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).