Most of us are relatively conservative when it comes to determining
how much we can afford to spend in retirement. All things being equal,
we would rather die with too much money than too little. Apparently,
however, some researchers are worried that we may not be spending
anywhere near enough and should buy life annuities to rectify that
situation. In their recent article, researchers Drs. David Blanchett and Michael Finke reach several conclusions, including:
- “Individuals tend to view money held in savings accounts differently than wealth held in the form of income.”
- “Retirees
spend a much higher percentage of their annuitized income and spend
about half the amount that they could safely spend from non-annuitized
wealth.” - “Our results provide evidence that retirees bracket
wealth held in investments differently than wealth held as income and
consequently spend less than would be optimal in a life-cycle model.” - “Retirees
who are behaviorally resistant to spending down savings may better
achieve their lifestyle goals by increasing the share of wealth
allocated to annuitized income”, and - “Less knowledgeable and
risk-averse retirees may be particularly prone to underspending [since?]
out of fear of depleting wealth.”
As a result of their
research, they argue for implementation of policies that incentivize (or
default to) the annuitization of retirement wealth.
We are solid
fans of using lifetime income (Social Security, pensions and life
annuities) to fund essential expenses in retirement, and we encourage
users of the Actuarial Approach to fund the present value of their
essential expenses with the present value of their non-risky assets in a
“Floor Portfolio” bucket. We are not big fans, however, of using these
non-risky assets to fund the present value of expected discretionary
expenses, as the expected return on such non-risky assets is generally
lower than the expected return on risky assets. Therefore, even though
we are not financial advisors, we have no problem encouraging retirees
to aggressively fund their expected discretionary expenses with risky
asset investments in their “Upside Portfolio” bucket.
Our position
on using risky assets to fund discretionary expenses appears to be at
odds with the recommendations of Drs. Blanchett and Finke. Not a
problem. While we have great respect for these gentlemen, this is not
the first time that we will have to agree to disagree with them.
The
purpose of this post is to provide assistance to readers who aren’t
necessarily interested in buying more life annuities than they need to
cover their essential expenses, but would like to maximize their
spending to the extent possible without leaving an unintended large
estate when they pass (assuming their demise does not occur earlier than
expected). We will also include an example.
Using Funded Status and a Surplus Bucket to Increase Spending During Retirement
This
is what we suggest to increase spending in retirement: If your
beginning-of-year Funded Status exceeds 150% (or 140% if you are more
aggressive), you can transfer from your Upside Portfolio Bucket to a
“Surplus Bucket” an amount equal to the amount that would reduce your
beginning-of-year Funded Status to 150%. The Surplus Bucket would be a
low-interest rate account that could be readily accessed (like a
checking account), and would not be considered part of the household’s
assets once transferred (for Funded Status calculation purposes). The
purpose of the Surplus Bucket would be to hold funds designed to be
spent over a relatively short period, including possibly taxes on the
amount transferred from the Upside Portfolio Bucket. This Surplus Bucket
transfer calculation is easy to do (iteratively) in the Actuarial
Financial Planner by simply entering an amount in one of the
non-recurring expense rows, 0 for the period of delay 1 for the payment
period and noting the impact on the calculated Funded Status.
By
transferring amounts from the Upside Portfolio bucket to the Surplus
Bucket, the household would acknowledge that these funds are “surplus”
funds that should be spent over some reasonable period of time in order
to maximize spending and avoid leaving an unintended large bequest.
Example
Steve
and Edie retired on January 1, 1995. They were both age 65. Steve’s
Social Security benefit was $12,000 per annum and Edie’s was $6,000
(one-half of Steve’s). Steve defined benefit pension was $15,000 per
annum payable for his life. They also had assets of $300,000 invested
100% in equities. Steve and Edie estimated their annual recurring
essential expenses (including taxes) to be $25,000 per annum and their
annual recuring discretionary expenses to be $10,000 per annum. They
planned to spend $10,000 per annum on vacations until they both reached
age 80 (considered to be 100% discretionary).
