Sunday, January 29, 2017

Why the Actuarial Approach Works Even Better

In his January 19 article, “Why this works better than the 4% rule for retirees,” Tom Anderson touts the benefits of using BlackRock’s cost of retirement income (CoRI) index over the 4% Rule for determining how much you will need to retire.  In this post, we point out that if you like the cost-determination concept of BlackRock’s CoRI index for calculating how much you will need to retire, you will like it even better when you use essentially the same cost-determination-concept and the Actuarial Approach to help you calculate how much:
  • you will need to retire, 
  • you will need to save during your pre-retirement period, and 
  • you can afford to spend during your post-retirement period. 
For readers unfamiliar with the CoRI index you can find it here.

BlackRock’s CoRI index and the Actuarial Approach Utilize Essentially the Same Cost-Determination Basis and Spreading Approach

If you use the Actuarial Approach with recommended assumptions and desired increases in future spending budgets equal to the assumed rate of future inflation (i.e., constant real-dollar spending budgets in retirement), you are using approximately the same cost basis (current insurance company annuity pricing) as is anticipated with the CoRI index to spread your adjusted assets (PV of assets minus the PV of future non-recurring expenses) over your expected lifetime planning period after retirement.


This can be illustrated by taking the basic actuarial equation that forms the foundation of this blogsite, and manipulating the terms as we did in our blog post of January 12 of this year, to develop the following equation:





The CoRI index is essentially the same calculation as the PV of future years in retirement, increasing each year by the assumed rate of inflation based on BlackRock’s analysis of current annuity purchase rates.  Here at How Much Can You Afford to Spend in Retirement, we don’t analyze annuity purchase rates every day (like they do at BlackRock) to develop our recommended assumptions, but we do look at them periodically for reasonableness.

The details of the calculations in our Actuarial Budget Calculator (ABC) workbooks are in the PV Calcs tab, where “Present Value of Future Years with Desired Increases” is shown.  This is the present value of future years of retirement used in the equation above, and should be very close to the CoRI index, when you input the recommended assumptions and desired increases equal to inflation into the ABC.  The good folks at BlackRock use somewhat different assumptions for the remaining lifetime planning period after age 65 and use different assumptions for future inflation and the discount rate consistent with life insurance annuity purchase rates, but for spending budgeting purposes, we believe the differences should be fairly insignificant.  The values shown in the ABC workbooks should be somewhat higher since we generally recommend assuming a longer period of retirement.  Since we encourage you to revisit your budget setting process at the beginning of each calendar year, we don’t believe it is necessary to adjust our recommended assumptions unless we become aware of significant changes in life insurance company annuity pricing.

We have no problem if you would rather use BlackRock’s CoRI index in your spending budget calculations if you believe they more accurately represent current insurance company annuity purchase rates.  If you do, however, you will need to solve for the discount rate(s), inflation rate(s) and lifetime planning periods after retirement assumed by BlackRock to develop their CoRI index, so that you can also calculate the present value of your future non-recurring expenses and the present value of IFOS in your budget setting calculations using the equation above.

If you are a big CoRI fan and you think it is time for us to update our recommended assumptions to reflect current insurance company annuity pricing, please let us know and we will review the relevant data and make appropriate changes.

Saturday, January 21, 2017

How Much Retirement Savings Will You Need to Feel Financially Secure?

The $64,000 question for individuals and couples who are planning for retirement is “How much do we need to retire?”  This post will discuss some of the factors you might want to consider in developing a reasonable estimate of retirement savings needed, or your “number”, and encourage you to use our workbooks to obtain this number rather than simply guessing.

