Sunday, August 27, 2017

Front-Loading Your Spending Budget by Treating Travel Expenses as a Non-Recurring Expense

After our last post, we received several questions on what we meant (and what would be involved) when we suggested that retirees might wish to consider treating certain expenses as non-recurring to “front-load” their spending budgets.  This post will present an example that might be helpful in explaining this particular “budget-shaping” approach. 

Example

Mary is a 65-year old with $500,000 in accumulated savings and she is receiving a Social Security benefit of $2,000 per month.  For simplicity purposes, let's assume these are her only two sources of income and her only expected non-recurring expense is $50,000 of unexpected expenses.  Using the Actuarial Budget Calculator for Retirees (ABC) and our recommended assumptions (4% discount rate, 2% inflation, 2% desired increases and 31 years LPP), Mary develops an annual recurring real dollar spending budget of $43,135.  This amount is equal to the present value of her future spending budgets of $1,014,425 divided by the present value of her future years with desired increases of 23.5177.  If all assumptions are realized in the future, Mary expects her spending budget to remain at this level in real dollars throughout her period of retirement. 

Mary has determined that her non-travel essential expenses are about $38,000 per year.  The spending budget that she has developed in the paragraph above therefore only leaves her with about $5,100 as an annual travel budget.  Based on her understanding of the “go-go, slow-go and no-go” stages of retirement, she understands that she may not have the same desire to travel when she becomes older, and she decides to consider “front-loading” her desired travel expenses over a limited period rather than spreading them equally over the remainder of her life.

So, let's assume that Mary decides that she is going to travel until she is 80 (15 years) and she would like to spend $10,000 per year in real dollars for travel each of those 15 years.  Since she does not anticipate traveling every year of her retirement, she treats her traveling expenses as a non-recurring expense rather than one that will last until she dies.  Using our Present Value Calculator spreadsheet, she determines the present value of her future traveling expenses to be $131,397 and enters this amount in the ABC along with the $50,000 present value she has budgeted for unexpected expenses.  This reduces her recurring non-travel budget to $37,547, but her total real-dollar travel and non-travel budgets for this year (and the next 14 years are expected to be $47,547 ($10,000 plus $37,547), or about 10% higher than her initial “non-front-loaded” spending budget.  All things being equal, however, she expects her real dollar total spending budget under this “front-loaded” approach for ages after 79 will only be $37,547 in real dollars, or about 13% less than the non-front-loaded budget.   Since this amount is a little bit more than her expected non-travel essential expenses, she considers this alternative front-loaded budget shaping approach as a possible way to go.  If Mary decided that a travel budget of $10,000 per annum may still not be sufficient to satisfy her desired travel plans, she could look at a higher travel budget and shorter travel period as another alternative. 

The graph below illustrates Mary’s choice, again assuming all assumptions made about the future are exactly realized. 

(click to enlarge)

Conclusion

The graph illustrates the general rule of spending in retirement that we refer to frequently in our blog:  You can spend it now or you (or your heirs) can spend it later.   There is no free lunch.  If you want a higher spending budget in retirement, you either need to increase your assets (for example, Mary could take a part-time job) or you can increase the risk that your spending will decrease in the future in real dollars by front-loading your current spending.

It is also important to note that assumptions made about the future will not be exactly realized.  For example, as you age, your lifetime planning period plus your age may increase (your expected age at death).  All things being equal, an increase in your expected age at death will result in an “actuarial loss” that will decrease your real dollar annual spending budget.  Therefore, it is critical to revisit one’s spending budget annually to reflect actual experience, actual spending and any changes in your desired spending goals.  Things change.  Budgeting your spending should not be a “one and done” process.

Tuesday, August 22, 2017

Are You Over-Estimating Your Future Retirement Spending Needs?

In this post, we will focus on the future estimated spending liabilities (right-hand side) of the Basic Actuarial Equation, which is frequently shown in this website and is advocated by us to develop your spending budget.


Accumulated Savings
 +
PV Income from Other Sources
 =
PV Future Non-Recurring Expenses
 +
PV Future Recurring Annual Spending Budgets
 

If you over-estimate your future spending liabilities, you run the risk of underspending today.  If you under-estimate your future spending liabilities, you run the risk of overspending today.  Clearly, the more “conservative” strategy is to over-estimate your future spending liabilities and spend less today.  On the other hand, if you are too conservative, you may be denying yourself the lifestyle you really want to enjoy today and may be unintentionally increasing the amount you ultimately leave to your heirs.  This is perhaps one of the most difficult trade-offs that you (possibly with the help of your financial advisor) will have to face in your financial planning.

We will address this important trade-off first for pre-retirees who may be considering retirement, and then for both pre-retirees and retirees.

