This post updates my 2015 spending budget recommendations of February 14, 2015 and December 3, 2014. For 2016, Instead of recommending one set of assumptions for your entire spending budget, I will recommend different sets of assumptions for different component categories of expenses, as discussed in several of my recent posts (see the post of June 7, 2015 for an example). If you separate your budget into these different categories, your overall spending budget for 2016 will be the sum of the various component categories. You (and/or your financial advisor) may wish to consider segregating the assets dedicated to each expense category and adopting different investment strategies for these various dedicated funds. Each year you will compare assets in each dedicated fund with the liabilities for future expected expenses and make necessary budget adjustments and/or transfers between dedicated funds if appropriate. As a general rule, benefits payable from Social Security, pension plans and annuities are used to satisfy essential expenses first.
Essential non-Health Related Expenses
In brief, I recommend the same assumptions for this category of expenses as I recommended for 2015 in my post of February 14, 2015. As for prior years, I have recommended an investment return assumption that is close to the interest rates “baked into” immediate life insurance annuity quotes. Current immediate annuity purchase rates for a 65-year old male with a life expectancy of 22.9 years (based on the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with mortality improvement) are consistent with an interest rate just a little bit lower than 4.5%. Therefore, I believe that the recommended investment return assumption for 2015 of 4.5% per annum is reasonable at this time. If the Fed continues to increase interest rates or immediate annuity rates change for other reasons, we may need to revisit this assumption during the year (as was the case in 2015). I continue to believe that a 2% spread between the investment return assumption and the inflation/desired increase assumption is reasonable and that 95 minus the retiree’s age, or life expectancy if greater, should be used for the expected payment period. See my post of December 3, 2014 for a graph that illustrates why I recommend using this expected payment period rather than life expectancy for this expense category.
If you use the recommended assumptions for this category, your effective goal for this budget component is to have relatively constant real dollar future essential non-health related spending at least until your late 80s.
Essential Health Related Expenses
Historically, health related expenses have increased about 1.5% to 2% faster per year than non-health related expenses. Given Medicare’s financial situation, there also appears to be trend toward passing these higher costs disproportionately to higher income individuals. If you consider yourself to be a relatively “higher income” retiree, I recommend that you use the same assumptions as above for this category, except with 4.5% annual desired increases (as opposed to 2.5%) for this category of expenses. If you do, then the fund you need to have to support these expenses this year will simply be your current expected payout period multiplied by your current essential health related expenses (adjusted if you considered some of your current expenses to be unusual and non-recurring in nature). So, for example, if you are currently age 65 (with a 30-year expected payout period) and $7,000 in current health related expenses, such as for premiums, co-pays, deductibles and non-insured prescription costs), then you should have current assets dedicated to future essential health related expenses of about $210,000 (30 X $7,000).
Long-Term Care Expenses
Since not everyone will require long-term care or they will pay for it with home equity that they don’t consider assets available for other expenses, this can be a difficult category to budget for. Data from the National Care Planning Council suggests that for those individuals who require long-term care, the average length of stay in an assisted living facility is about 2.5 to 3 years with many leaving the facility to go to a nursing home or another facility that provides more intensive (and expensive) care. The council also indicates that about 75% of the cost is covered by the family, not insurance. I recommend that you investigate current assisted living facility and nursing home costs in your area and plan on about 3 years at the assisted living facility and one year at a nursing home. For example in California average assisted living facility costs are about $45,000 per year and nursing home costs are almost double that amount, so budgeting about $200,000 for this expense would not be unreasonable if you plan on enjoying long-term care in California. I would also assume that these costs would increase by 4.5% per year (inflation plus 2%) so that you would need a dedicated fund of about $200,000 today to cover this future expense. If you do plan to use some or all of your home equity to pay for this expense, you should include an estimate of the home equity you plan to use in your current assets, when comparing your assets with your liabilities.
Other Unexpected Expenses
When establishing your spending budget, you will probably want to set aside a reasonable amount of assets dedicated to meeting unexpected future expenses (or a “rainy day” fund not dedicated to any of the other expenses discussed in this post).
Non-Essential Expenses and Bequests
If you have assets remaining after dedicating them to fund the other expense buckets above, you can use these assets to fund non-essential expenses such as travel, entertaining, dining out, gift giving, etc. Your bequest motive can also be included in this category or in the Essential non-health Expense category. Since some experts indicate that non-discretionary expenses are likely to decrease in real dollar terms as we age, it may be reasonable to assume less than 2.5% annual increases in future non-essential expenses or a shorter expected life period than recommended for essential expenses. If you do use these less conservative assumptions for determining how much you can withdraw from your non-essential asset account, you should realize that unless investment returns exceed the 4.5% assumption, your withdrawals from this account will likely decrease on a real basis over time. Note that amounts entered as bequests in our spreadsheets are nominal amounts and not real dollars, so if you want to leave real dollar amounts, you will have to increase the nominal amounts with assumed inflation.
We will illustrate operation of the 2016 assumptions in January when we revisit Richard Retiree and help him develop his 2016 budget and see how it compares with the budgets we calculated for him for 2015 and 2014.