To calculate Steve
and Edie’s January 1, 1995 Funded Status, their Social Security benefits
were assumed to increase each year with inflation. Steve’s pension was a
fixed dollar amount payable for his life. Their expenses were also
assumed to increase with inflation each year. They assumed that the
equity in their fully-paid home would cover their long-term care needs
if necessary.
Based on a 6% non-risky investment return
assumption, an 8% risky investment return assumption 3% inflation and
the current AFP lifetime planning period default assumptions, they
calculated their January 1, 1995 Funded Status using the Actuarial
Financial Planner to be 110.40%.
Projection assumptions:
We projected Steve and Edie’s Funded Status calculations each year from
January 1, 1995 to January 1, 2025 using the following projection
assumptions: The household Social Security benefits and expenses were
increased each year by the actual Social Security COLA increase for the
year. Their equity investments were assumed to earn the actual return
for the S&P 500 for each year. They were assumed to live each year
and spend exactly the amounts inputted at the beginning of the year for
their expenses. Whenever their beginning of year Funded Status exceeded
150%, they were assumed to transfer funds to their Surplus Bucket to
approximately bring their Funded Status down to around 150%. In 2002,
the assumed non-risky investment return valuation assumption was lowered
from 6% to 5%. In 2008, the assumed non-risky investment return
assumption/inflation assumption was lowered from 5%/3% to 4%/2.5%, and
in 2023, it was increased to 5%/3%.
Projection Results:
As of January 1, 2025 when both Steve and Edie were 95 years old,
Steve’s Social Security benefit was $25,303, Edie’s was $12,652 and
Steve’s pension was still $15,000. Their annual recurring essential
expenses were $52,711 and their annual discretionary expenses were
$21,080. They no longer budgeted for vacation expenses (as initially
planned). Their January 1, 2025 assets were $475,491 and over the years,
they had transferred over $1,000,000 to their Surplus
Bucket to spend as they desired. They transferred money to their Surplus
Bucket in all but 8 years of their retirement (the first 4 years when
their Funded Status was less than 150%, 2003, 2004, 2009 and 2010 when
their Funded Status dipped below 150%. As of the beginning of 2025, they
transferred $90,000 to their Surplus Bucket and their Funded Status was
156.58%. They still had their home equity and any unspent Surplus
Bucket assets to use to fund any long-term care and funeral expense
needs.
The largest drop in their Funded Status (which treats any
transfers to the Surplus Bucket as spending) was years 2000 to 2003 when
it decreased by a total of 26%. So, if their Funded Status was 150% as
of January 1, 2000 (which it wasn’t because they transferred less than
the full amount they could for 2002), it would have dropped to about
111% as of January 1, 2003. Therefore, at no time during the projection
period were Steve and Edie required to decrease their budgeted
discretionary spending, and if they had been required to do so, they
probably could have simply dipped into their Surplus Bucket at the time,
assuming they hadn’t spent all of it (which might have been tough for
them to do).
From about 2008 on, the present value of Steve and
Edie’s non-risky assets ceased to cover the present value of their
essential expenses (because of Steve’s fixed dollar amount life
annuity). They could have purchased additional annuity amounts to cover
the difference, but again, their likely unspent Surplus Bucket would
have more than covered the relatively small emerging shortfall.
If
they spent most of the money in their Surplus Bucket on items that were
meaningful to them, Steve and Edie were successful in managing their
spending and retirement experiences and for the most part, avoided
leaving an unintended large legacy.
Summary
We
have no reason to question Drs. Blanchett and Finke’s research
concluding that less knowledgeable and risk-averse retirees may be
particularly prone to underspending out of fear of depleting wealth. It
is our hope, however, that by using a better metric (Funded Status) than
typically used by financial advisors or other 4% Rule advocates, and
perhaps using the Surplus Bucket approach, our more knowledgeable
readers can overcome this fear and better manage their spending to
achieve their goals. Further, the example in this post clearly shows
that if future equity returns duplicate returns over the past 30 years
(which we are told we shouldn’t assume), the potential for greater
returns and spending maximization is much more likely to occur with a
significant portion of household retirement funds in equities rather
than a preponderance in annuities.