Pre-retirees Considering Retirement

Some retirement “experts” tell us that we need to replace 70% - 80% of our pre-retirement gross income to enjoy the same lifestyle after retirement as before.  Other experts tell that we need to accumulate savings of 10 times or more of our pre-retirement gross pay to retire at age 67.  These “rules of thumb” frequently over-state post-retirement spending liabilities, particularly if, just prior to retirement, the individual (or couple) has been:

  • saving significant amounts, 
  • making large mortgage payments, or 
  • making large education payments
Since these types of expenditures are frequently not required throughout the entire period of retirement, it will generally not be required to consider them as recurring expenses to be replaced in retirement.  For this reason, we encourage pre-retirees to compare expected recurring spending budgets in retirement with expected recurring spending (in real dollar terms) just prior to retirement for retirement planning purposes.

The table below shows a distribution of mean spending by age and spending category.  The source of this data was the 2015 Consumer Expenditure Survey (table 1300) prepared by the U.S. Department of Labor Bureau of Labor Statistics.




click to enlarge

The first take-away from this table is that total mean spending decreases with age.  Mean spending (including taxes) for individuals (family units) age 65 - 74 of $54,465 was about 78% of mean spending for those age 55 - 64 ($70,059).

The second take-away from this table is that much of the decrease in mean spending between these two age groups may be explained from spending reductions generally associated with retirement:

  • Reduced FICA taxes 
  • Reduced taxes, and 
  • Reduced work-related expenses, including savings for retirement
This data suggests that a better target for an initial spending budget in retirement will be about 80% - 85% of one’s pre-retirement spending levels, if your goal is to approximately replace your pre-retirement living standards.  Therefore, you may wish to categorize your spending in a manner similar to that shown in the Consumer Expenditure Survey (CES) table for purposes of determining a more reasonable spending target and determining whether you can afford to retire.

The third key point from this table is that spending appears to decrease in real terms as we age after retirement.  This leads us to the next section, which discusses several approaches you can consider (either before or after retirement) to possibly avoid over-estimating your spending needs in retirement, when using the Actuarial Budget Calculator (ABC) or the Actuarial Approach to develop your spending budget.  These approaches are all designed to increase current spending budgets.  You should be aware, however, that increasing current spending budgets may also decrease future spending budgets, all things being equal, so these approaches should be considered more as “Budget Shaping” approaches.

Budget Shaping Approaches to Avoid Over-Estimating Your Spending Needs

Assuming Decreasing Real Dollar Spending


The CES survey data above and data from other surveys suggest that spending does not keep pace with inflation as we age.  While certain types of expenses may remain constant in real dollars, or even increase (like healthcare), total real dollar spending appears to decline with age.  Therefore, when using the ABC to develop your spending budget, you may wish to consider inputting a lower rate for “desired increase in future budgets” than you input for “expected rate of inflation.”

Use a Less Conservative Lifetime Planning Period (LPP)

For the Actuarial Budget Benchmark (ABB), we recommend using a lifetime planning period (LPP) developed using the 25% probability of survival from the Planning Horizon section of the Actuaries Longevity Illustrator assuming excellent health, non-smoker mortality.  If you are aware of health issues (or you are a smoker), you may wish to use average health or a shorter, more realistic, LPP to develop your spending budget.

Treat Certain Expenses as Non-Recurring

Many retirees want to travel and have that as one of their spending goals in retirement.  However, you may not want to travel as much when you are in your 80s as when you first retire.  Rather than plan on the same level of travel each year of your retirement (by spreading these expenses over your entire LPP), you should consider setting up a non-recurring expense reserve for travel that you plan to exhaust over a period shorter than your LPP.  You should consider doing this for other types of expenses that you do not anticipate lasting your entire retirement, such as mortgage payments that you intend to pay off before you die.

Spending After First Spouse Death

If you are married, you should consider what will happen to sources of income and spending after the death of your spouse (assuming you survive).  Some expenses may remain constant and some may be reduced.  We discussed how to adjust assets and spending liabilities to reflect different expected LPPs for married couples in our post of July 4, 2017.  It would not be unreasonable, however, to assume that recurring expenses drop by one-third after the first death.

Assume Lower Non-Recurring Costs


As we have previously discussed, if you are spending the budget determined under the Actuarial Approach and you are increasing your LPP as you age to determine such budget, it is likely that you will die with assets remaining.  As a result, you may be “doubling up” to a certain degree, by inputting a specific level of desired amount remaining at the end of the LPP.  Additionally, you may have other plans for near end of life care so that you may not want to build a large reserve for long-term care.