But first, let’s bring out Steve Harvey and play a little “Family Feud” to see what a survey says.   The 17th Annual Transamerica Survey Retirement Survey of American Workers posed the question of how much retirement savings is needed.  The results shown on page 50 of the survey were:

Estimated Retirement Savings Needs

  • Less than $100,000     15% 
  • $100,000 but less than $500,000     21% 
  • $500,000 but less than $1,000,000     21% 
  • $1,000,000 but less than $2,000,000     23% 
  • $2,000,000 or more     20%
The median answer was $500,000.  Somewhat surprisingly, the median answer in the previous year’s survey was $1,000,000.
 

Page 51 of the survey summarized the basis reported by respondents to make their estimate of retirement savings needed.  The answers reported were:
 

Basis for Estimating Retirement Savings Needed
  • Guessed     47% 
  • Estimated based on current living expenses     23% 
  • Used a retirement calculator     9% 
  • Expected earnings on investments     6% 
  • Read / heard that is how much is needed     5% 
  • Amount given by a financial advisor     4% 
  • Completed a worksheet / did calculation     4% 
  • Other     2%
Given that more than 50% of the respondents (47% guessed and 5% read/heard something) didn’t crunch any numbers to develop their estimate, perhaps it is not all that surprising that the median answer changed so significantly from the previous year’s survey.  And while it is more fun to play Family Feud with survey information rather than sitting down and crunching your numbers, you just aren’t going to get much useful information unless you look at your own situation and goals for retirement.  Below are some factors you will want to consider.  All of them will affect the estimate of how much you will need at retirement.
 

Factors to Consider When Developing an Estimate of Retirement Savings Needed at Retirement
  1. Are you planning for just yourself or for your household? 
  2. In addition to Social Security, what other sources of income will you be relying on in retirement?  For example, do you have a company pension benefit or do you plan to work in part-time employment after retirement (a popular answer in the survey)?  How will you use your home equity to fund retirement liabilities? 
  3. When do you (and your spouse) plan to retire and when do you (and your spouse) plan to commence Social Security benefits or other sources of income?  Do you have a reasonable estimate of what your Social Security benefits will be at different ages of commencement? 
  4. What is the standard of living that you and your spouse are trying to replace in retirement? 
  5. How will you address long-term care costs and other non-recurring costs, such as unexpected expenses and bequest motives? 
  6. What are your assumptions for future investment return on your accumulated savings, length of retirement planning period and future inflation? 
  7. Is your estimate based on today’s dollars or future inflated dollars? 
  8. How do you expect your spending to increase in retirement?  Will spending needs increase with expected future inflation or will spending needs decrease in real dollars as you age? 
  9. What does it really mean for you to “feel” financially secure?
Using Basic Actuarial Principles and our Workbooks to Derive a More Reasonable Number
 

The basic actuarial equation matching household assets and liabilities that is the foundation for this website is:


 

To solve for how much accumulated savings/invested assets are needed at retirement in today’s dollars, all we need to do is subtract the PV IFOS from both sides of the equation to obtain:




where these calculations are performed as of the expected time of retirement using today’s dollars.  The necessary calculations can either be performed using our Present Value Calculator spreadsheet (PVC) or either of our Actuarial Budget Calculator workbooks (ABC).  For example, using our ABC for Retirees, you would follow the process below.

  1. Enter expected IFOS data, expected PV future non-recurring expenses and assumptions about the future (including future increases in spending budgets) in today’s dollars as of your expected retirement age. 
  2. Solve for the current value of investments/accumulated savings that gives you your desired first year spending budget.  This current value of assets that produces this desired first year spending budget is your reasonable estimate of retirement savings needed, or your estimated “number” at retirement in today’s dollars.
While many individuals believe that Social Security will not be their primary source of income in retirement, historically it has been the primary source for a large percentage of retirees and, in today’s low interest rate environment, the relative value of this source of retirement income is even greater today than in prior years.  Therefore, it is important for most individuals to obtain accurate estimates of these benefits.  We discussed our recommended approach for obtaining reasonable estimates of these benefits using the Social Security Quick Calculator in our post of October 12, 2016.  If you use this calculator, be sure to check to see results in “today’s dollars.”
 

