Saturday, August 20, 2016

Planning for Constant Real-Dollar Spending in Retirement — Is It Setting the Bar Too High? Part II

This post is a follow-up to my post of March 31 of this year in which I encouraged you (or your financial advisor) to use the Budget by Expense-Type Tab of the Actuarial Budget Calculator to develop a reasonable spending budget that more closely meets your spending objectives with respect to the various types of expenses you expect to incur in the future.

Initial Spending Budget

Developing an initial spending budget using the Actuarial Approach is a two-step process:
  • The first step in the process is to determine the total present value of the assets you have to spend.  This present value includes your current liquid assets, the present value of your Social Security benefits, the present value of your defined benefit plan benefits, the present value of any annuity income you may have, the present value of non-liquid assets you may own that you plan to sell in the future, the present value of rental income from properties you may own, the present value of future wages you may earn, etc. 
  • The second step in the process is to determine how you want to spread this total present value of assets over your expected payout period.
The result, Current Year's Total Actuarial Spending Budget based on annual desired increase (shown in row 42 of the Input Tab of the Actuarial Budget Calculator spreadsheet), shows this year’s actuarially determined spending budget:
  • if you decide to spread the total present value of your assets, less Desired amount of savings remaining at death (input in row 33), over 
  • the Expected payout period (input in row 29), based on the assumption that future spending budgets will increase each year by the Annual desired increase in future budget amounts percentage (input in row 31).
If the same assumption is input for the Annual desired increase in future budget amounts (in row 31) as is input for Expected annual rate of inflation (in row 35), you are essentially planning for constant real-dollar spending throughout your retirement:
  • assuming all the assumptions input in the spreadsheet (including the mortality assumption) are exactly realized (and unchanged), and 
  • your actual spending exactly matches your spending budget each year.
We know, however, that all of the assumptions you input in our spreadsheet won’t be exactly realized (and/or unchanged) each year, and your actual spending will probably not be exactly equal to your spending budget.  That is why we added the 5-year Projection Tab, so that you could see how variations in investment returns and actual spending could affect your future spending budgets.

We also know that not all of your future expenses are likely to increase at the same rate, which is why we added the Budget by Expense-Type Tab to the spreadsheet.  This tab gives you the ability to spread the present value of your assets (which is also equal to the present value of your future spending budgets) between five different types of expense:

  • long-term care 
  • unexpected 
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
and to make different future increase assumptions for these expenses:
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
This is one of the many benefits of using the Actuarial Approach that you just don’t get with many other approaches — the flexibility to decide how you want to budget the spending of your retirement assets.

Planning for Constant vs. Decreasing Real-Dollar Spending

And the foregoing brings us to the inspiration for today’s post (with my apologies for taking so long to get here).

Three of retirement researcher Wade Pfau’s recent articles,

note that average spending appears to decrease consistently during retirement, until individuals become quite old, at which time their expenses (mostly health-related) increase.  Therefore, according to Dr. Pfau and other researchers, “Suggesting that retirees should plan for constant inflation-adjusted spending may overestimate the required retirement savings that many households will require for a successful retirement.”  Stated in another way, this research appears to support some degree of “front-loading” of the early years’ real-dollar spending budgets, relative to later years (i.e., larger early year budgets than later year budgets, measured in real dollars).  In his “Smile” article, Dr. Pfau cites research from David Blanchett that shows that real-dollar spending for a retiree whose initial spending is about $100,000 is expected to decrease by about 1% per year until the retiree reaches her early 80s, at which time health-related expenses will tend to increase real-dollar spending.

While I agree that non-essential expenses are likely to decrease in real dollars as we age in retirement, I also agree with Dr. Pfau that other types of expenses in retirement are likely to remain constant in real dollars or even increase.  It is for this reason that I recommended different rates of assumed increases for
  • essential non-health (ENH) expenses, 
  • essential health (EH) expenses and 
  • non-essential (NE) expenses
for determining 2016 spending budgets in my post of December 21 of last year.

It is important to note, however, that if we assume:

  • essential non-health (ENH) expenses will increase with inflation in the future, 
  • essential health (EH) expenses will increase faster than general inflation and 
  • non-essential (NE) expenses will increase at a rate less than inflation,
then the expected rate of increase or decrease in the total real-dollar spending budget will depend on the relative levels of these three separate budget components.

The larger the portion of the spending budget that is represented by non-essential expenses (using different rates of assumed increases for essential non-health (ENH) expenses, essential health (EH) expenses and non-essential (NE) expenses), the greater the annual decrease expected in future real-dollar total spending budgets.

Examples using James and Michael

Let’s take a look at two different retirees to illustrate this point.  Both James and Michael are:

  • 65-year old males 
  • with $20,000 annual Social Security benefits, 
  • a $10,000 annual pension benefit, 
  • no other sources of retirement income and 
  • no bequest motive.
The only difference between James and Michael is their accumulated savings:
  • James has accumulated savings of $500,000 and 
  • Michael has accumulated savings of $1,000,000.
Both retirees use the Actuarial Budget Calculator to develop their spending budget for this year and our recommended assumptions of:
  • 4.5% discount rate 
  • 2.5% inflation 
  • expected retirement period equal to age 95 minus attained age or life expectancy if greater.
Under these assumptions, the present value of assets are:
  • $1,129,966 for James, and 
  • $500,000 higher, or $1,629,966 for Michael’s.
If these present values are spread over their expected retirement periods as a constant real-dollar amount (increasing each year at the same 2.5% annual rate assumed for inflation), their spending budgets for this year would be:
  • $49,156 for James 
  • $70,907 for Michael.
Examples Using Budget by Expense-Type Tab

Both James and Michael have determined their expenses as:

  • essential non-health (ENH) expenses for the upcoming year are $30,000 
  • essential health (EH) expenses are $7,000 
  • essential non-health (ENH) expenses will increase by inflation in the future (2.5% as stated above) 
  • essential health (EH) expenses will increase by inflation (2.5%) plus 1.5%, or 4.0% 
  • non-essential (NE) expenses will remain constant in nominal dollars
For the sake of simplicity, we are going to assume that both have separately set up sufficient reserves for long-term care expenses and unexpected expenses.

If instead of planning for constant real-dollar spending, these retirees use the Budget by Expense-Type Tab of the spreadsheet and the increase assumptions for each budget expense type discussed above,

  • James will develop a total spending budget for this year of $51,351 (or about 4.5% greater than his constant dollar spending budget), while 
  • Michael’s total spending budget would be $80,725, (or about 13.8% higher than his constant dollar spending budget).
The reason for the different rates of increase is that non-essential (NE) expenses represent a much larger proportion of James’ total spending budget than for Michael’s.


The following two charts illustrate this concept by showing expected real-dollar budget components and total spending budgets for the two retirees by age, if all assumptions are realized.

click to enlarge

click to enlarge

It is important to note that we show expected budget components and totals only until age 90.  This is because real-dollar spending budgets developed as the sum of these three budget components under the Actuarial Approach are expected to decrease significantly once the retiree’s current age plus life expectancy starts to exceed age 95.  At that time, however, the retiree presumably has long-term care and unexpected expense reserves to dip into.

Over the 25-year period from age 65 to age 90, James’ expected total real-dollar spending budget decreases by about .25% per year, while Michael’s total real-dollar spending budget decreases by about 1% per year.  Thus, the results for Michael are very close to the results for the average retiree with initial income of $100,000 noted by David Blanchett.  However, it is important to look at your own situation to determine what is appropriate for you.