Use a Higher Discount Rate

If you believe that your investments will consistently achieve higher returns than those inherent in insurance company annuities with no additional risk, you can assume a higher discount rate than we recommend.  Unlike the items mentioned above, however, we are less enthusiastic about this option.

Conclusion

We are fine if you want to be conservative in estimating your future spending needs.  If you are still working, enjoy your job and have no trouble getting out of bed in the morning to go to work, we encourage you to keep working even if you might be able to afford to retire.  As we have indicated in previous posts, we estimate that an individual’s annual recurring retirement spending budget will generally increase by almost 10% for each year additional year of employment.  On the other hand, if you just can’t wait to retire, you might consider some of the Budget Shaping alternatives discussed above, to see if your retirement goals can be accomplished using somewhat more realistic assumptions about future spending needs.

By the way, if you are working and determine that you still can’t afford to retire even after trying some of the approaches above, we encourage you to increase your pre-retirement savings until it hurts.  Doing so has a double benefit.  It simultaneously increases your assets and decreases your post-retirement spending target.
We are also fine if you are already retired and just want to be more conservative in your spending.  We aren’t trying to push anyone to spend more now rather than later.  We are all about encouraging you to develop a reasonable spending budget that considers your specific situation and spending goals.  If you believe your current spending plan is not meeting your goals, however, you may wish to consider one or more of the Budget Shaping approaches discussed above.

Feel free to discuss meeting your spending goals with your financial advisor by applying these approaches, but don’t be terribly surprised if his or her planning software doesn’t handle some of them adequately.  You may also find it difficult to accomplish your spending goals if you use approaches that “cobble together” sources of lifetime income and involve strategic withdrawal plans (SWPs), like the 4% Rule or the Required Minimum Distribution (RMD) approach, as these approaches generally aren’t very flexible.  By comparison, if you are willing to do a little number crunching and are willing to live with the potential consequences of being a little less conservative, the Actuarial Approach can help you tailor your spending plans to better meet your anticipated spending needs and goals.

Happy Budget Shaping!

Tuesday, August 8, 2017

Budgeting to Meet Your Spending Goals in Retirement vs. Cobbling Together Sources of “Lifetime Income”

This post is a follow up to our post of April 9, 2017, The Whole is Greater than the Sum of its Parts (and several other of our previous posts) where we maintained that using the Actuarial Approach advocated in this website is superior to summing up sources of lifetime income (Sum of the Sources) for developing a reasonable spending budget designed to achieve your spending goals in retirement.  This post will include a “real world” example that we believe will demonstrate why it is worthwhile to spend the extra half hour to crunch your numbers using the Actuarial Approach, rather than to rely on a Sum of the Sources approach.

We at How Much Can I Afford to Spend are retired pension actuaries, not insurance company actuaries, academic retirement researchers, financial advisors, or investment advisors.  Our primary mission is to provide you (or your financial advisor) with an actuarial framework that can be used to develop an annual spending budget that reflects your specific situation and your lifetime spending goals.  It is not our mission to:

  • Convince you to buy lifetime income products from insurance companies 
  • Advise you on the best way to invest your assets 
  • Influence public policy to encourage plan sponsors or financial institutions to offer “lifetime income” options from qualified defined contribution plans or IRA’s 
  • Refine existing research relating to retirement, or 
  • Develop the optimal Systematic Withdrawal Plan (SWP) so that withdrawals under such plan may be added to other sources of lifetime income.
We are disappointed that the major actuarial organizations in the U.S. appear to be more focused on advocating the cobbling together of various lifetime income “solutions” (including lifetime income insurance products and SWPs) than advocating the use of basic actuarial principles to help individuals achieve their spending goals.  The American Academy of Actuaries (AAA) actually sponsors a Lifetime Income Initiative which claims, “The Academy has identified lifetime income as a top public policy issue and strongly supports initiatives that will lead to more widespread use of lifetime income options.”

We will be the first to admit that the actuarial calculations required to develop a reasonable spending budget, that reflects your specific situation and that is consistent with your goals, can be somewhat complicated.  For this reason, we have tried to make these calculations a little bit simpler by developing our Actuarial Budget Calculators (ABC).  Sometimes, however, your personal situation may not be adequately handled by the ABC.  In these situations, we recommend that you go back to the basics and apply the Basic Actuarial Equation to develop your spending budget.  The following is an example of such a calculation.