It is important to remember that in addition to covering the present value of your future recurring spending, your assets at retirement will also need to cover the present value of your non-recurring expenses.  So, those expected expenses for new cars and your kitchen remodeling will either need to be covered by your estimate for non-recurring expenses or by your recurring spending budgets.
 

The next step in estimating your number will be to determine your desired first-year spending budget and the assumption for how you want this spending budget to increase in years after your retirement.  Most people want to maintain their pre-retirement standard of living.  In fact, 59% of the respondents in this year’s Transamerica survey indicated that they expected their standard of living to stay the same or increase in retirement (page 25).  Well, what does having the same standard of living mean?  We believe a reasonable interpretation of having the same standard of living means that spending after retirement will be approximately the same as spending prior to retirement.  For most individuals or couples, this means they will need to replace somewhere in the neighborhood of 75% of their pre-retirement gross income.  This percentage assumes that the individual or couple was saving about 10% of pay prior to retirement and will no longer have work-related expenses or pay FICA taxes.  They will probably also have somewhat lower income tax requirements.  Individuals or couples who were saving more than 10% of pay prior to retirement may target a lower percentage of pay to replace the same standard of living.  Those who want to do a fair amount of traveling or have more expensive plans for retirement activities may wish to target a somewhat higher replacement rate. For purposes of calculating your first-year spending budget target in today’s dollars, the replacement percentage you select should be applied to your current gross pay.
 

Once you determine your number, you can use the ABC for Pre-retirees to see how much you may need to save each year to reach your reasonable estimate of retirement savings needed, or your “number” (both in real and in nominal dollars).
 

Lots of Levers to Pull
 

If you don’t like the answer you get using the process above on your first attempt, try again.  There are lots of levers you can pull to get a different answer.   For example, you can change:
  • Your anticipated retirement age 
  • Assumptions about the future 
  • Your target replacement rate or the rate of increase of your spending budget after retirement 
  • Assumed income from other sources (including part-time employment) 
  • Assumed non-recurring expenses, etc.
The idea here, however, is not simply to change data or assumptions until you get an answer you like, but rather to help you in your financial planning. 
 

Conclusion

No one really knows how much you will need to save for you to feel financially secure at retirement.  No one knows how long you and your spouse will live or what the future holds for you in terms of your spending, your health, your investment returns or for inflation.  For that matter, no one, except possibly you, knows what does or doesn’t make you feel secure.  So, the concept of a “number” that works for everyone is just ridiculous.  The best any of us can do is to make our best estimates about the future, plan accordingly and be prepared that our assumptions will probably be wrong.  Or, you can just guess.  It is up to you. 

Thursday, January 12, 2017

Another Call for a Paradigm Shift in Retiree Spending Budget Thinking

In our post of October 27 of last year, we called for a paradigm shift in thinking about the use of a strategic withdrawal plan (SWP) in the development of a reasonable spending budget in retirement.  This post was followed by an article in Advisor Perspectives and our post of December 21, where we somewhat facetiously called for attachment of an “Actuaries’ Warning Label” to SWPs.  In these communications, we warned that the Old Paradigm of simply adding the amount determined under an SWP to income from other sources (IFOS) for the current year may not produce a spending budget that is consistent with the retiree’s spending goals.

Old Paradigm:  Take x% of invested assets per SWP and add to IFOS, to get this year’s spending budget.

