Tuesday, September 9, 2014

Complimentary Posts From Steve Vernon

It is always nice to get a compliment--even if it comes from a friend.  Out of the blue last week, my friend, Steve Vernon, Research Scholar for the Stanford Center on Longevity and blogger for CBS MoneyWatch, decided to say a couple of nice things in his blog about our website and the Actuarial Approach for determining a spending budget.  His posts are A simple tool for figuring retirement income and How much can I spend in retirement?

As usual, Steve does an excellent job of discussing his topic in a straight-forward and understandable (i.e., non-actuarial) manner.  I just have just a couple of "clarifying" comments:

Steve indicates that you can input the amount of Social Security in the spreadsheet tool.  This isn't the case.  The "Excluding Social Security V 2.0" Excel spreadsheet is designed to produce a number that you can add to any inflation-indexed income you receive, such as Social Security, to determine your spending budget.

While Steve discusses the need to periodically adjust withdrawals to reflect events that have occurred (which I believe is more important than the sophistication level of the spending tool employed), he does not discuss the smoothing algorithm I recommend in this website.  I believe that it is important to smooth the gains and losses that will occur in the future in a reasonable manner.  And I believe the smoothing algorithm we recommend is an important part of the Actuarial Approach.  

Lastly, although it makes for a good story, I did not develop the Actuarial Approach and website to figure out my own retirement spending budget (although I certainly do use it).   As a defined benefit pension actuary, I became concerned about how individuals will have to "self-insure" their retirement in a defined contribution (401(k)) world over ten years ago while I was still working.  At that time, I pitched my ideas to Dallas Salisbury and others at the Employee Benefit Research Institute (EBRI), AARP and other organizations representing retirees as well as my own professional actuarial organizations.  I thought that my approach could help retirees better manage the risks involved in determining how much they could afford to spend each year.  Apparently, these organizations disagreed.  When I did receive feedback, I was told that my approach was either too complicated or not complicated enough.  This feedback was a source of frustration for me.  When I was close to retiring, my friend and co-worker at Towers Watson, Kin Chan, offered to help me set up this website to help me communicate the approach.  It is an offer that he now, I'm sure, regrets as I send him new thoughts to post every few days.

Sunday, August 31, 2014

Managing Your Spending in Retirement--It's Not Rocket Science

This post once again takes on the so-called experts who say that most retirees aren't smart enough or motivated enough to properly manage their spending.  For some reason, they believe that individuals who have managed to live within their means prior to retirement (and even save money) will no longer be able to do so during retirement.  I believe that with a little bit of effort and the tools provided in this website most retirees can do a reasonably good job of managing their spending in retirement.  It is really as simple as following these four steps:

Step 1:  Develop a Reasonable Budget--Using one of the spending spreadsheets and the recommended assumptions set forth in this website, determine how much total income you can spend for the upcoming year (from Social Security, pensions, annuities, withdrawals from accumulated assets and income from employment).  To determine your "income" from withdrawals, you may need to adjust your current accumulated assets for events expected to occur in the future.  For example you may add the present value of amounts you expect to receive, such as gains from downsizing your home, expected inheritances, re-payments of loans owed you, etc.  Conversely you may subtract the present value of such items as future loan repayments you owe or amounts you wish to set aside for unusual future expenses (as discussed in the previous post).  The June, 2014 article in the articles and spreadsheets section of this website provides a brief description of how to use the Actuarial Approach to determine a spending budget and includes several posts that provides examples of these adjustments.

Step 2:  Determine Your Spending Needs/Living Expenses For the Upcoming Year--Most retirees keep track of their expenses, so they have a pretty good idea of normal living expenses.  To this amount add an estimate for other expenses you expect to incur.  Don't forget to include taxes that you may need to pay.

Step 3:  Compare the Results of Step 2 with Results of Step 1 and Make Necessary Adjustments--If the results of Step 2 are higher than the results of Step 1, you may need to reduce some of your expenses for the year or you may need to increase your income.  You can increase your income by working more or you can revisit the assumptions used to develop your budget.  For example, you may be comfortable developing a budget that is not expected to remain constant in real dollar terms from year to year, so this adjustment may increase your spending budget for the current year (at the expense of reducing it for future years, all things being equal).  Alternatively, you may simply decide that it is not important to have your expenses match your budget for the upcoming year.

Step 4:  Repeat Steps 1-3 at Least Once Per Year--This is not a "set-and-forget" process.   You need to periodically (I recommend doing this once each year at the beginning of each calendar year) revisit the three step process described above to reflect investment gains and losses, changes in assumptions, deviations of actual spending from the budget or other changes.  I recommend using the recommended smoothing algorithm in this website for this purpose.  Under this smoothing algorithm, you generally increase your budget by the increase in inflation over the previous year unless your budget falls outside a 10% corridor around the "actuarial value" produced by the spreadsheet.  Depending on actual results, your budget may increase or decrease from year to year.

That's it!  Yes, it takes some work and some discipline but after the first time it will probably take you less time than you take to plan your next trip, fill out your NCAA tournament brackets or make your fantasy league picks. 

Wednesday, August 27, 2014

Budgeting Around "Lumpy" Expenses

There may come a time during your retirement where you are looking at an expense that may blow your annual budget.  Examples of such expenses include the purchase of a new car or vacation home, helping your children purchase a new home, paying for a wedding, etc.  This post will take a look at several different ways you can handle these "lumpy" expenses under the Actuarial Approach. 