Example

Data and Goals
Bill and Betty are a married couple who have retired and both are in relatively good health.  Bill is age 65 and has already commenced his Social Security benefit.  Betty is age 55.  They have a daughter.  Their financial goals include:

  • Betty would like to maximize her Social Security benefits 
  • Neither would like to become a burden on their daughter 
  • They don’t want to outlive their assets 
  • The would like to earmark $20,000 per year in real dollar spending for the next 20 years for travelling expenses, as they are quite interested in travelling while they are able to do so. 
  • They desire relatively constant real dollar non-travel spending from year to year while they both are alive, with about 2/3rds of such real dollar spending to continue after the death of the first spouse.
  • They plan to use about 1/2 of their existing home equity to finance recurring expenses, leaving the other half to finance expected long-term care costs.  They understand that they may have to downsize or take some other action during retirement to extract home equity assets. 
  • They establish an initial reserve for unexpected non-recurring expenses of $100,000. 
  • They have no desire to establish a separate reserve to fund a bequest motive for their daughter.  They understand that it is likely that some assets will remain for this purpose at the second death of the couple.
Bill’s assets:
  • Bill has commenced his Social Security benefit of $20,000 per annum 
  • Bill has a QLAC (deferred annuity contract) that will pay $20,000 per annum for his life, commencing at age 85
Betty’s assets:
  • Betty estimates (by using the Social Security Quick Calculator) that her Social Security benefit will be about $35,000 per annum if it commences at age 70 
  • Betty has a pension benefit that will pay her $12,000 per annum for her life, commencing at age 65
Joint assets:
  • The couple has combined accumulated savings (pre-tax and post-tax) equal to $1,000,000 
  • The couple estimates that the equity in their home is currently $600,000, with no mortgage.
Assumptions:

For present value calculations, Bill, Betty and their financial advisor have selected:

  • 4% annual discount rate 
  • 2% annual rate of inflation 
  • Using the Actuaries Longevity Illustrator and a probability of survival of 25%, they determine that:
o    Bill’s lifetime planning period is 29 years,
o    Betty’s is 42 years, 
o    the expected period at least one of them alive is 42 years and
o    expected period both are alive is 27 years.
  • The couple expects their home equity will increase at 4% per annum, the same rate of annual increase as assumed for their other investments. 
  • The calculations of the present values in the table below can be duplicated using either our ABC (Retiree) or Present Value Calculator spreadsheets.
Actuarial Balance Sheet

Here is Bill and Betty’s Actuarial Balance Sheet

(click to enlarge)

The left-hand side of the Actuarial Balance Sheet shows the present value of Bill and Betty’s assets, and the right-hand side shows the present value of their spending liabilities.  Note that the total of the present value of their assets (the left-hand side) must equal the present value of their spending liabilities (the right-hand side).  The present value of Bill and Betty’s future recurring spending budgets ($1,946,707) is the balancing item that makes the totals equal (balance).

Spending Budgets

The final step in developing Bill and Betty’s first year spending budget is to divide the present value of their future recurring spending budgets shown above ($1,946,707) by the present value of their future years of life, based on the assumption that the spending budgets will increase by inflation of 2% per year until the first death, at which time real dollar spending budgets will be reduced by a third.  The calculation of this present value of future years (27.1890) is discussed in our post of July 4, 2017.  The resulting budget is the sum of:

  • non-travelling recurring spending of $71,599 ($1,946,707 ÷ 27.1890), plus 
  • their travelling budget for the year of $20,000, 
  • for a total spending budget for this year of $91,599.
If all assumptions are realized in the future, Bill and Betty’s spending budget is expected to increase each year with inflation for the first 20 years, after which it would be expected to drop to $71,599 (when their 20-year temporary travelling budget expires) in real dollars until Bill’s expected time of death, at which it would be expected to drop to $47,733 (2/3rds of $71,599) in real dollars.

“Sum of Sources” approach

By comparison, if they had used the “Sum of Sources” approach and used the 4% Rule for their SWP, their initial total spending budget would have been only $60,000 (Bill’s $20,000 Social Security benefit plus 4% of their accumulated savings of $1,000,000).  Of course, when Betty’s Social Security, Betty’s pension and Bill’s QLAC actually kick in, their spending budget under this Sum of Sources approach would be much higher in real dollar terms.  By that time, however, it might be too late for Bill and Betty to enjoy the travelling they so desired.  By using the Actuarial Approach, they increased their initial spending budget by almost 53% and, on an expected basis, satisfied all of their spending goals.

Note that if Bill and Betty’s spending goals included relatively constant real dollar non-travel spending on “essential expenses” (which they estimated to be $45,000 per annum while they are both alive) and declining real dollar spending on non-essential expenses (inflation minus 1% per year), their first-year spending budget could have been increased to $96,091, or about 60% greater than under the Sum of the Sources approach.

Final Words

You only get one attempt at enjoying your retirement.  There is no opportunity for a “do-over.”  This is why we believe it is important for you to spend a little bit more time and use basic actuarial principles to develop a reasonable plan (and spending budget) that is consistent with your spending goals rather than cobbling together sources of lifetime income.