Wednesday, May 25, 2016

How Much of that Part-Time Income Can You Afford to Spend in Retirement?

Many individuals who are retired take a part-time job to supplement their income in retirement.  Frequently, these retirees believe that this income can increase their annual retirement spending budget by the net amount received during the year from such employment (wages minus increase taxes and increased employment-related expenses).  This post will encourage retirees who work to possibly consider taking a longer-term “actuarial” perspective by spreading the present value of this extra income over their remaining period of retirement.

Let’s look at an example of how this may work.  John is age 65 with an annual Social Security benefit of $20,000 and accumulated savings of $525,000.  He estimates his essential non-health expenses (including taxes) are currently about $36,000 this year, and he expects these expenses to increase with inflation in the future.  He estimates that his essential health expenses are currently $6,000 this year and will increase by inflation plus 2% in the future.  He believes that the equity in his home will cover his long-term care expenses (or will be used for his bequest motives), and he would like to have an emergency fund budget of $25,000.  The rest of his assets will be used for non-essential expenses, which he plans to budget spending at about the same amount each year of his retirement without any assumed future increases due to inflation (essentially decreasing in the future in real dollar terms).

John goes to the Input page of the Actuarial Budget Calculator V 1.1 and inputs his Social Security benefit and accumulated savings as well as the recommended assumptions (and no bequest motive).  He sees that the present value of his current and expected future retirement income is $984,747.   He then goes to the “Budget by Expense-type” tab of the spreadsheet and enters “0” for long-term care expenses, $25,000 for the present value of unexpected expenses, $36,000 increasing by 2.5% for essential health expenses and $6,000 increasing by 4.5% for essential health expenses.  At this point, John sees that his assets (the present value of his future spending budgets) are insufficient to provide for these three items, let alone provide for any non-essential expenses.   In fact, it looks like he has to reduce his budget for unexpected expenses by $1,823 to develop a $40,000 per year spending budget (excluding unexpected expenses) under these assumptions with a $0 budget for non-essential expenses.

John decides that he could use some more money in retirement and he also would like to get out of the house a little anyway.  He decides to take a part-time job that will pay him $1,000 per month.  After taxes and employment-related expenses, John figures that this job will net him about $700 per month in extra income, or about $8,400 per year.  John’s initial thought is that this job will be enable him to increase his unexpected expenses budget to $25,000 and increase his non-essential expense budget by almost $8,400 per year.

But, after John gives this a little more thought, he concludes that he really doesn’t want to do this part-time job for more than 5 years.  So if he spends all of the extra net income from the part-time job each year, he will have a significant drop in his spending budget once his part-time employment is terminated.  Instead of simply adding his expected net income from employment to his budget, John decides to treat the expected net income as another retirement income source like Social Security or his accumulated savings.   He goes to the present value calculator in this website and determines that the present value of $8,400 starting 0.5 years from now and payable for 5 years is $37,696.  He goes back to the input page of the Actuarial Budget Calculator and inputs this amount as the present value of other sources of income.  This increases the present value of his future spending budgets to $1,022,443 and enables John to establish his $25,000 unexpected expenses budget and increases the present value of his non-essential expense budget to $35,873.  If he decides to spread this present value over his expected retirement period with no future increases, it will provide him with a first year non-essential expense budget of $2,107 and a total spending budget of $42,107 (excluding unexpected expenses).  When he determines his spending budget for next year, John will input the present value of 4 years of part-time work assuming he still believes he will only work until age 70.  Using this alternative approach, John hopes to avoid the significant a decrease in his spending budget when his part-time employment is terminated.  In effect, he is saving some of his part-time income for his future retirement years. 

As I have said many times in this blog, developing a reasonable spending budget in retirement is part science and part art.  John can annually spend anywhere from an extra $2,107 to $8,400 as a result of his part time employment.  He has to decide the spending level that is most consistent with his objectives in retirement.   The Actuarial Budget Calculator and this website give him the tools to make a more informed decision.