Saturday, February 4, 2017

Five Ways to Increase Your Near-Term Spending, Part II

This post is a follow-up to our post of November 30, 2015 in which we talked about ways to increase your near-term spending in retirement.   In that post we discussed:
  1. Finding part-time work or other sources of income 
  2. Deferring commencement of Social Security or purchasing annuities 
  3. Using more aggressive assumptions in your calculations 
  4. Using more aggressive assumptions for non-essential expenses, and 
  5. Simply increasing your budget (or your spending) by x%
We also cautioned our readers that, all things being equal, increasing near-term spending increases the risk of declining real (today’s) dollar spending later in retirement.  In this post, we will focus on a subset of the third approach discussed above; lowering the assumed annual target rate of increase for future spending budgets to increase current spending budgets (or reduce the assets needed to fund a given level of spending). 

Within the past few years, several researchers and retirement experts have observed that retiree spending appears to decline in real dollar terms as individuals age.  We discussed this research and how retirees could use our spreadsheets to anticipate declining real dollar spending in developing their spending budgets in our posts of March 31, 2016, August 20, 2016 and November 4, 2016.  More recently, a retirement expert from the UK, Abraham Okusanya, argued in this article that spending in retirement does not follow a “U-shaped pattern” as previously thought, but rather declines in real dollar terms throughout the entire retirement period.


Considering the growing volume of research showing declining real dollar spending in retirement, several retirement experts have suggested that individuals should consider developing their spending budgets so that they also decline in real terms throughout retirement. For example, Mr. Okusanya implies that, based on spending research in the U.S., it would be ideal to target inflation minus 1% (or more) for purposes of developing future spending budgets in the U.S. 

The retirement experts have concluded that this lower target for future spending means that either near-term spending can be increased or the amount a person needs to save for retirement can be reduced, compared with assuming a constant real dollar future spending target.  The experts are less clear, however, as to exactly how much spending may be increased (or savings decreased) by assuming the lower future spending target.

As with all spending matters, we at How Much Can I Afford to Spend leave decisions of how much you spend in a year up to you and your financial advisor.  We simply provide you with tools that give you data points designed to help you make your spending decisions.  However, unlike the retirement experts, we can easily quantify for you how much your current spending budget will be increased (or your necessary savings decreased) if you assume that your future spending budgets will increase by inflation minus 1% in retirement, rather than by inflation. We determine the relevant percentages by first taking the basic actuarial equation that is the foundation for this website:




and manipulating it to obtain: 




To quantify how much This year’s spending budget will increase by targeting future spending budget increases of inflation minus 1%, rather than inflationary increases, we need to divide PV future years increasing by the assumed rate of inflation by PV future years increasing by inflation minus 1%.  The PV future year values are available in the Present Value Calcs tab of our workbooks. 

Similarly, the reciprocal of this ratio will give us the % decrease of needed savings to produce a desired level of spending.



The table above shows the results under our current recommended assumptions at various ages. So, developing a spending budget at age 65 under these assumptions and further assuming future spending budgets increase by 1% per year, rather than the recommended inflation assumption of 2% per year, would increase the actuarially calculated spending budget by 13.3% (or decrease the adjusted assets needed to provide the desired level of spending assuming retirement at age 65 by 11.8%), all things being equal.

Note that if you are, or your financial advisor is, determining your spending budget by adding the results from a Systematic Withdrawal Plan (SWP) to your income from other sources (including Social Security), it may be somewhat more difficult than as described above to develop a spending budget designed to increase at a rate other than inflation.  As discussed in prior posts, SWPs are not really designed to work well unless Social Security is the only other source of income in retirement and the retiree’s spending objective is to have constant real dollar spending in retirement.

While research may support decreasing real dollar spending in retirement, we encourage our readers to develop their future spending increase assumption (or assumptions) by separately examining expected future increases for the three types of future expenses in our Budget by Expense Type tab in our Actuarial Budget Calculator (ABC) workbooks:

  • Essential non-health expenses 
  • Essential health expenses 
  • Non-essential expenses
Since it is not unreasonable to assume that future essential non-health expenses will increase with inflation and essential health expenses may increase at a faster rate than inflation, you may not be comfortable assuming total future recurring spending budgets will increase at a rate of inflation minus 1% (or more) unless your non-essential expenses are assumed to be a relatively large component of your initial spending budget.

Thursday, February 2, 2017

Avoiding Financial Regret about Retiring Too Early

In their recent Wall Street Journal article, “Before Retiring, Take This Simple Test,” Dr. Shlomo Benartzi and Dr. Martin Weber encourage individuals considering retirement to take a “two-question quiz that can help predict whether [they will] regret the timing of [their] retirement.”  Dr. Benartzi is a behavioral economist professor at UCLA, and Dr. Weber is a professor at the University of Mannheim in Germany, with special interests in behavioral finance and its psychological foundation.  It is an interesting article that advocates the use of behavioral economics tools like the two-question quiz to “help us find ways to stop people from retiring too early" and regretting their decision.

The two questions in the quiz are almost the same, but the slight difference in timing of the two questions allows for measuring the consistency of time preference.  That is, answering the two questions inconsistently exhibits preference for immediate rewards, as opposed to postponement of rewards.

The recommendation comes from a study of over 3,000 Germans who answered the quiz.  Per the authors, the respondents with inconsistent answers to the quiz:

  • “exhibit a tendency known as present bias, or hyperbolic discounting”, 
  • “tend to retire…earlier (about 2.2 years on average) than those with consistent preferences”, and 
  • “over time, these people are also far more likely to say they regretted the timing of their retirement.”
The authors also concluded that retiring about 2.2 years on average earlier than those with consistent preferences resulted in “roughly a 13% reduction in their monthly benefits.”  Perhaps the German retirement system is different from that in the U.S., but as we will show in the example below, each year of continued employment and deferral of retirement from age 62 to age 70 results in closer to a 10% increase in an individual’s real dollar spending budget, rather than the 6% figure (13% divided by 2.2) cited by the authors.

