|
Accumulated savings
|
+
|
PV future income
|
=
|
PV expected non-recurring expenses
|
+
|
PV future spending budgets
|
A second basic actuarial principle is
to revisit this calculation periodically (we recommend annually) to maintain
the actuarial balance in the equation above.
Actuaries call this basic principle “annual actuarial valuations.”
Most of the calculations required to
match one’s assets with one’s spending liabilities involve making assumptions
about the future, and calculating PVs of streams of payments. Our website includes a Present Value Calculator spreadsheet for this purpose, and the ABC
spreadsheet that anticipates some of the more common PV calculations for
individuals, and is thus designed to reduce much of the math burden for
users. When in doubt, however, it is
always wise to go back to the basic principle embodied in the equation above.
While we have focused on helping
retirees determine how much they can afford to spend in retirement, these same
actuarial principles (including the asset/liability matching equation above)
can be applied to the question of:
- how much a pre-retiree can afford to spend and
- how much he or she should be saving in order to meet financial goals.
This post will discuss how pre-retirees
can use the new Pre-Retirement Spending
Savings tab we have added to the ABC
spreadsheet to develop a reasonable pre-retirement spending/savings
budget. An example of how to use our new
tab will be included in a future post.
How
Much Do You Need to Save?
So, how much do you really need to save
each year to achieve your financial goals?
Most “experts” recommend saving as much as possible or some rule of
thumb percentage. For example, a recent Nerdwallet study suggests that 22% of income may be
the new retirement saving target for millennials. Our advice is that it depends on many
factors, including:
- Your financial goals
- Your accumulated savings
- Your other expected sources of income
- How much your assets will earn, how long you will live, and the rate of future inflation and its impact on your expected future expenses
- Other non-recurring expenses you may have
- How long you want (or will be able) to work
- Your capacity and willingness to save, etc.
The new Pre-Retirement Spending Savings tab in our revised ABC spreadsheet
gives you the ability to model the impact, on your expected retirement spending
budget, of variations in your assumed future savings rate, as well as
variations in the items above. If you
are already retired, you can continue to use the ABC spreadsheet and simply
ignore the new tab.
How
to Use the New Pre-Retirement Spending Savings Tab in the ABC
In order to determine how much of your
current gross pay you can afford to spend while saving the remainder in order
to accomplish your financial goals, we expanded the PVs in the equation above to
cover both pre-retirement and post-retirement periods. The ABC
already considers post-retirement, so the new tab includes assets and
liabilities for the pre-retirement period.
The first step in this process is to
determine the PV Future (Retirement)
Spending Budgets, by entering data into the Input tab of the ABC spreadsheet:
- Accumulated savings (cell B7)
- Estimated amounts of future retirement income, such as Social Security (cell B9) and any life annuity (cells B13, B17 or B21), and expected commencement of such income (cells B11, B15, B19 or B23)
- The PV other sources of income in retirement, including proceeds from asset sales or reverse mortgages, income from part-time employment, rental income, etc. (cell B25)
- Assumptions about the future, including future investment returns (cell B27), future rates of inflation (cell B35), and lifetime planning period (pre-retirement period + expected payout period) (cell B29), and Desired amount remaining at end of lifetime planning period (cell B33)
Note: If you have an
estimate of your Social Security benefit payable at some age in the future that
is in current dollars, you will need to increase that estimate based on future
pre-retirement inflation.
The significant result of inputting these
items is the PV Future (Retirement) Spending Budgets found in cell B41 (row 41 and column B)
of this Input tab of the ABC spreadsheet, which becomes the
starting value on the new Pre-Retirement
Spending Savings tab. Once you have
completed this first step, proceed to the new Pre-Retirement Spending Savings tab.
In Step
1 of the new tab, PV future gross pay (cell C9) is
developed, which, when added to the PV
other pre-retirement income (such as employer contributions to a defined
contribution plan) (cell B10) becomes PV
Pre-Retirement Assets (cell C11).
This is added to the starting value of PV Future (Retirement) Spending Budgets (cell D3). If you anticipate working on a part-time
basis after retirement, that expected PV should be entered as part of PV
Other Sources of Income
(cell B25) of the Input tab, not
here. Also note that Social Security
applies an earnings test to employment earnings prior to your Social Security
Normal Retirement Age. Therefore, you
need to coordinate the Desired number of
future years until retirement (B7) with the Social Security benefit commencement year (cell B11 on the Input tab).
Next, in Steps 2 and 3 input expected PV
Long-term Care Costs (cell B13) and the PV Unexpected Expenses (cell B15).
The program then subtracts these amounts from the remaining PV from the
previous step. If there are other
expected non-recurring expenses, such as expected college expenses, add the PV
of such items in one of these two steps. (See our post ofJanuary 12, 2016 for a discussion of how you can modify your estimate of
Long-term Care Costs to reflect a reduction in normal annual expenses
associated with moving into an assisted living facility.)
In Step
4, the spreadsheet calculates PV
Pre-Retirement Spending and subtracts it from the remaining PV from the
previous steps. It does this by asking
you to input the percentage of your pre-retirement gross pay you intend to save
this year and every year until you retire, Desired
percentage of annual gross pay savings
(cell B18). This percentage multiplied
by your gross pay is your savings budget.
The remainder of your pre-retirement gross pay constitutes your
pre-retirement spending budget, and
is intended to cover all your expenses including taxes.
In Step
5, the spreadsheet takes the amount of remaining PV after Step 4 (cell D20)
and spreads it over your expected period of retirement (your lifetime planning period (Input tab B29) minus the Desired number of years until retirement
(cell B7)), based on the input desired
annual increase in post-retirement spending budget (cell B23). As discussed in previous posts, if most of
your expenses in retirement will be essential expenses, you will probably want
your post-retirement spending to keep up with inflation. If a significant portion of your post-retirement
expenses are discretionary, it may be ok to assume future spending increases
less than assumed inflation.
These calculations produce a retirement
spending budget replacement ratio (ratio
of first year retirement spending budget to final working year spending budget,
in real dollars (cell E26) under the assumptions entered into
the spreadsheet. It is not unrealistic
to plan on some decline in real dollar spending in the first year of
retirement, as taxes will generally be lower, work-related expenses will be
lower and mortgages may be paid off. How
much of a reduction in your pre-retirement standard of living you are
comfortable with is, of course, the purpose of this exercise. For example, if you are not comfortable with the
estimated decrease in your post-retirement spending, you may need to increase
your Desired percentage of annual gross
pay savings (cell B18) or increase your Desired number of years until retirement (cell B7) or both. Or you may need to increase the PV of
post-retirement part-time work you entered in cell B25 of the Input tab. There are many levers in this spreadsheet you
can vary in your pre-retirement spending/savings budget planning.
Caution: Note that the Runout, Inflation Adjusted Runout,
5-year Projection and Budget by Expense-Type tabs in this
spreadsheet will not be valid for this pre-retirement spending/savings budget
exercise. They were developed to provide
additional information to retirees who have commenced spending their retirement
assets.