We apologize to our readers who have already grasped the importance of changing their thinking about SWPs.  Unfortunately, there are still quite a few financial advisors and retirement experts out there who still don’t get it.  Why?  We can only imagine that it is due to a combination of several factors, including:

  • Poor communication skills on our part 
  • Lack of awareness of our call for change 
  • The Old Paradigm is strongly ingrained and some just don’t want to deal with a New Paradigm
Because we feel strongly about this subject, we are going to take another shot in this post at explaining the problems with the Old Paradigm and the benefits of using the New Paradigm.  We are going to do this by manipulating the basic actuarial equation, discussed in this website, to try to make our points clearer to those who are still having trouble grasping the issue.  It is our hope that after reading this post you will come away with two main take-aways:

Take-Aways

  1. You shouldn’t just start developing your budget by spreading your current investments over your remaining lifetime using an SWP formula, as suggested by many retirement experts.  Before you develop a spending budget for recurring annual expenses, you need to set aside assets for future expected non-recurring expenses, such as long-term care expenses, unexpected expenses and amounts desired to be left to heirs.  This may involve determining the present values of at least some of these future expenses, and subtracting the results from your current investments.
     
  2. If you want to develop a recurring spending budget that is consistent with your retirement goals, you should spread the present value of your IFOS over your expected retirement period, and add the result to your SWP amount for the year (or you can simply use the actuarial approach set forth in this website rather than using an SWP approach).
Manipulating the Basic Actuarial Equation to Develop the New Paradigm

The basic equation for personal financial planning in retirement that is the foundation for this website is Equation (1):




where PV IFOS is the present value of your (and your spouse’s) future retirement income from all other sources and includes Social Security income, pension income, annuity income, income from part-time or full-time employment, proceeds from future asset sales, rental income, etc.

We now want to solve this Equation (1) for this year’s spending budget.

Step 1: Subtract PV Future Non-Recurring Expenses from both sides of Equation (1) and re-arrange terms, to get Equation (2):




Step 2: After deciding on the desired rate of increases in future recurring spending budgets (x%), divide both sides of Equation (2) by the present value of $1 payable per year for the expected lifetime planning period and increasing by x% per year (PV future years increasing by x%).  The result can be expressed as Equation (3):




Equation (3) supports the two take-aways discussed above.  The first item on the right-hand side of Equation (3) tells us that we must first reduce the current value of assets by the PV Future Non-Recurring expenses before we spread the net value over the retiree’s expected lifetime.  This is what you want your SWP to do (if you insist on using one).  The second item on the right-hand side of Equation (3) supports the second take-away discussed above.  It tells us that instead of adding the SWP amount to IFOS for the year to develop your spending budget, you should add the SWP amount to the present value of IFOS spread over the future expected lifetime.

When is the Old Paradigm Ok?

Under certain limited circumstances, the Old Paradigm will produce the same answer as the New Paradigm.  To accomplish this, advocates of SWPs will typically assume that:

  1. non-recurring expenses are separately funded elsewhere 
  2. IFOS consists only of immediate Social Security benefits or perhaps of immediate life annuity benefits indexed to inflation, and the retiree desires future spending budgets to be constant in real dollars.
Under these convenient assumptions, the present value of IFOS spread over the retiree’s future lifetime will be equal to the IFOS for the year, and the Old Paradigm will work.

In many instances, however, the two assumptions above necessary to make the SWP approach work will not be consistent with reality.  We can probably work around the first assumption relative to non-recurring expenses, but it isn’t all that easy to work around the second assumption relative to constant IFOS.  For example, my wife is younger than I.  I have started receiving my Social Security benefits and my company-provided pension.  She, however, wants to commence her company-provided pension in 6 years and wants to commence her Social Security benefit in 11 years.  In addition, I have a QLAC (deferred life annuity) scheduled to commence in 18 years.  We clearly don’t have the constant IFOS needed to make the Old Paradigm work well (and even if we did, we might not be happy with the Old Paradigm requirement that future spending budgets to be constant from year to year in real dollars).

But don’t just take our word for it.  Go to the Actuarial Budget Calculator (ABC) for Retirees in this website and develop a spending budget by entering different sources of income and different starting dates for this income.  Then go to either of the runout tabs and look at the expected pattern of future withdrawals from accumulated savings.  You aren’t going to find a “systematic” pattern of withdrawals.

