In his most recent CBS MoneyWatch article, my friend and fellow actuary Steve Vernon reminds us that home rich/cash poor Americans can use their home equity to fund their retirement. He discusses various ways this can be done, including downsizing and reverse home mortgages. He concludes his article by saying, “It's simply common sense to carefully consider how to deploy all the retirement assets you own.” Well, thank you very much, Steve, because careful consideration of how to deploy all the retirement assets you own is what the Actuarial Approach for developing a reasonable spending budget is all about.
The basic concept of the Actuarial Budget Calculator spreadsheet provided in this website is to match your retirement assets (including the present value of future Social Security benefits, pension benefits and future sales of other assets) with the present value of your future spending budgets and the present value of your bequest motive (called Desired Amount of Savings Remaining at Death in our spreadsheet). And don’t be frightened by the fact that the calculations involve present values; our Actuarial Budget Calculator spreadsheet does them for you.
Before I give an example of how you can use the Actuarial Budget Calculator spreadsheet to “deploy” your home equity, I would like to, once again,point out that even though it may be common sense to deploy all your assets to meet your retirement spending objectives, you generally won’t find much discussion of how to accomplish this with rule of thumb withdrawal approaches such as the 4% Rule or other safe withdrawal rate approaches. What you do hear with those approaches is something like, “trust us, based on complicated Monte Carlo modeling, if you invest your accumulated savings at least 50% in equities, you will have a 95% chance of not running out of money.” On the other hand, with the Actuarial Approach, you develop a reasonable spending budget based on your best estimates of future experience and your financial situation.
Recently one of my readers wanted to know how to determine a reasonable spending budget during a period of time prior to commencing his Social Security benefit recognizing, that he had a fair amount of equity in his home in addition to a fair amount of more liquid accumulated savings. I’m going to change his fact situation somewhat for simplicity sake. Let’s assume that
“David” is age 65,
no longer working,
has $500,000 of liquid accumulated assets,
$400,000 of equity in his home, and
he projects his Social Security benefit will be $30,000 per year when he commences it at age 70 (in 5 years).
David believes that, in about 15 years, he will downsize his house to a condominium and,at that time, he will be able to pull out about 50% of his equity. He wants to use what he can pull out when he downsizes to increase his current spending budget. David wants to use the remaining 50% of his equity for long-term care costs when he no longer can live by himself in his condominium. Thus, David estimates the present value of the equity he will be able to pull out of his current home when he downsizes to a condominium at $200,000 (half of the $400,000 of equity in his home). David assumes that his home equity will increase by 4.5% per year, the same assumption he makes for investment return on his more liquid accumulated savings.
Using the Actuarial Budget Calculator, David enters
$500,000 in accumulated savings,
$30,000 in Social Security benefits commencing in 5 years,
$200,000 as the present value of other sources of income and
the recommended assumptions (4.5% investment return, 2.5% inflation and 30- year retirement period).
He has no bequest motive.
Since we are going to use the Budget by Expense tab and look at the components of David's spending budget, we don't need to make an assumption about the desired increase in David's total spending budget in the input tab.
The present value of David’s retirement assets under these input items and assumptions is $1,181,925 (plus the 50% remaining equity that is assumed to cover David’s long-term care costs).
$50,000 for the present value of unexpected expenses,
$35,000 increasing with inflation for essential non-health expenses and
$7,000 increasing with inflation plus 2% for essential health costs.
He then goes to the Budget by Expense-type Tab of the spreadsheet and budgets
$0 for long-term care costs (because they are to be covered by his condominium equity), and the three assumptions above.
This leaves him with $117,367 for the present value of his non-essential expenses, which he decides to spread over his expected retirement as the same constant dollar per year, giving him a current year non-essential spending budget of $6,895 and a total current year spending budget of $48,895. Note that because he is not currently receiving Social Security benefits, this amount must come entirely from his liquid accumulated savings and represents about 9.8% of his current liquid assets.
While a 9.8% withdrawal from David’s liquid assets is relatively high, he knows that withdrawals from his liquid assets will decrease when he starts collecting his increased Social Security benefit and he also knows that if he runs low on his liquid assets, he can choose to downsize his home earlier than planned to take out some of his equity. He also knows that his situation will change each year and he will have to revisit his calculations annually to make necessary adjustments.
Had he been advised to use the 4% Rule, there is no telling what portion of his liquid accumulated savings David would have decided to spend. $20,000 (= .04 x $500,000)? $20,000 plus the amount of the Social Security benefit he could have received if he wasn’t deferring? Something more than this based on his knowledge that he has a fair amount of home equity?
With the Actuarial Approach, David has set aside money for long-term care, future unexpected expenses, future essential expenses and future non-essential expenses. This is the real benefit to David of doing a little number crunching rather than blindly relying on some rule of thumb approach.