think actuarially and follow the five-step general actuarial process:
1. Gather relevant data as of a measurement date.
2. Make assumptions about relevant future experience.
3. Apply algorithms (calculation methods) and assumptions to determine outcomes (in this case, the amount you can spend in a year).
4. Store outcomes of the calculations in Step 3 for future use.
5. Repeat the process periodically to compare actual experience with your projections, and then apply algorithms to make any necessary adjustments. This last step is actually the most important as it automatically adjusts your spendable income to reflect actual experience.
The website I have developed, How Much Can I Afford to Spend in Retirement, contains a simple Excel spreadsheet that you can use in Step 3 to determine an annual spendable amount.
Will it Work for You?
If you decide to self-insure your retirement, you should consult a financial advisor to help you formulate a long-term investment strategy. You should periodically monitor its success (or shortcomings), and adapt your strategy to changing conditions as necessary. A successful investment strategy will certainly go a long way toward making the retirement budgeting process a more pleasant experience. Nothing in this article, however, should be interpreted as recommending or even suggesting any particular investment strategy.
As long as your assumptions are reasonable, the general actuarial process can help you avoid running out of money, provided you respect your spending limits and use a smoothing algorithm in Step 5 that keeps you up-to-date with actual experience. Unfortunately, even doing everything right will not necessarily provide a stable income. If you self-insure your retirement, the pattern of your retirement income may not be as stable as you’d like and it’s still possible to run out of money. To avoid income fluctuations and running out of money, you might want to look to structured bond investments or annuitization. There are no guarantees when you self-insure.
The simple calculation tool available in my website assumes that your goal is to have a reasonably stable pattern of spendable income from year to year measured in inflation-adjusted dollars. It would need to be adjusted if, instead, you wanted to use your accumulated savings to provide a different pattern of retirement income.
If you decide to self-insure your retirement, you can enhance your financial security by following the same principles actuaries employ to help pension plan sponsors meet their pension promises. This website contains a simple calculation tool but other calculation tools may be equally or more effective. The level of sophistication of the calculation tool used is generally not as important as following the general actuarial process each year to adjust for actual experience and changes in assumptions.
KEN STEINER is an actuary with 38 years of pension consulting experience. For further discussion of the actuarial process, calculation methods and smoothing algorithms discussed above, you can visit:
How Much Can I Afford to Spend in Retirement