Tuesday, August 8, 2017

Budgeting to Meet Your Spending Goals in Retirement vs. Cobbling Together Sources of “Lifetime Income”

This post is a follow up to our post of April 9, 2017, The Whole is Greater than the Sum of its Parts (and several other of our previous posts) where we maintained that using the Actuarial Approach advocated in this website is superior to summing up sources of lifetime income (Sum of the Sources) for developing a reasonable spending budget designed to achieve your spending goals in retirement.  This post will include a “real world” example that we believe will demonstrate why it is worthwhile to spend the extra half hour to crunch your numbers using the Actuarial Approach, rather than to rely on a Sum of the Sources approach.

We at How Much Can I Afford to Spend are retired pension actuaries, not insurance company actuaries, academic retirement researchers, financial advisors, or investment advisors.  Our primary mission is to provide you (or your financial advisor) with an actuarial framework that can be used to develop an annual spending budget that reflects your specific situation and your lifetime spending goals.  It is not our mission to:

  • Convince you to buy lifetime income products from insurance companies 
  • Advise you on the best way to invest your assets 
  • Influence public policy to encourage plan sponsors or financial institutions to offer “lifetime income” options from qualified defined contribution plans or IRA’s 
  • Refine existing research relating to retirement, or 
  • Develop the optimal Systematic Withdrawal Plan (SWP) so that withdrawals under such plan may be added to other sources of lifetime income.
We are disappointed that the major actuarial organizations in the U.S. appear to be more focused on advocating the cobbling together of various lifetime income “solutions” (including lifetime income insurance products and SWPs) than advocating the use of basic actuarial principles to help individuals achieve their spending goals.  The American Academy of Actuaries (AAA) actually sponsors a Lifetime Income Initiative which claims, “The Academy has identified lifetime income as a top public policy issue and strongly supports initiatives that will lead to more widespread use of lifetime income options.”

We will be the first to admit that the actuarial calculations required to develop a reasonable spending budget, that reflects your specific situation and that is consistent with your goals, can be somewhat complicated.  For this reason, we have tried to make these calculations a little bit simpler by developing our Actuarial Budget Calculators (ABC).  Sometimes, however, your personal situation may not be adequately handled by the ABC.  In these situations, we recommend that you go back to the basics and apply the Basic Actuarial Equation to develop your spending budget.  The following is an example of such a calculation.


Data and Goals
Bill and Betty are a married couple who have retired and both are in relatively good health.  Bill is age 65 and has already commenced his Social Security benefit.  Betty is age 55.  They have a daughter.  Their financial goals include:

  • Betty would like to maximize her Social Security benefits 
  • Neither would like to become a burden on their daughter 
  • They don’t want to outlive their assets 
  • The would like to earmark $20,000 per year in real dollar spending for the next 20 years for travelling expenses, as they are quite interested in travelling while they are able to do so. 
  • They desire relatively constant real dollar non-travel spending from year to year while they both are alive, with about 2/3rds of such real dollar spending to continue after the death of the first spouse.
  • They plan to use about 1/2 of their existing home equity to finance recurring expenses, leaving the other half to finance expected long-term care costs.  They understand that they may have to downsize or take some other action during retirement to extract home equity assets. 
  • They establish an initial reserve for unexpected non-recurring expenses of $100,000. 
  • They have no desire to establish a separate reserve to fund a bequest motive for their daughter.  They understand that it is likely that some assets will remain for this purpose at the second death of the couple.
Bill’s assets:
  • Bill has commenced his Social Security benefit of $20,000 per annum 
  • Bill has a QLAC (deferred annuity contract) that will pay $20,000 per annum for his life, commencing at age 85
Betty’s assets:
  • Betty estimates (by using the Social Security Quick Calculator) that her Social Security benefit will be about $35,000 per annum if it commences at age 70 
  • Betty has a pension benefit that will pay her $12,000 per annum for her life, commencing at age 65
Joint assets:
  • The couple has combined accumulated savings (pre-tax and post-tax) equal to $1,000,000 
  • The couple estimates that the equity in their home is currently $600,000, with no mortgage.

For present value calculations, Bill, Betty and their financial advisor have selected:

  • 4% annual discount rate 
  • 2% annual rate of inflation 
  • Using the Actuaries Longevity Illustrator and a probability of survival of 25%, they determine that:
o    Bill’s lifetime planning period is 29 years,
o    Betty’s is 42 years, 
o    the expected period at least one of them alive is 42 years and
o    expected period both are alive is 27 years.
  • The couple expects their home equity will increase at 4% per annum, the same rate of annual increase as assumed for their other investments. 
  • The calculations of the present values in the table below can be duplicated using either our ABC (Retiree) or Present Value Calculator spreadsheets.
Actuarial Balance Sheet

Here is Bill and Betty’s Actuarial Balance Sheet

(click to enlarge)

The left-hand side of the Actuarial Balance Sheet shows the present value of Bill and Betty’s assets, and the right-hand side shows the present value of their spending liabilities.  Note that the total of the present value of their assets (the left-hand side) must equal the present value of their spending liabilities (the right-hand side).  The present value of Bill and Betty’s future recurring spending budgets ($1,946,707) is the balancing item that makes the totals equal (balance).

Spending Budgets

The final step in developing Bill and Betty’s first year spending budget is to divide the present value of their future recurring spending budgets shown above ($1,946,707) by the present value of their future years of life, based on the assumption that the spending budgets will increase by inflation of 2% per year until the first death, at which time real dollar spending budgets will be reduced by a third.  The calculation of this present value of future years (27.1890) is discussed in our post of July 4, 2017.  The resulting budget is the sum of:

  • non-travelling recurring spending of $71,599 ($1,946,707 ÷ 27.1890), plus 
  • their travelling budget for the year of $20,000, 
  • for a total spending budget for this year of $91,599.
If all assumptions are realized in the future, Bill and Betty’s spending budget is expected to increase each year with inflation for the first 20 years, after which it would be expected to drop to $71,599 (when their 20-year temporary travelling budget expires) in real dollars until Bill’s expected time of death, at which it would be expected to drop to $47,733 (2/3rds of $71,599) in real dollars.

“Sum of Sources” approach

By comparison, if they had used the “Sum of Sources” approach and used the 4% Rule for their SWP, their initial total spending budget would have been only $60,000 (Bill’s $20,000 Social Security benefit plus 4% of their accumulated savings of $1,000,000).  Of course, when Betty’s Social Security, Betty’s pension and Bill’s QLAC actually kick in, their spending budget under this Sum of Sources approach would be much higher in real dollar terms.  By that time, however, it might be too late for Bill and Betty to enjoy the travelling they so desired.  By using the Actuarial Approach, they increased their initial spending budget by almost 53% and, on an expected basis, satisfied all of their spending goals.

Note that if Bill and Betty’s spending goals included relatively constant real dollar non-travel spending on “essential expenses” (which they estimated to be $45,000 per annum while they are both alive) and declining real dollar spending on non-essential expenses (inflation minus 1% per year), their first-year spending budget could have been increased to $96,091, or about 60% greater than under the Sum of the Sources approach.

Final Words

You only get one attempt at enjoying your retirement.  There is no opportunity for a “do-over.”  This is why we believe it is important for you to spend a little bit more time and use basic actuarial principles to develop a reasonable plan (and spending budget) that is consistent with your spending goals rather than cobbling together sources of lifetime income.