The simple answer for most individuals or couples, who don’t live in a retirement researcher’s artificial bubble, is to avoid SWPs.  Just because the researchers may use Monte Carlo modeling with 10,000 (or more) simulations, to project the future to compare various esoteric SWPs, doesn’t make these SWPs any more relevant to individuals or couples who have several sources of income.  Yes, to get a more reasonable spending budget, we might have to calculate a present value or two.  But, we make that task easier for you (and your financial advisor) with our Actuarial Budget Calculator and Present Value Calculator on this website.

Those individuals and financial advisors who insist on staying with their SWPs, and who set aside sufficient assets for non-recurring expenses, will also need to appropriately adjust IFOS to develop a reasonable spending budget in instances where IFOS is not expected to be constant from year to year.  To add confusion to this issue, it is our understanding that many financial advisors who claim to use SWPs do, in fact, do these adjustments.   It is important to note, however, that if these financial advisors perform these adjustments correctly, withdrawals from current investments (increased or decreased as necessary for the difference between actual IFOS and adjusted IFOS) will not necessarily be equal to the amount determined under the SWP algorithm, so these financial advisors aren’t technically using SWPs and the Old Paradigm.


Sunday, January 8, 2017

4 Keys to Winning the Financial Security Game

Depending on many factors that are usually somewhat out of one’s control, winning the Financial Security Game can either be a relatively easy process, or it can involve a significant amount of hard work, sacrifice and patience.   You can be lucky and marry someone with lots of money, inherit lots of money, discover a rich gold-mine in your back yard or win a Megabucks lottery.  Or, you can take the more traditional approach:  you can work for many years and prudently spend and save until you think you have accumulated enough assets to feel financially secure.

Generally, there are four keys to winning the financial security game:

  1. Accumulate your assets 
  2. Grow your assets 
  3. Protect your assets 
  4. Find the right balance between Trade-offs
This post will discuss, in general terms, how you can go about trying to win the Financial Security Game.  Unfortunately, since we don’t have the phone numbers of attractive and wealthy potential mates, locations of gold-mines or future winning lottery numbers, we will focus mostly on the more traditional approach to achieving financial security.

Accumulate Your Assets


The first step toward achieving financial security is to begin to accumulate assets.  Note that these should legally be your assets.  So, if you have married someone with lots of money or you expect to receive a large inheritance (or you expect to win the lottery), you should exercise some caution in your financial planning with respect to those assets until you actually have a legal right to them. 


As frequently noted in this website, the basic actuarial equation for determining how much you can afford to spend (a key determinant of financial security) depends on how much assets you accumulate. 

This equation can be stated as follows:


Where the items on the left-hand side of the equation are your assets and the items on the right-hand side are your spending liabilities. 

Generally, the traditional way to accumulate assets is to become gainfully employed and spend less than one’s employment income (save).  For younger individuals interested in becoming financially secure, this should be a high priority as the current value of their investments is likely to be fairly small and therefore their only significant asset to be tapped for future spending is going to be their future savings.

Grow and Protect Your Assets


Once you have accumulated some assets, your financial life becomes more complicated as you will now need to grow and protect those assets.  These two objectives can often be conflicting.   The following tables show financial priorities for growing and protecting assets for younger pre-retirees and for older retirees/near retirees. 



click to enlarge



click to enlarge


In developing these priority tables, we have assumed that younger pre-retirees will continue to grow and protect their assets until they decide that they have enough to retire.  Therefore, their top “asset growing” financial priorities will generally continue to be saving a significant portion of their employment income (inside employer sponsored plans or outside), earning Social Security benefits, earning pension benefits (if available) and investing accumulated assets.  While their focus is primarily on growing their assets, they must also be concerned with protecting the assets they have already accumulated and expected future income.  This is accomplished mostly through various types of insurance.  For example, life insurance or disability insurance can be very important for replacing future expected income for affected young families with children. 