As retired actuaries and not behavioral economists, we at How Much Can I Afford to Spend in Retirement believe that substituting facts for appearances and demonstrations for impressions are still good ways to influence individual behavior.  And while we share the goals of behavior economists to help people make better decisions, we believe that any “framing” of the retirement age decision should be based on reasonable calculations.

Example

Let’s assume we have a single female, Beth, currently age 62, making $100,000 per year.  She has $500,000 in accumulated savings, in addition to her home equity.  She is currently eligible to receive an immediate annual Social Security benefit of $20,124, but she has no other sources of retirement income.  Her employer sponsors a 401(k) plan that matches contributions up to 6% of pay with a 50% match.  Beth contributes enough each year to receive the maximum employer match and her annual savings (including her 401(k) contributions) are 15% of pay. 

Beth wants to know about how much her real annual spending income would be if she retired today at age 62 or if she kept working and retired at age 65, 68 or age 70.  For immediate retirement, she uses our Actuarial Budget Calculator (ABC) for retirees workbook.  For the other ages at retirement, she uses our ABC for pre-retirees.  She makes the following assumptions and other data entries:

  • Our recommended assumptions for discount rate (4%), inflation (2%) and lifetime planning period (death at age 95) 
  • Her pay will increase in the future with inflation (2%) 
  • No amounts desired to be left to heirs 
  • Present value of unexpected expenses: $50,000 
  • Desired increases in future spending budgets equal to inflation (2%) 
  • Continued pre-retirement savings rate: 15% 
  • The present value of her long-term care costs will be covered by her home equity
She uses the Social Security Quick Calculator to estimate what her Social Security benefit in today’s dollars will be (shown in the table below) if she continues her employment.  She enters the following amounts into the ABC pre-retirement workbook for future dollar amounts (today’s dollars increased by 2% per year inflation):




The Table below shows the results of Beth’s calculations:






The table shows that, given Beth’s information and assumptions, her spending income will increase about 10% for each year she continues to work and save 15% of her pay.  She can either choose to look at how much her income will increase each year by working or, as suggested by the behavioral economists, she can look at her relative loss by not working.  However she looks at it, she will benefit from using our workbooks to help her make her decision about when to retire. It is important to note that results will vary for different individuals and you should always model your own situation. 

Sunday, January 29, 2017

Why the Actuarial Approach Works Even Better

In his January 19 article, “Why this works better than the 4% rule for retirees,” Tom Anderson touts the benefits of using BlackRock’s cost of retirement income (CoRI) index over the 4% Rule for determining how much you will need to retire.  In this post, we point out that if you like the cost-determination concept of BlackRock’s CoRI index for calculating how much you will need to retire, you will like it even better when you use essentially the same cost-determination-concept and the Actuarial Approach to help you calculate how much:
  • you will need to retire, 
  • you will need to save during your pre-retirement period, and 
  • you can afford to spend during your post-retirement period. 
For readers unfamiliar with the CoRI index you can find it here.

BlackRock’s CoRI index and the Actuarial Approach Utilize Essentially the Same Cost-Determination Basis and Spreading Approach

If you use the Actuarial Approach with recommended assumptions and desired increases in future spending budgets equal to the assumed rate of future inflation (i.e., constant real-dollar spending budgets in retirement), you are using approximately the same cost basis (current insurance company annuity pricing) as is anticipated with the CoRI index to spread your adjusted assets (PV of assets minus the PV of future non-recurring expenses) over your expected lifetime planning period after retirement.


This can be illustrated by taking the basic actuarial equation that forms the foundation of this blogsite, and manipulating the terms as we did in our blog post of January 12 of this year, to develop the following equation:





The CoRI index is essentially the same calculation as the PV of future years in retirement, increasing each year by the assumed rate of inflation based on BlackRock’s analysis of current annuity purchase rates.  Here at How Much Can You Afford to Spend in Retirement, we don’t analyze annuity purchase rates every day (like they do at BlackRock) to develop our recommended assumptions, but we do look at them periodically for reasonableness.

The details of the calculations in our Actuarial Budget Calculator (ABC) workbooks are in the PV Calcs tab, where “Present Value of Future Years with Desired Increases” is shown.  This is the present value of future years of retirement used in the equation above, and should be very close to the CoRI index, when you input the recommended assumptions and desired increases equal to inflation into the ABC.  The good folks at BlackRock use somewhat different assumptions for the remaining lifetime planning period after age 65 and use different assumptions for future inflation and the discount rate consistent with life insurance annuity purchase rates, but for spending budgeting purposes, we believe the differences should be fairly insignificant.  The values shown in the ABC workbooks should be somewhat higher since we generally recommend assuming a longer period of retirement.  Since we encourage you to revisit your budget setting process at the beginning of each calendar year, we don’t believe it is necessary to adjust our recommended assumptions unless we become aware of significant changes in life insurance company annuity pricing.

We have no problem if you would rather use BlackRock’s CoRI index in your spending budget calculations if you believe they more accurately represent current insurance company annuity purchase rates.  If you do, however, you will need to solve for the discount rate(s), inflation rate(s) and lifetime planning periods after retirement assumed by BlackRock to develop their CoRI index, so that you can also calculate the present value of your future non-recurring expenses and the present value of IFOS in your budget setting calculations using the equation above.

If you are a big CoRI fan and you think it is time for us to update our recommended assumptions to reflect current insurance company annuity pricing, please let us know and we will review the relevant data and make appropriate changes.