How Much Can I Afford to Spend in Retirement?: Measuring Retirement Risks

This post is a follow-up to our post of September 2, 2023, Manage Your Financial Risks in Retirement Like an Actuary,
and is in response to the following recent quote from a well-known
retirement researcher, “The No. 1 risk in retirement, hands down, is
longevity risk.”

Risk/Assumptions in the Aggregate/Potential Impact on the Household Funded Status

If
we define retirement risk as the need to either increase household
assets or decrease household spending liability in the future as a
result of actual future experience being less favorable than assumed
experience in the aggregate, then risk will depend on the household’s

• Plan
• Ages
• Funded Status, and
• Assumptions for the future

If
assumptions about the future (explicit and implicit) are realized in
the aggregate and are unchanged, the household’s Funded Status is
expected to remain approximately unchanged from year to year. 

The
assumptions used to measure household assets and spending liabilities
for planning purposes include explicit expectations with respect to:

• lifetime planning periods,
• timing of future planned expenses (separated into recurring and non-recurring as well as essential and discretionary),
• increases in future planned expenses,
• timing and amounts of future lump sum or streams of income payments, and
• returns on invested assets.

In addition to these explicit assumptions, more implicit assumptions may include:

• No future changes in Social Security law or in other sources of income,
• No future marital dissolution or early death of a spouse, and
• No spending in excess of budgeted spending

If
planning assumptions or expectations about the future are wrong in the
aggregate (and they will be), we must be prepared to make adjustments in
our spending or somehow increase our assets to keep our finances in
balance. And, unfortunately, a lot can potentially go wrong with
personal financial assumptions. For example,

• We may live longer than our expected lifetime planning periods
• The value of assets/investments we own may decrease or not increase as expected
• Our long-term care or other medical expenses may be more costly than we assumed
• The household member with greater lifetime income assets may die early or we may divorce,
• Our taxes or our premiums for various types of insurance may increase faster than expected
• Our future Social Security benefits may be reduced (or not fully indexed with inflation)
• Higher than assumed Inflation may make some or all our planned expenses higher than assumed,
• Our investments may experience periods of lower-than-expected returns
• We may suffer uninsured losses or be a victim of fraud,
• We, or other members of our family, may experience emergencies requiring unexpected expenses, or
• We may, for whatever reason, simply spend more than we thought we would

The
events described above (and potentially others) will generally either
increase household spending liabilities relative to household assets or
decrease assets relative to spending liabilities. In response, if
negative experience is not balanced by positive experience, the
household may have to reduce planned spending, increase household assets
or will have to temporarily dip into rainy-day funds to keep spending
liabilities in approximate balance with assets. 

Risk/Individual Assumptions/Impact on Funded Status

Since
favorable experience with respect to one assumption can balance the
negative experience with respect to a different assumption, we don’t
normally focus on individual assumption risks but that is certainly
possible to do using the Actuarial Financial Planner models available in
our website. All that is required is to simply change one default
assumption at a time and measure the impact on the plan’s baseline
Funded Status. 

For this post, we determined the baseline Funded
Status for a 62-year-old male retiree with $1,000,000 of accumulated
savings (60% of which was assumed to be invested in non-risky assets and
40% in risky assets), a Social Security benefit of $20,000 per annum
and the following expected expenses:

• Annual essential expenses, increasing with inflation: $45,000
• Annual discretionary expenses, increasing with inflation: $15,000
• Annual fixed dollar discretionary expenses: $5,000

We used the current default assumptions to determine his baseline Funded Status for this person to be 105.87%

If
we increased the default lifetime planning period (LPP) assumption from
32 years to 40 (a 25% increase) and made no other assumption changes,
his calculated Funded Status would decrease from 105.87% to 97.26%

By
comparison, if we increased each of the above expected expenses by 25%
and used the default assumptions, his Funded Status would decrease from
105.87% to 84.69%

Clearly, if expenses are increased by 25%
because of inflation or just because of overspending, this would have a
larger impact on our hypothetical retiree’s Funded Status than a 25%
increase in his assumed lifetime planning period.

Note that the
effects of either increasing the LPP by 25% or expenses by 25% would be
larger if the change in assumptions were delayed to a later year, but
the increase associated with the 25% increase in expenses would still be
expected to be larger than the increase in lifetime planning period.
The reason for this is that the increase in lifetime planning period
also increases our hypothetical retiree’s present value of assets by
extending Social Security benefit payments, thus mitigating this
increase somewhat.

Summary

Assumptions
about the future will not be exactly realized. Differences between
actual future experience and assumed future experience create potential
risks. That is why it is important to monitor your Funded Status from
year to year to observe the trend and make assumption changes (or
spending changes) when necessary. The Lifetime Planning Period is an
important assumption in this process, but it is not the number 1 risk in
retirement, hands up or hands down.