It’s that time of year again to sit down to determine your spending budget for the upcoming year. See our post of December 21, 2015 for a discussion of our recommended assumptions for 2016 spending budgets. It just takes a little data gathering and number crunching, but you will find that the time it takes will be well worth your while. Yes, you may have to miss an entire half of one of the upcoming important football games.
The rest of this post will illustrate the Actuarial Approach for Richard Retiree, the hypothetical retiree we have visited each year around this time for the past three years. The last time we visited Richard was in our post of January 1, 2015 when he developed his 2015 spending budget. To refresh your memory, Richard retired on December 31, 2012 at age 65. After a good investment year in 2014, Richard decided to take $100,000 of his January 1, 2015 accumulated savings and segregate these assets in a "rainy day fund" for unexpected future expenses. This left him with $821,853 in investments, his annual Social Security benefit of $20,340 and an annual life annuity of $15,000 from which to develop his spending budget for 2015. He also owns his home, but he does not consider his home equity to be part of his assets for budget setting purposes, as he plans to use the proceeds from the sale of his home to cover future long-term care expenses. He has no heirs so, he plans on having $10,000 or more available upon his death to cover death expenses.
Last year, he determined his essential expenses to be $55,000 and he decided that he would invest 33% of his assets in equities and 67% in fixed income securities. His total spending budget for 2015 was $66,884 ($31,544 from accumulated savings + $15,000 from his annuity + $20,340 from Social Security).
He earned a 2% rate of return on his rainy day fund and didn't use that fund for any emergencies during the year, so as of the end of 2015, he has $102,000 in the rainy day fund. His total investment return for 2015 on his non-rainy day investment funds was $15,000. Since his equity investments were down mid-way through 2015, Richard decided that he would try to limit his spending somewhat during the year and he ended up spending just $59,000 (including taxes). Thus, at the end of 2015, his non-rainy day accumulated savings are $813,193 ($821,853 (beginning of year assets) + $20,340 (Social Security benefit) + $15,000 (annuity benefit) + $15,000 (investment return) - $59,000 (total amount spent).
For 2016, Richard (who is now age 68) has decided that he will break up his total spending budget into several different component categories and dedicate assets to each separate category:
Long-term care: Richard has looked into the cost of assisted living and nursing home care in his area and has determined that the cost of three years of assisted living and one year of nursing home care would be about $180,000. He assumes that selling his home would cover this cost, even if long-term care costs increase at a faster rate in the future than the projected proceeds from selling his home, but he will continue to monitor the reasonableness of this assumption in the future.
Unexpected Expenses: Richard has $102,000 in this account and does not consider the money in this account for determining his 2016 spending budget.
Essential Health-Related Expenses: Richard's current health related costs are about $5,000 per annum. He goes to the "Excluding Social Security V 3.1" spreadsheet in this website and solves for how much of his accumulated savings he would need to provide a stream of payments starting at $5,000 per year and increasing by 4.5% per year over a 27 year period (95 minus his current age of 68) assuming he earns 4.5% per annum on the assets. He determines that this amount is $135,000.
Essential Non-health Related Expenses: Richard has determined that his annual essential non-health related expenses are about $50,000. Since his Social Security benefit for 2016 remains at $20,340, he will need $29,660 ($50,000 - $29,660) from his annuity and withdrawals from his accumulated savings. He again "backs into" how much accumulated savings plus his $15,000 annual annuity benefit will provide a stream of payments starting at $29,660, increasing by 2.5% per annum and leaving a fund of $10,000 at the end of 27 years. He determines this amount to be about $390,900.
Non-Essential Expenses: Richard has $813,193 in assets not allocated to his rainy day fund or his long-term care fund. He subtracts the amounts dedicated to his essential expenses discussed above to develop a total of $287,293 ($813,193 - $135,000 -$390,900). This is the amount he will dedicate to future non-essential expenses. He develops the portion of his spending budget attributable to non-essential expenses by inputting this amount in the spreadsheet as accumulated savings, 4.5% investment return, 0% future desired increases and a period of 27 years. This gives him a non-essential expense budget of $17,793. Richard knows that assuming 0% future increases for this item means that if all assumptions are realized in the future, his non-essential expense budget will not keep up with inflation. Richard also knows that he could be even more aggressive with this "front-loading" by assuming a payment period equal to his expected life expectancy (about 20 years under the Society of Actuaries' 2012 Individual Mortality Table with mortality projection) rather than a 27-year period, but he is happy with this result.
Total Spending Budget for 2016: Richard's total spending budget for 2016 is 72,793 ($5,000 for essential health related expenses + $50,000 for essential non-health related expenses + $17,793 for non-essential expenses). This budget is higher than the spending budget for 2015 of $66,884 even though Richard did not enjoy a particularly good year in 2015 investment-wise. This difference is primarily due to Richard's decision to somewhat front-load his non-essential expenses (in terms of real dollars). He decides that 2016 will be a year of more travel while he still able to do so. Richard notes what the expected amount of assets will be in each dedicated fund at the end of 2016 so that he can monitor his progress during 2016 and make spending adjustments if necessary (or possible).
Richard decides that he will talk to his investment advisor about how best to invest the various funds dedicated to his expense components. He feels that funds dedicated to essential expenses should be much more conservatively invested than his funds dedicated to non-essential expenses, and he may consider buying additional immediate annuities during 2016 if purchase rates become more favorable. He also decides that he feels much more comfortable with his decision to break up his expenses into separate categories, make different assumptions about how these expenses may increase in the future and treat them separately for investment purposes. And he feels infinitely more comfortable using this approach rather than using a "safe" withdrawal rate that doesn't consider his situation or goals.