You should be aware that increasing spending earlier in your retirement will increase the probability that you will need to reduce spending later, all things being equal. Also, investment in riskier assets in the hope of achieving higher returns will generally increase spending volatility. Therefore, if you do implement a more aggressive investment or spending strategy with respect to your upside portfolio, you will want to be comfortable accepting these risks. Depending on your tolerance for risk, you will want to carefully select which of your expenses you consider to be essential and which are truly discretionary. As our friend Dirk Cotton said, “the most important decision you will make in retirement planning is how much of your resources to allocate to the upside and floor portfolios. The correct balance [between floor and upside portfolios] will depend on how willing you are to risk losing your standard of living for the chance of having an even higher one.”
Workbook Default Assumptions
We recently changed the default assumptions in our ABC workbooks to the following:
Investment
Return/Discount rate
|
3.5%
per annum
|
Inflation/Desired
future increases in future recurring expenses
|
1.5%
per annum
|
Lifetime
Planning Period
|
25%
probability of survival for a healthy non-smoker male or female from the Actuaries Longevity Illustrator
|
These assumptions are intended to be approximately equivalent (in the aggregate) to assumptions used by Principal Insurance actuaries to price inflation-adjusted annuities in the U.S. And while we believe the default assumptions are reasonable for pricing essential spending liabilities, we acknowledge that they may be somewhat conservative for pricing discretionary spending liabilities (or all post retirement spending liabilities for younger pre-retirees). So, the example below will walk you through how you can use our workbooks with the default assumptions to first price your essential spending liabilities and then use more aggressive assumptions to price your discretionary spending liabilities.
Example
On January 1, 2020, John will be a 62-year old single male retiree with $1 million in accumulated savings. He will be eligible to receive an annual Social Security benefit of $13,761, but he has decided that he will defer commencement of his benefit until he reaches age 70. Using the default assumption for inflation, he estimates his Social Security benefit will be $27,252 if it commences at age 70. To simplify the calculations, we are going to assume that he has no bequest motive, his long-term care expenses will be covered by equity in his home, and he has no other expected or unexpected non-recurring expenses other than:
- Three years of extra medical expenses of $5,000 per year increasing at 2.5% per year
- A new (to him) car expected to cost $20,000 in five years
- Travel expenses of $10,000 per year increasing with inflation each year until he reaches age 80
 |
| (click to enlarge) |
The above screen shot of the Input & Results tab of the Actuarial Budget Calculator for Single Retirees for John shows the input items and develops a total spending budget for 2020 of $65,575, consisting of a recurring spending budget of $50,575 and a non-recurring spending budget of $15,000 (consisting of extra medical expenses of $5,000 plus travel expenses of $10,000).
John then goes to the Asset Reserves by Expense Type tab and enters the following for his expected Recurring Expenses and future expected percentage increases in those expenses:
Recurring Expenses
|
Current Year Annual
Amount
|
Annual Increase
Rate
|
Essential
non-health expenses
|
$
25,000
|
1.50%
|
Essential
health expenses
|
6,000
|
2.50%
|
Discretionary
expenses
|
18,600
|
1.50%
|
He also determines that his extra medical expenses and his future new car expenses are “essential” but he considers his annual travel expenses to be “discretionary,” so using data from the PV Calcs tab, he enters 17% for the percentage of his expected non-recurring expenses as essential ([$14,856 + $16,839] / $184,967).
The Asset Reserves by Expense Type tab tells him that:
- the present value of his current assets is about $1.4 million (cell I3), of which
- about $800,000 (cell G26) will be necessary to fund his essential expenses (both recurring and non-recurring),
- leaving about $600,000 (cell H26) available to fund his discretionary expenses.
If he stays with the default assumptions, the total discretionary expense budget for 2020 that can be funded with $600,000 in accumulated savings will be about $28,600:
- $18,600 for recurring discretionary expenses and
- $10,000 for travel expenses.
- $26,000 for recurring discretionary expenses and
- $10,000 for travel expenses.
These discretionary expenses budget amounts can be verified by inputting the following in the Input & Results tab of the ABC for Single Retiree workbook:
- accumulated savings of $600,000 (and no other assets) in cell D7,
- the $10,000 per year discretionary travel expenses in line 22, and
- varying the default assumptions using the override feature.
Many individuals believe our default assumptions are too conservative for pricing discretionary expenses that can be funded with an upside portfolio comprised mostly of equities. As shown in the example above, using alternative assumptions about the future that “pre-recognize” favorable investment returns expected from equities or that assume shorter lifetime planning periods can increase one’s discretionary spending budget. Of course, increasing your current discretionary spending budget will increase the risk of having to reduce your discretionary spending budget in the future. Therefore, you should carefully determine which of your expenses are truly discretionary and can be reduced if future experience is less favorable than assumed.
