Saturday, July 19, 2014

How Well Does Your Retirement Budget Process Handle Your Specific Situation and Objectives?

While many retirees worry about how much they can spend in retirement, not all retirees enjoy the same financial situation and not all retirees have the same objectives in retirement.  This is why it may be important to you to use the Actuarial Approach outlined in this website and not some other approach such as  the 4% Rule (or some other safe withdrawal rate) to determine your annual spending budget.  This post will provide an illustration of how your specific situation and objectives can affect your spending budget. 

Your initial spending budget in retirement can be affected by a number of factors including your age and health, your significant others age and health,  your investment strategy, relative levels of Social Security benefits and/or pension or other annuity income (and whether such income is immediately payable or deferred), your bequest motives, any income from employment, your desire for constant real dollar income in retirement, etc.   Subsequent years spending budgets can also be affected by a number of factors including actual investment return, actual inflation, actual amounts spent, changes in items used to develop your initial spending budget, etc.  If you are simply spending 4% of your accumulated savings at initial retirement increased with inflation each year, you are probably not adequately reflecting your specific situation or objectives. 

Let's illustrate the previous statement with an example.  Assume Joe retires at age 65 with a Social Security benefit of $2,000 per month.  He also has accumulated savings in an IRA of $800,000.  He is not married and he has no bequest motive and no immediate pension or annuity income.  Since he is worried about outliving his savings, he decides to take advantage of the new Qualified Longevity Annuity Contract regulations and takes $100,000 of his accumulated savings and buys a deferred annuity that will pay him $31,250 per year starting at his age 80 (and nothing if he dies prior to that age).  This leaves Joe with $700,000 of retirement assets to invest after the annuity purchase.  Joe has also read the research paper from David Blanchett which indicates that spending generally declines in real terms as retirees age.  Therefore, Joe decides that instead of planning on a spending budget that will remain constant in real dollar terms, he is willing to live with a spending budget that will increase by the cost of living measured by the CPI decreased by 1% each year. 

To develop his initial spending budget, Joe inputs his information into the "Excluding Social Security V 2.0" spreadsheet in this website (accumulated savings of $700,000, deferred annuity of $31,250 starting in 15 years, $0 desired at the end of the payout period) and all the recommended assumptions (5% investment return, 30 year payout period) except 2% per year desired increases rather than 3%.  He still enters 3% for the expected rate of inflation to see the possible impact on his spending budget (before adding Social Security) of his decision not to have constant dollar spending budget (shown in inflation-adjusted run out tab).   The resulting spendable amount (all from accumulated savings) is $43,264, or 6.18% of his initial accumulated savings of $700,000.  To this amount he adds his annual Social Security benefit of $24,000 to get a total spending budget for his initial year of retirement of $67,264.

In subsequent years (prior to commencement of the deferred annuity), Joe will use the smoothing algorithm recommended in this website.  He will do this at the beginning of each year by inputting his specific information into the spreadsheet to get a preliminary value to be withdrawn from accumulated savings and will add his expected Social Security for the year to get a total preliminary budget for the year.  He will then increase the actual previous year's total budget by the increase in inflation less 1% and test to see that this amount falls within a 10% corridor around the total preliminary budget amount.  If it does, this amount will be his total budget for the year and the budget amount to be withdrawn from accumulated savings will equal the total budget amount less Social Security. 

Is the actuarial approach more complicated than simply withdrawing 4% of accumulated savings in the first year of retirement and increasing that amount by inflation every year?  Yes, but in my opinion it is worth the extra 15 minutes a year it might take you to reflect your specific financial situation and objectives and do the calculation right.  In Joe's case, he is looking at an initial year's spending budget that is about 29% higher ($67,264 under the Actuarial Approach vs. $52,000--$28,000 from accumulated savings and $24,000 from Social Security--under the 4% Rule).