In our December 26 post, Richard Retiree assumed that he would live another 27 years and die at age 95. He also developed a reserve for future LTC costs by assuming that he would spend three years in an assisted living facility and one year in a nursing home and that those costs would be covered by the equity in his home. In addition to these expenses, Richard developed his budget for 2016 assuming that all types of expenses (other than his unexpected expenses) would be incurred until his assumed death in 27 years at age 95. However, as Mr. Castle pointed out, it is likely that some of the expenses that Richard plans to incur prior to entering LTC will be reduced after he enters LTC (which he expects to be in 23 years). So how should we adjust Richard's previously determined budget for this apparent overlap period?
We can argue about which expenses might be reduced when Richard enters into LTC, and we can also argue about how much those expenses might be reduced. Fortunately, I am going to let Richard and his financial advisor make this decision. Richard decides that even though he plans to spend a total of four years in LTC facilities, he will not see a reduction in his essential health-related expenses when he enters the facility and while his essential non-health related and non-essential expenses may be reduced, he expects that they will not be totally eliminated (at least not until perhaps his final year). He decides that instead of assuming a 23-year period for incurring these expenses (i.e., the number of years before he plans to enter the LTC facility) or a 27-year period (as he did for the December 26 post), he will split the difference and assume that the reduction in his essential non-health related expenses and non-essential expenses will be equivalent to assuming that they cease completely 25 years from now.
The basic principle underlying the Actuarial Approach is that to be considered in actuarial balance, a retiree's assets (current assets plus the present value of future expected benefit payments or payments from other sources of income) must be equal to the retiree's liabilities (the present value of future expected expenses/amounts left to heirs). The chart below shows Richard's revised Actuarial Balance Sheet. Some explanation of the numbers in this chart follows:
|(click to enlarge)|
Richard's accumulated savings of $1,095,193 (which includes $180,000 of home equity assets) is allocated to the following reserve accounts as follows:
- Reserve for future unexpected expenses: $102,000
- Reserve for future LTC expenses: $180,000
- Reserve for future Essential Health Expenses: $135,000
- Reserve for Essential Non-Health Expenses (for next 25 years): $361,330
- Reserve for death benefit expenses (assumed to be payable in 27 years): $3,047
- Reserve for Non-Essential Expenses: $313,816
The present value of Richard's immediate life annuity payments of $242,199 is the present value at a 4.5% discount rate of a stream of annual payments of $15,000 per year for 27 years (also assumed to be payable at the beginning of each year).
The reserve for future LTC expenses of $180,000 is developed by assuming that Richard's home equity is $180,000 and will increase by 4.5% per year, or alternatively that it is more than $180,000 but will increase by less than 4.5% per year but will still cover Richard's expected LTC costs.
The reserve for Essential Non-health Expenses was derived by using the "Excluding Social Security V 3.1 spreadsheet and solving for the accumulated savings that, together with 25 years of expected Social Security and annuity payments would provide for expected essential non-health expenses of $50,000 per year increasing at 2.5% per annum.
The present value of essential non-health related expenses of $1,000,943 is equal to the present value of a stream of payments of $50,000 per year increasing by 2.5% per annum for 25 years.
The present value of the remaining expenses (except for non-essential expenses) are equal to the asset reserve allocated to that item above.
The present value of the non-essential expenses of $348,439 is equal to the reserve for non-essential expenses of $313,816 shown in the assets above plus the present value of the final two years worth of Social Security and annuity payments not used to support essential non-health expenses.
By assuming a 25-year funding period rather than a 27, the present value of Richard's essential non-health expenses (plus death benefit expenses) have been reduced by about $61,100 (there is some rounding involved). In addition to increasing his non-essential spending assets by about $61,100, Richard will be spreading his non-essential expenses over a 25 year period rather than a 27-year period, so his non-essential spending budget for 2016 will increase from $17,793 to $22,486, and his total spending budget will increase from $72,793 to $77,486, as follows:
- Essential Health Budget: $5,000
- Essential Non-Health Budget: $50,000
- Non-Essential Budget: $22,486
- Total 2016 Spending Budget: $77,486
Always happy to learn from others. Keep those good suggestions for improvements in the Actuarial Approach for spending budgets coming!