As individuals get close to retirement or reach retirement, their financial priorities generally shift somewhat.  While they still must grow their assets (generally by investing them), they must also protect their (now presumably much more significant) assets to make sure that they last for the rest of their lives.  Therefore, they may choose to consult with an investment manager/Financial Advisor.   A good Financial Advisor will help them develop an investment plan (to continue growing assets) as well as a spending plan that meets their financial goals in retirement (which presumably includes not outliving assets).   In addition to possibly investing their assets more conservatively than younger individuals, retirees and near-retirees will generally select different forms of insurance than younger individuals to protect against relevant risks.

Of course, pre-retirees, retirees and their financial advisors can use our Actuarial Budget Calculators (ABC) to help develop savings strategies (generally for pre-retirees), spending strategies (generally for retirees) and for determining when they may have enough assets to afford to retire.  If you develop a spending/savings budget as an individual or as a couple, you might also want to develop separate “contingency” budget strategies based on alternative assumptions about the future, including assumptions that:

  • your current employment ceases,  
  • your significant other dies, 
  • you get divorced or 
  • one of you becomes disabled or requires long-term care,
You can also use the 5-year projection tabs to model the impact of variations in investment returns and spending.  This “contingency” modeling may be helpful in selecting types of insurance to protect your assets, deciding on an appropriate investment strategy or simply developing “what if” strategies for planning purposes.

Finding the Right Balance Between Trade-offs

Unless you are one of the extremely lucky few who suddenly comes across a big pile of money, it is not necessarily an easy task to win the Financial Security Game these days.  There are a lot of trade-offs involved and opportunities to make mistakes.  In addition to the trade-off whether to grow assets or to purchase insurance to protect your assets, you must choose how much you can afford to spend today vs. how much you will be able to spend in the future.  These decisions would be much easier to make if you could only predict your (and/or your significant other’s) future employment, lifetime, health, investment returns on your assets, inflation, inheritances, etc.  Unfortunately, we just don’t know what the future holds.  Therefore, we must make our best-estimate (or conservative) assumptions about what the future holds and be prepared when our assumptions inevitably turn out to be wrong.

Tuesday, January 3, 2017

How Did You Do Last Year?

We encourage retirees to maintain a record of prior years’ spending budget calculations and prior years’ expenses.  This historical information can 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.  So, every year around this time, in addition to encouraging you to develop your new year’s spending budget (and saving this information), we also encourage you to take reasonable steps to compile and save useful information regarding your actual spending for the previous year.

In addition to comparing your actual spending with your spending budget for the previous year, it may be helpful to determine how much of your spending was for the following expense types:

  • essential non-health related expenses, 
  • essential health related expenses, 
  • non-essential expenses and 
  • unexpected expenses
If your history shows that you have constantly overspent your spending budget (in total or by expense type), you may be understating your spending needs when developing your budget.  Or, if your history shows that your overspending relative to your budget is increasing from year to year, this can be a signal of financial problems on the horizon.  On the other hand, a history of ever widening under-spending relative to your spending budget provides evidence that you may be too conservative with your spending.

If you don’t use the Actuarial Budget Calculator (ABC) workbook with recommended assumptions to develop your spending budget, you may want to track the difference over time between your spending budget and the budget developed under the ABC with recommended assumptions.  If your history shows a widening of the gap between your calculated spending budget and the ABC amount, you may wish to revisit how you develop your spending budget.

Do you need to track your spending exactly?  While it may be helpful to do so, particularly if you develop your spending budget as the sum of several different categories, it probably isn't necessary.  If you know all of the items in the equation below other than your spending, you can solve for the amount you spent during the year.





Regarding the other important assumptions used in developing your spending budget, you can also track how well you did on your investments vs. your assumed rate of return, and actual inflation vs. assumed inflation.  Of course, every year that you and your significant other (if you have one) survive to work on a new year's spending budget should be considered a good year.

Happy budgeting and wishing you all the best in 2017.

