Thursday, September 29, 2016

How Much Do You Really Need to Save Each Year to Achieve Your Financial Goals?

Since its inception in 2010, this website has been primarily focused on helping retirees develop a spending budget in retirement.  We have advocated using several basic actuarial principles to do this.  The first basic actuarial principle involves matching your assets with your spending liabilities using this balance equation:

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.