Sunday, November 20, 2016

Using Multiple “Data Points” to Determine How Much You Should Spend

The primary purpose of this website is to help individuals (with possible assistance from their financial advisors) determine how much they can afford to spend each year.  Our website was initially established in 2010 to help retirees with this issue, but we have recently expanded the scope of our purpose to address this issue for pre-retirees as well.  We have developed several spreadsheets that utilize basic actuarial principles to help individuals develop reasonable spending budgets.  And while we believe the development of a reasonable spending budget is an important part of an individual’s spending decision process, it is but one “data point” of several  that may be considered.  This post will discuss other possible data points that may also be useful in your spending decision process.

Applying the ABC Data Point

The Actuarial Budget Calculator (ABC) contained in this website determines a spending budget for the current year by mathematically balancing an individual’s assets (current assets and the present value of future income from other sources) with her current and future spending liabilities.  Thus, significant increases or decreases in the individual’s current assets from one year to the next can result in some volatility in the actuarially calculated spending budget from year to year.  As we have said many times in this blog, we have no problem if a retiree chooses to smooth her spending budget from year to year or to smooth her actual spending.  In fact, we have suggested that retirees consider establishing a “rainy day fund” after one or two favorable investment years to be available in subsequent unfavorable years as one approach to mitigate such fluctuations.  Thus, last year’s spending level may be another “data point” to consider.

The ABC with Recommended Assumptions Data Point

We understand that some of the users of the ABC do not use the recommended assumptions to determine their spending budgets.   These users may feel that because they invest a significant portion of their assets in risky investments, our recommended investment return/discount rate is too conservative and does not represent their best estimate.  We also understand that some retirees and/or their financial advisors may use any number of non-actuarial approaches to determine spending budgets.  And this is fine, too.  We don’t insist that the ABC using recommended assumptions is the one and only true answer.  However, we do suggest to these individuals that they also run the ABC with the recommended assumptions as another data point, for comparison purposes.  The ABC with recommended assumptions produces an actuarially calculated spending budget under the assumption that assets will be invested in relatively low-risk investments (approximately interest rates imbedded in life annuity products).  A significant positive difference between the retiree’s spending budget and this actuarially calculated budget can provide a measure of how much extra risk the retiree is “capitalizing” through his or her investment strategy.  In any event, running the ABC with recommended assumptions provides another data point that tells the retiree how far off the “actuarially balanced” track she may have strayed with her current spending strategy.

ABC Run-Out Tabs Data Point

The ABC also provides run-out tabs that show future spending and assets if all assumptions are realized in the future and spending exactly follows the budget plan.  In situations where the retiree expects to receive income from deferred sources (such as from a future sale of an asset or from deferred annuity contracts) the run-outs may show assets declining precipitously prior to receipt of the deferred income if spending continues course.  In such situations, the run-out tab information can serve as another data point in the spending decision process.

ABC 5-Year Projection Tab Data Point

In the 5-year projection tab, the ABC also provides the capability to model future investment and spending experience that differs from assumptions.  The results of this tab can be useful for developing contingency plans in the event actual experience deviates significantly from assumed experience and can also provide another data point in the spending decision process.

As indicated in our post of October 31 of this year, the run-out tabs also indicate what next year’s assets will be if all assumptions are realized during the budget year and spending exactly follows the budget, so this number is also another data point in determining this year’s spending if it looks like assets at the end of the year will be significantly different from this number.

Historical Record Data Points

We encourage retirees to maintain a record of prior years’ spending budget calculations and prior years’ expenses.  This historical information can also serve as additional data points to help with future spending decisions.  The information can also be useful in selecting assumptions about the future, particularly about future assumed increases in various types of expenses.

Your Gut Instinct

As we said in our post of October 17 of last year, “Unlike many experts who think that most retirees aren’t smart enough or motivated enough to manage their own money, I believe that most retirees possess the necessary skills to successfully manage their finances in retirement, much like they successfully managed their finances when they were employed.  Of course, for those retirees who can afford one, a financial advisor can be very helpful in this process.  However, when push comes to shove, it is you, Mr. or Ms. Retiree, who are ultimately responsible for making the investment and spending decisions that affect your financial situation during your retirement.”  This brings us to our final data point – your gut instinct.  As we have said many times in this website, it is ok to spend less than your spending budget.  It may also be ok to spend more sometimes (but, please don’t use this as your excuse for running out and buying a big boat).  Once you have gathered sufficient information, you and your significant other, if you have one, need to make the final call on your spending.

Gathering all these data points to make spending decisions may seem like a lot of extra work.  For some retirees (those with just one or two sources of retirement income, for example), it may not be necessary or worthwhile to gather this additional information.  For those with more complicated situations (including those with multiple sources of retirement income), it may.  You must find the appropriate balance between the time you spend managing your retirement and just enjoying your retirement.  We are here to help you (or your financial advisor) find the best answer for your specific situation.