Monday, January 2, 2017

Recommended Smoothing Approach for Actuarially Calculated Spending Budget in Retirement


As discussed many times in this website and in the Workbook Overview tab of our Actuarial Budget Calculator (ABC) for Retirees:

The ABC produces an actuarially determined spending budget that balances a retiree’s current assets with his or her future spending liabilities.  This actuarial spending budget can and will increase or decrease from year to year based on many factors, including actual investment performance, actual spending, changes in assumptions used to estimate spending liabilities, etc.  There is no requirement to spend the actuarial spending budget each year.  A retiree can spend more or less than such budget, can decide to smooth such budget or can decide to smooth actual spending from year to year.

All things being equal, most retirees prefer relatively predictable spending budgets in retirement.  On the other hand, most retirees have at least some of their retirement assets invested in risky assets that can fluctuate from year to year.  Too much smoothing of spending can subject the retiree to significant sequence of return risk.  Not enough smoothing can cause unnecessary and undesirable fluctuations in spending.   Several of our readers have asked us for our recommended algorithm for smoothing the actuarially calculated spending budget.  While there is no one perfect approach, we like the approach we initially recommended in our post of October 11, 2013 which is an attempt to balance the smoothing characteristics inherent in a “static” safe withdrawal approach with the asset/liability balancing inherent in the “dynamic” actuarial approach.

Recommended Smoothing Algorithm

The recommended smoothing algorithm involves taking the spending budget amount from the previous year, increasing that amount by the desired increase in spending budget for the previous year (relative to actual inflation) and testing that the resulting value is not more than 110% of, and not less than 90% of, the current year’s actuarially determined value.  If the previous year’s adjusted value falls within this corridor, that adjusted value becomes the spending budget for the current year.  If the previous year’s adjusted value falls above or below the corridor limit, the applicable corridor value is used as the current year’s budget.

Example

For example, consider Sarah, a sample retiree, who wants her spending budgets in retirement to remain relatively constant from year to year, measured in real dollar terms.

Let’s assume her 2016 spending budget was $40,000, while her 2017 Actuarial Spending Budget from the ABC for Retirees workbook is $46,000.  She wonders whether she can safely increase her spending budget for 2017 in real dollar terms.

The steps she uses in utilizing the recommended smoothing algorithm are:

A. Increase her 2016 Spending Budget by actual inflation (this is her preliminary 2017 spending budget),
B. Determine the 10% corridor around her 2017 Actuarial Spending Budget,
C. Test where her preliminary 2017 spending budget falls relative to the corridor determined in step B above.

Because the cost-of-living increase for 2017 Social Security benefits is 0.3%, she assumes that the actual cost of living (or inflation) for 2016 for purposes of her calculations is this same 0.3% (https://www.ssa.gov/cola/).

Step A:  Sarah’s 2016 spending budget increased by actual inflation is:

$40,000 x (1.003) = $40,120.  This is her preliminary 2017 spending budget
                                                  
Step B:  The 10% corridor around her 2017 Actuarial Spending Budget is determined to be:

Lower end of corridor = 90% of 2017 Actuarial Spending Budget = (.9 x $46,000 = $41,400)

Upper end of corridor = 110% of 2017 Actuarial Spending Budget = 1.1 x $46,000 = $50,600.

Step C:  Sarah tests to see whether her preliminary 2017 spending budget falls inside or outside the 10% corridor around her 2017 Actuarial Spending Budget of $46,000.  She determines that it is slightly below the lower end of the corridor, so she decides to increase her spending budget for 2017 from the preliminary value of $40,120 to the lower end of the 10% corridor of $41,400. 

Note that if Sarah has decided that she wants her future spending budgets to increase by inflation minus 0.5% each year (to front-load her spending in real terms), then strict application of the recommended algorithm would involve calculation of a preliminary 2017 budget equal to $39,920 ($40,000 x .998).