In summary, there are quite a few reasonable ways to adjust your budget for unanticipated expenses under the Actuarial Approach. In many ways, developing a budget for retirement is more of an art than a science. Irrespective of what your budget is, you are the one who decides how much of your available assets you will spend each year. After all, it is only a budget, and no one is going to force you to live within it. On the other hand, if you believe you will have unanticipated expenses in the future, it may be prudent to reserve for such expenses by reducing the accumulated assets you have available for normal retirement expenses and establishing a separate unanticipated expense fund.

Before discussing the different ways to adjust your budget for unexpected expenses, lets provide some facts for a hypothetical retiree so that we can illustrate the impact of using the different approaches:

Raymond retired at age 65.  At that time, he had accumulated assets of $500,000, a fixed dollar pension of $10,000 per year and Social Security of $24,000 per year.   He used the Excluding Social Security V 2.0 spreadsheet in this website with the recommended assumptions.  Because he wanted to leave some of his assets to his daughter, he developed his initial spending budget by inputting $100,000 in the amount to be left to his heirs. 

His resulting first year budget is $51,733 ($24,000 from Social Security, $10,000 from his pension and $17,733 from withdrawals).  In the first year of retirement, his accumulated assets earn 10%.  In the second year of his retirement, his accumulated assets earn 3%.  Let's assume that CPI increases were 2% in each of his first two years of retirement and further assume that Raymond spends exactly his total budget each year.  To determine his budget in subsequent years, Raymond applies the smoothing approach recommended in this website to the sum of his pension and withdrawals and then adds his Social Security benefit for that year.

Since the budget amount (prior to adding Social Security) increased by inflation in each of his first two years of retirement remains inside the 10% corridor around the actuarial value, Raymond determines his budget for his second year of retirement by increasing the first year pension and withdrawals of $27,733 by 2%.  This equals $28,288 so he withdraws $18,288 from his accumulated savings and his total budget for his second year is $52,768 ($24,480 from Social Security, $10,000 from the pension and $18,288 from withdrawals).

Late in his second year, Ray determines a preliminary budget for his third year.  He increases the pension and withdrawal from the previous year of $28,288 by 2% to get a sum of $28,854 for a total budget of $53,824 ($24,970 from Social Security, $10,000 from the pension and $18,854 from withdrawals.  At the beginning of his third year of retirement, he has $527,572 in accumulated assets.  By comparison, the actuarial budget for his third year (based on the spreadsheet without smoothing) would be $55,094 ($24,970 from Social Security, $10,000 from the pension and $20,124 from withdrawals).

But, let's assume that at the beginning of his third year of retirement, Ray discovers that he has an upcoming expense of $40,000 at some time in the near future.  How should he adjust his third year budget in light of this new expense?

Approach #1--Restart the Actuarial Approach

Under Approach #1, Ray redetermines his budget for year 3 reducing his assets at the beginning of year 3 by $40,000 (even though all of this expense may not occur in year 3).  So, instead of inputting $527,572 in assets to determine the actuarial budget, he enters $487,572 and a 28 year remaining period.  The resulting total budget is $53,265 ($24,970 from Social Security, $10,000 from the pension and $18,295 from withdrawals). 

Approach #2--Treat the Unexpected Expense as Any Other Gain/Loss (Including Deviations of Withdrawals from Budget)

Under Approach #2, Ray inputs $487,572 into the spreadsheet as his accumulated assets (the same as in Approach #1).  Using the smoothing method, he compares the result of the spreadsheet calculation ($28,295 = $10,000 from the pension and $18,295) with the previous years total increased by 2% inflation ($28,854).  Since the amount from the previous year increased by inflation falls within a 10% corridor around the actuarial value, Ray adds $28,854 to his Social Security benefit of $24,970 to get the same budget for his third year that he had prior to recognition of the unexpected expense. 

Approach #3--Recognize the Expense in Budget Over a limited Period

Ray doesn't feel comfortable with the negligible or no decreases in budget resulting under the first two approaches and feels that spending an extra $40,000 in accumulated saving should be recognized in his spending budget over a shorter time-frame.  Therefore, under Approach #3, Ray decides that he will reduce his spending budget for each of the next four years by $10,000 per year.  To accomplish this, Ray will add $40,000 to his reduced assets of $487,572 in year three and will determine the same budget (without recognition of the extra expense) of $53,824.  From this amount, he will subtract $10,000 to get a third year expense budget of $43,824.
To determine the budget in year 4, Ray will follow the regular actuarial process, but instead of adding $40,000 to his beginning of year assets, he will only add $30,000.  He will then subtract $10,000 from the resulting budget.  He will continue this process for two more years until there are no more adjustments to the inputted assets and no more $10,000 subtractions from the budget.  Depending on whether Ray actually pays attention to his spending budget, this approach is more conservative than the first two, but results in approximately a $10,000 increase in his annual budget when the expense is fully recognized. 

Approach #4--Reduce Amount Desired to be Left to Heirs

Yet another approach is to use either Approach #1 or Approach #2 and reduce the amount previously input for the bequest motive.  This approach may be perceived to me more reasonable if in fact the unanticipated expense is in reality a pre-payment of one's bequest motive (such as a gift to assist a child purchase a home).