Saturday, June 21, 2014

Another Example of the Actuarial Approach for Determining Your Annual Spending Budget in Retirement

When I talk to people about the Actuarial Approach recommended in this website, I usually get one of two responses:  1)  It is too complicated or 2) your spreadsheet is too simple and doesn't handle every situation.  The more conflicting feedback I get like this, the more I tend to believe that, on average, the method is just about right. 

Last week, Kathleen Pender, a business reporter for the San Francisco Chronicle noted that my approach was more complicated than the 4% Rule. 
Readers of this website pretty much know how I feel about the 4% Rule.  First, it is not necessarily all that simple, and second, the little extra effort you may have to take to apply the Actuarial Approach should help you sleep better at night knowing you are on track with your spending budget. 

This week I also received feedback from another actuary who said that my simple spreadsheet (Excluding Social Security v 2.0) would be better if it handled more situations.  Specifically, he suggested that users should be able to input expected income to be received in the future that may not be paid for life as well as payments generally paid from pension plans that are not fully indexed with inflation.  I responded to this actuary that, since every future year will produce deviations from assumed experience (such as different investment return, deviations from the spending budget, etc.),  it is more important that the retiree follow the process we recommend in this website than it is to have the world's most accurate spreadsheet. 

But, for the retirees out there who have sources of retirement income that don't seem to be anticipated by the simple spreadsheet, here is an example that may help you develop your spending budget.

Rosemary Retiree retired on January 1, 2013 at age 65.  She had $250,000 in accumulated savings/investments, an annual pension of $12,000 per year indexed with the CPI minus 1% per year, a series of equal periodic payments of $15,000 per year payable shortly after the beginning of the year for the next 10 years, and a Social Security benefit of $18,000 per year. 

With respect to the 10-year certain payments of $15,000, Rosemary determines the present value of such payments at 5% interest to be $121,617.  To this amount she adds her accumulated savings of $250,000 and enters $371,617 as accumulated assets in the V 2.0 spreadsheet on this website together with the recommended assumptions and an amount desired to be left at death of $10,000.  With respect to the partially indexed pension annuity, she can either choose to treat this source of retirement income as a fully indexed pension similar to Social Security or she can choose to treat it as a fixed annuity payment.  She knows that either approach is not 100% accurate, but the difference will just be one more gain or loss that will be treated the same way as all the future gains and losses.  She chooses to treat the partially indexed annuity as a fully indexed annuity and does not enter an amount in the spreadsheet. 

So, her total spending budget for 2013 is $46,046.  This is comprised of $16,046 from accumulated savings (from the spreadsheet), $18,000 from Social Security and $12,000 from the pension. 

During 2013, the CPI increased by 1.3%.  Rosemary received one of her $15,000 periodic payments, $52,000 in investment income, $12,000 in pension payments and $18,000 in Social Security payments.  Let's assume that she only spent $40,000 in 2013, so her total assets at the end of 2013 (not counting the present value of her remaining 9 structured payments) equals $307,000.  To this amount, she adds the present value at 5% interest of her remaining 9 periodic payments for total accumulated savings of $418,948.  Her Social Security benefit has been increased by 1.3% to $18,234 and her pension payment has increased by 0.3% to $12,036.

At the end of 2013, Rosemary enters her new accumulated savings of $418,948 and a payment period of 29 years.  All the other input items in the spreadsheet are the same as entered in 2013.  The resulting spendable amount is $18,559 to which she adds her 2014 Social Security benefit of $18,234 and her 2014 pension benefit of $12,036 to get a total actuarial spending value of $48,829.

Using the algorithm recommended in this website to smooth gains and losses, Rosemary then checks to see whether last year's budget amount increased with 1.3% inflation ($46,645) falls within the 10% corridor around this year's actuarial value of $48,829.  Since it does, she uses $46,645 as her total spending budget for 2014.

Rosemary knows that since the actuarial value for 2014 exceeds her budget, she has some accumulated gains (primarily from favorable investment experience and under spending her 2013 budget) that she can use in later years to offset possible losses.