Last Saturday, my wife and I met a lovely couple at my Brother’s 15th birthday party (Leap Day baby). We talked about their plans for retirement and they indicated that although they were in their mid-50s, they were contemplating retirement in the next few years. Fortunately for them, they had both worked for an employer that had sponsored a defined benefit plan and they felt pretty confident about their retirement prospects. We are going to use this couple as the basis for this post’s example calculations. No, I didn’t ask these nice folks a lot of personal financial questions over dinner. The example data (and their names) have been made up.
Review of 7-Step Process
Here, again, is the process we discussed last year:
Step 1: Estimate your future recurring expenses
Step 2: Estimate your future non-recurring expenses
Step 3: Categorize each expense in steps 1 and 2 as "essential" or "discretionary"
Step 4: Using one of our Actuarial Budget Calculator workbooks for retirees, determine the actuarial reserves (investment portfolios or budget buckets) theoretically needed to separately fund your future essential expenses and your future discretionary expenses
Step 5: Compare the total current (or present) value of your assets with total actuarial reserves needed as calculated in Step 4. If the total current value of your assets is greater than the total actuarial reserves needed,
- increase your current and future spending budgets,
- increase your rainy-day fund or
- increase some combination of the two.
- increase your assets (for example through part-time employment),
- decrease your current and future spending budgets,
- apply reasonable smoothing to your current spending budget or
- some combination of these alternatives.
Step 7: Repeat above steps at least once a year
Example #2—Pensions are Nice
Gloria is 57 and Carl is 58 years old. They have significant home equity, but at this point, they plan to save their home equity for long-term care, bequests, rainy-day funds, etc. They have accumulated savings of $1,000,000. They are lucky; they both have company-provided pension benefits which they plan to take as life annuities rather than as lump sum payments. Carl’s pension is $25,000 per annum for life (fixed) payable commencing at age 65 and Gloria’s is $18,000 per annum (fixed) commencing at age 65. Carl estimates his Social Security benefit will be $35,000 per annum (in future dollars) payable when he reaches age 70, and Gloria estimates her Social Security benefit will be $30,000 per annum commencing when she reaches age 67.
With respect to non-recurring expenses, Carl and Gloria currently have a mortgage payment on their house of $20,000 per annum (fixed) which they anticipate paying off in four more years. They also estimate that if they retire their total medical costs will be about $8,000 per year (in today’s dollars) greater over the next eight years until they become eligible for Medicare. Finally, they would like to budget an extra $16,000 per annum for travel over the next 15 years.
They have budgeted a present value of unexpected expenses of $25,000 and they have budgeted expected funeral costs of $25,000 in today’s dollars.
Carl and Gloria reviewed their recent spending data for purposes of completing Steps 1-3 above, and came up with the following chart, where “R” denotes recurring expenses and “NR” denotes non-recurring expenses. They note that categorizing expenses into essential and discretionary categories can be somewhat arbitrary and agree to revisit this task after looking at the potential floor/upside portfolio implications below.
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*Expected to decrease by $20,000 per annum after 4 years
**Expected to decrease by $6,000 per annum after 8 years
***Expected to decrease by $16,000 per annum after 15 years
Following Step 4 in the process, they input their data and default assumptions into the Actuarial Budget Calculator (ABC) for Retired Couples, producing the following results:
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They then go to the “Asset Reserves by Expense Type” tab of the ABC and enter their expenses by type.
The results of tab look like this:
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The surplus of $292,605 in column H(22) quantify the results of Step 5 of the process and indicate that their assets appear to be more than sufficient to cover their expected future expenses under these assumptions and input expenses. The surplus (and the existence of their significant home equity) also provide them some comfort in the event that one of their family members may need some unanticipated financial help in the future.
Following Step 6 of the process, if Carl and Gloria like the “Floor and Upside Portfolio” investment strategy, they see that about 69% of the total present value of their retirement assets of $2,555,711 should be devoted to funding what they classified as essential expenses (and therefore invested in low-risk investments like their Social Security and pensions) leaving about 31% of their retirement assets that could be devoted to funding what they classified as discretionary expenses and invested in more risky assets. Given the present values of their pensions and Social Security (developed in the PV Calcs tab), this means that about 80% of their $1,000,000 of accumulated savings could be invested in more risky assets, constituting their “upside” portfolio. Their plan to defer commencement of their pensions and Social Security benefits could, however, affect how aggressively they invest their accumulated savings.
After re-running the ABC for Retired Couple spreadsheet with earlier pension commencement dates, Carl and Gloria decide that they like a plan that does not involve spending almost all of their accumulated savings initially. Having more accumulated savings will give them spending and investment flexibility as discussed in our post of November 12, 2019.
In future years, in accordance with Step 7, Carl and Gloria will repeat the above process steps to keep their spending and their investment strategy on track and consistent with their changing assets, expense categorizations and retirement goals.
Summary
In this post we applied our recommended 7-step planning process to the hypothetical data and goals of Carl and Gloria, a couple fortunate enough to both have pensions that they plan to take as lifetime annuities, not lump sums. They use the ABC for Retired Couples to confirm that they have sufficient assets to cover their expected future recurring and non-recurring expenses, and they use the Asset Reserves by Expense Type tab to help them develop an investment strategy. They understood that their initial plan could have some cash-flow issues, so they decided to commence their pension benefits earlier to maintain more of their accumulated savings and increase their spending and investment flexibility.
