Friday, July 28, 2017

Got “Lumps” in Your Sources of Income or Your Expenses? Smooth Them Out with the Actuarial Approach

Ever notice when you are reading about the best way to spend down your invested assets in retirement how most retirement researchers or retirement experts will demonstrate how well their Systematic Withdrawal Plan (SWP) works by assuming:
  • Sources of retirement income will commence at the same time and will generally only involve Social Security and withdrawals under the SWP 
  • Any other sources of income will commence at the same time, will be paid for life and will generally increase with inflation 
  • Expenses in retirement will be smooth from year to year and will generally increase with inflation 
  • Individuals or couples will develop their annual spending budget by summing their retirement income sources (sum of the sources) each year and will spend exactly this amount every year, and 
  • The family unit’s goal is to have a recurring spending budget (and actual spending) that remains constant in Real Dollars for as long as they live.
For many individuals and couples, these just aren’t realistic assumptions, and application of the expert’s SWP can lead to undesired consequences under more real-world situations.  Amazingly, however, these potential problems don’t seem to stop the retirement researchers from continuing to tout the 4% Rule, the Required Minimum Distribution (RMD) Rule, some variation of these rules or some other rule of thumb SWP as the best way to spend down your assets.  We have previously discussed the potential shortcomings associated with SWPs and “sum-of-the-sources” budgeting if sources of income aren’t “smooth” throughout retirement (most recently in our post of April 9, 2017).  This post will focus on the problems associated with using SWPs that can also occur if expenses in retirement are expected to be “lumpy,” and how the Actuarial Approach can be used to smooth out such lumpy expenses, just as it works to smooth out lumpy sources of income.

How do lumpy expenses affect your annual recurring spending budget?

It is just kind of silly to assume that your expenses are going to remain constant in Real Dollars from year to year.  At some point during your retirement, you or your spouse is going to decide that your house needs a new roof, the kitchen needs to be remodeled, you need one or more new cars, etc.  As the old saying goes, “Expenses Happen.”  And these larger expenses are unlikely to fit into your recurring annual expense budget.  This is why we suggest that you establish reserves for unexpected expenses and other non-recurring expenses (in addition to your reserves for Long-Term Care and bequest motives, and general Rainy Day Funds to dip into if your investments perform poorly).  To the extent that these expenses are covered by reserves for this purpose, there may be no effect on your annual recurring spending budget (although you may have to build the reserves up again for the next unexpected expense, and this could reduce your annual recurring spending budget).

Sometimes these larger expenses, such as home improvements, can be considered as investments that increase (or do not decrease) the total value of your assets.  In this event, the diminution of your accumulated savings may be totally or partially offset by the increase in your home value, and depending on how you plan to use your home to finance your retirement, you may not have to experience a reduction in your annual recurring spending budget by incurring this type of expense.

Other expenses, for which you have established no reserves or that don’t increase the value of some other asset you own, are just large expenses, and you will have to decide whether they are “recurring” or “non-recurring.”  If you can’t (or don’t want to) absorb them entirely in this year’s recurring spending budget), then your assets will be reduced and your next year’s recurring spending budget may be reduced, just as it may be with any asset loss.
You may expect to incur some temporary, but not permanently, expenses over several years.  For example, you may have temporary family loans/support, plans to travel over a defined period of time or remaining mortgage payments when you retire.  As illustrated in the example below, you may wish to establish non-recurring expense reserves for these types of expenses, rather than have them significantly affect short-term and long-term annual recurring spending budgets.

Finally, research has shown that retirees tend to spend less in Real Dollar terms as they age.  If you are comfortable with developing a more “front-loaded” spending budget, you can use the Actuarial Approach to “smoothly” reflect this reality.


Let’s assume we have a retired 65-year old female with:

  • $500,000 in accumulated savings 
  • a Social Security benefit of $20,000 per annum payable immediately 
  • four years left on her home mortgage at $24,000 per annum that she does not want to pay-off early.
For calculation simplicity, let’s also assume that she inputs $0 for
  • bequest motive, 
  • PV Long-Term care costs 
  • PV unexpected expenses

She desires to have constant Real Dollar recurring spending in retirement.  However, she establishes a reserve to pay off her current mortgage of $96,602.

Using the Actuarial Budget Calculator and our recommended assumptions, she determines her annual recurring spending budget for this year to be $37,408.  If all her assumptions about the future are realized, this will be her Real Dollar recurring spending budget for her first year of retirement and for the rest of her life.  If she actually spends this amount plus the $24,000 of mortgage payments from her non-recurring fund, she will spend a total of $61,408.  By comparison, if she used the 4% Rule and didn’t set up a separate mortgage payment reserve, her total spending for her first year would be limited to $40,000, and would be expected to remain at this Real Dollar level throughout her retirement.  In her first year of retirement, however, her non-mortgage spending would only be about $16,000, compared with non-mortgage real dollar spending of $40,000 after her mortgage is paid off.


If you live in the real world where sources of income and expenses may not always follow the simplifying assumptions made by retirement researchers, we encourage you (or your financial advisor) to use the Actuarial Approach to develop a more reasonable recurring spending budget.  Even if your situation is consistent with the assumptions above, we still encourage you to become familiar with and apply our Actuarial Budget Calculators.