Use the Funded Status Metric & A ‘Surplus Bucket’ to Increase Spending in Retirement

Using funded status & a ‘surplus’ bucket to increase spending in retirement

If the client’s beginning-of-year funded status (the ratio of the present value of their assets to the present value of their spending liabilities) exceeds 150% (or 140% if the client is more risk tolerant), inform the client that they can increase their budgeted spending, and communicate to them the maximum amount of increased spending for the year.

To further encourage those clients who may be “behaviorally resistant” to increasing their spending, the advisor could establish a third spending bucket, called the “surplus bucket.” It would consist of amounts transferred from the client’s upside portfolio bucket in excess of the 150% funded status target. The maximum amount that could be transferred at the beginning of each year would be equal to the amount that would reduce the client’s beginning-of-year funded status to 150%.

The surplus bucket could be a low (or no) 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 normal ongoing funded status calculation purposes). It would hold funds designed to be spent over a relatively short period, including possibly taxes on amounts transferred from the upside portfolio bucket.

The maximum annual Surplus Bucket transfer calculation is easy to do (iteratively) in the Actuarial Financial Planner available on my website. Simply enter the proposed amount in one of the non-recurring expense rows, 0 for the period of delay 1 for the payment period and note the impact on the calculated Funded Status.

For clients who don’t want or need to have funds actually transferred to the surplus bucket to encourage them to increase spending, it may only be necessary to calculate and communicate the annual maximum annual transfer amount. By actually transferring amounts from the upside portfolio bucket to the surplus bucket, however, it would be clearer to the household that these funds are indeed “surplus” funds that may be spent over some reasonable period of time to maximize spending and avoid leaving an unintended large legacy.

Example

Steve and Edie retired on January 1, 1995, and hired a financial advisor, Jim, to help them plan.

Steve and Edie’s data as of 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’s defined benefit pension was $15,000 per annum, payable for his life.
• They had portfolio assets of $300,000.

Expense budget:

• Steve and Edie estimated their annual recurring essential expenses (including taxes) to be $25,000 per annum and their annual recurring 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).

January 1, 1995 funded status calculation:

• To calculate Steve and Edie’s January 1, 1995 funded status, Jim assumed their Social Security benefits would increase each year with inflation. Steve’s pension was a fixed dollar amount payable for his life. Jim assumed their expenses would also increase each year due to inflation. He assumed the equity in their fully paid home would cover their long-term care needs if necessary. Steve and Edie agreed with Jim’s recommendation to invest 100% of their portfolio assets in equities.
• Based on a 6% nonrisky investment return assumption, an 8% risky investment return assumption, 3% inflation, and the current AFP lifetime planning period default assumptions, Jim calculated their January 1, 1995 funded status using the Actuarial Financial Planner (AFP) to be 110.40%.

Future-year projection assumptions:

Jim recalculates Steve and Edie’s funded status as of each January 1 from January 1, 1996 to January 1, 2025 using the following projection assumptions:

• The household Social Security benefits and expenses increase each year by the actual Social Security COLA increase for the year.
• Their equity investments earn the actual return for the S&P 500 for each year.
• They both survived each year and spent exactly the amounts inputted at the beginning of the year for their expenses.
• Whenever their beginning of year Funded Status exceeded 150%, Jim calculated and communicated the maximum amount to be transferred to the surplus bucket and the three of them would decide how much would actually be transferred.
• In 2002, Jim reduced the assumed nonrisky investment return valuation assumption from 6% to 5%. In 2008, the nonrisky investment return assumption/inflation assumption was lowered from 5%/3% to 4%/2.5%, and in 2023, it was increased to 5%/3%.
• In 2010, Jim retired, and Sylvia became Steve and Edie’s advisor.

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 specifically budgeted for vacation expenses (as initially planned). heir January 1, 2025 assets (for funded status determination purposes) were $475,491, and over the years, they had transferred more than $1,000,000 to their surplus bucket (a 0% earning checking account) to spend as they desired.

They transferred money to their surplus bucket in all but eight years of their retirement (the first four 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, Sylvia calculated their maximum surplus bucket transfer to be $105,000, and they decided to transfer $90,000, leaving their beginning-of-year funded status at 156.58%. They still had their home equity and some unspent surplus bucket assets to use to fund their long-term care and funeral expense needs.

The largest drop in their funded status (which treats any transfers to the surplus bucket as spending) during their retirement was in years 2000 to 2003, when it decreased by a total of 26%. So, if their funded status had been exactly 150% as of January 1, 2000 (which it wasn’t, because Steve and Edie decided to transfer less than the maximum amount they could for 2002), it would have dropped to about 111% as of January 1, 2003. Therefore, at no time during their retirement were Steve and Edie required to decrease their budgeted discretionary spending. 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 still might have been tough for them to do).

From 2008 on, the present value of Steve and Edie’s nonrisky assets ceased to cover the present value of their essential expenses (due to the effect of inflation on 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 sitting in their checking account would have more than covered the relatively small emerging shortfall.

If all the assets they decided to transfer to the surplus bucket were subject to an average capital gains tax of 15%, the total amount, net of taxes, transferred to their surplus bucket would have been about $858,000. If they spent most of that money on items that were meaningful to them, Steve and Edie, with their advisor’s help, would have been successful in managing their spending and retirement experiences, and arguably, would have been reasonably successful at avoiding leaving an unintended large legacy.

Annuity purchase comparison

Instead of investing their $300,000 upside portfolio in equities, let’s assume Steve and Edie instructed Jim to purchase a single life annuity for Edie on January 1, 1995 with that amount. Jim helped them secure a contract that would provide Edie with an annual benefit of $24,000 for her life.

If they spent this annuity and their other income as received, their spending in 1995 would be $57,000 and their spending budget in 2025 would have grown to $76,955, or about 39% lower than in 1995 as measured in 1995 dollars, due to the effects of inflation on Steve’s fixed dollar pension and Eddie’s fixed dollar annuity. This result would not have been consistent with their plan in 1995. They could have asked Jim to change their plan in 1995 to save some of the early surplus income to be used in later years. However, they decided they would just spend all income as it came in, and they didn’t need to meet with Jim annually to discuss their spending.

Their total spending from 1995 to 2025 under this annuity alternative would have totaled about $2,018,000, which is about $598,000 less than the total spending and surplus bucket transfers under the surplus bucket approach (even after the assumed 15% capital gains tax reduction). If Steve and Edie only spent half of the amounts transferred to the surplus bucket over this period, net of assumed capital gains, they would still have spent about $169,000 more since 1995 than under the annuity purchase approach. Under this approach, however, Steve and Edie would not have any unspent assets as of the beginning of 1995 or upon their ultimate deaths (other than their home equity).

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 my hope, however, that by using a better metric than probability of success or the 4% rule (and its many variations), and perhaps using the surplus bucket approach — if desired by clients — financial advisors can help clients overcome this fear and better manage their spending to achieve their goals.

Further, the example in this article clearly shows that if future experience duplicates experience over the past 30 years, the potential for greater returns and spending maximization is much more likely to occur with a significant portion of household retirement funds invested in equities rather than a preponderance in annuities. And for clients who may not actually need to establish a physical surplus bucket to increase their spending, they can benefit from knowing when their beginning--of year funded status is in excess of 150% and the maximum amount of additional spending they can enjoy each year.

Ken Steiner is a retired actuary with a website titled, "How Much Can I Afford to Spend in Retirement?"

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