Is it Time for a 2016 Spending Check?

The last thing I want to do with this post is put a damper on your holiday season, but we only have two months left in the calendar year, and for many retirees, the holiday season can involve increased expenses.  Before you generously shower gifts on your family and friends this year, you might want to check to see how you are doing so far with your 2016 spending and investments. 

As discussed in our post of September 4 of last year, if you are using the Actuarial Approach to determine your spending budget, there is a relatively easy process you can use to check to see how you are doing in terms of meeting your spending and investment targets for the year.   The Runout Tab of the Actuarial Budget Calculator you used to determine your 2016 spending budget showed your expected accumulated savings at the beginning of year 1 (2017) if all assumptions were realized and you spent exactly your 2016 spending budget.  

To see how well you have done so far for 2016, you will need to

• estimate your spending and income for the final two months of 2016 and 
• compare your estimated end-of-year accumulated savings with the beginning of year 1 (2017) amount shown in the Runout tab of the 2016-year calculation.

If your estimate of year-end accumulated savings is significantly lower than the expected value (either because of over-spending or lackluster investment returns (or a combination of the two), you might want to consider reducing some of your expenses for the remainder of the year if you can.  To see the impact of over-spending or under-earning on your 2017 actuarially determined spending budget (before any smoothing you might choose to use), just enter your end-of-year accumulated savings estimate in the spreadsheet and pretend you are doing the calculation at the beginning of 2017. 

Focus on Your Spending Budget in Retirement–Not How Much You Can Withdraw from Your Investment Portfolio

It seems like every other week some retirement expert, financial planner or investment firm is coming out with their recommendation for the best withdrawal strategy to use to tap one’s savings in retirement.  The new and improved strategy may be “fixed”, “variable,” or a hybrid of the two.  It may be a “safe” withdrawal rate (as contrasted with one that is unsafe?)  It may have “guardrails.”  It may involve using the Excel PMT financial function.  It may be a rate that retirees should “feel free” withdrawing, or it may be one of the many approaches that adjusts the 4% Rule in some manner to supposedly make it better.  I refer to these systematic withdrawal approaches as “rule of thumb” (RoT) approaches.

All of these RoT approaches miss the point.  The point of the exercise is to determine approximately how much you can afford to spend each year while meeting your financial objectives, not how much to withdraw.  Sometimes adding the amount you can withdraw under these RoT approaches to other income you may be receiving for a given year will give you something close to a reasonable spending budget for that year, and sometimes it won’t.

The current widely-followed practice of first determining how much can be withdrawn from savings and then adding that amount to other available income for the year is just bass-ackward and, in my opinion, should be changed.
 

The process recommended in this website involves

• first determining a reasonable spending budget based on sound actuarial principles and 
• then subtracting other available income for the year to determine how much, if any, should be withdrawn from accumulated savings.

Thus, the reasonable actuarially-developed spending budget and the other income you may be receiving during the year determines how much you should  withdraw from your accumulated savings, not some RoT approach that doesn’t even consider how much other income you may or may not be receiving that year.

Under the Actuarial Approach, withdrawals from savings may be much greater than or much less than withdrawals suggested by RoT approaches, and this situation may change over the period of retirement.  An example of the former situation is when income in retirement is deferred (such as when Social Security or income from an anticipated home sale is deferred).  An example of the latter situation is when income in retirement is front-loaded (such as when a retiree works in part-time employment or receives other income for a temporary period of time).

Note:  It is certainly possible that the annual income from various sources in retirement may even temporarily exceed the year’s actuarially calculated spending budget.  In that event the withdrawal from accumulated savings for that year will be negative.  In other words, instead of withdrawing and spending x% from savings that year as the retiree may do under a RoT approach, under the Actuarial Approach she would actually be saving to fund future spending needs.

If you (or your financial advisor) are currently using a RoT approach to develop your spending budget, I strongly recommend that you change your mindset (as suggested in the graphic above) and consider the Actuarial Approach as a better alternative.  At a minimum, we encourage you to compare the spending budgets developed under your approach with that developed under the Actuarial Approach and make sure you are comfortable with any significant differences.

For those of you still wondering about the graphic above:  No I am not calling for a small change (20 cents) in practice.  I am calling for a paradigm shift.

Development of Betsy’s Pre-Retirement Spending/Savings Budget

In our post of September 29, we introduced a new tab in the Actuarial BudgetCalculator (ABC) to help pre-retirees develop a reasonable spending budget in order to achieve their financial goals. That post discussed how to use the Input tab and the Pre-Retirement Spending & Savings tab of the ABC for this purpose and promised to include an example in a future post. This post includes the promised example for a hypothetical pre-retiree named Betsy.

 

Since release of the latest version of the ABC last month, we have decided that eventually we will probably develop separate ABC spreadsheets for pre-retirees and retirees as the current version is somewhat “clunky.”  For the time-being, however, pre-retirees can use this somewhat more clunky version. 

 

While most retirees know approximately how much their Social Security benefit is or will be in the future, some younger retirees and many pre-retirees may not have a good idea of how much they should input in our spreadsheets for their benefit.  This post will describe a process that can be used for this purpose. 

 

Betsy’s Financial Goals

  

• Betsy wants to retire from her current job at age 65 with no part-time employment thereafter
• Betsy would like her real dollar first year post-retirement spending to be no less than 75% of her real spending in her final year of employment
• Betsy has no other financial goals, such as paying for her son’s college expenses
• Betsy doesn’t want to over-save or under-save for her retirement.  In other words, she would like to maintain a reasonable balance between her pre- and post-retirement lifestyles.
• Betsy doesn’t want to become a burden on her son, but doesn’t feel a need to leave him a large estate. 

Betsy’s Data

  

• Betsy is age 50 and is divorced
• She is employed and her current gross pay is $70,000 a year
• Her employer matches her 401(k) contributions $.50 for each dollar up to 6% of pay
• The current value of her home is $250,000

Betsy’s Assets:  

  

• Accumulated savings, 401(k) and personal assets, of $100,000
• The present value of her future employment income
• The present value of her estimated future Social Security benefit of $46,900 per year commencing in 20 years at age 70.  Betsy develops her estimated age 70 Social Security benefit of $46,900 using the following process:

Step 1:  Betsy goes to the Social Security Quick Calculator on the Social Security website.

Step 2:  She enters her date of birth, gross pay in the current year and her desired future benefit commencement date.  She also indicates that she wants her benefit estimate to be in current dollars and submits her request.

Step 3:  She multiplies the resulting monthly benefit estimate by 12 and divides the result by her annual gross pay.  This gives Betsy a replacement ratio.

Step 4:  She multiplies the replacement ratio developed in Step 3 by her estimated pay in the year preceding her retirement (and if this date precedes her Social Security benefit commencement, by the anticipated increase in inflation for the bridge period).  Her estimated pay in the year preceding her retirement is based on her assumption for future pay increases as discussed in the assumptions section below. 

 

Betsy follows the process above and develops a replacement percentage of 46%, which she multiplies by her gross pay of $70,000 and 19 years of 2% per annum increases (a factor of 1.457) to produce an estimated annual age 70 benefit of about $46,900. 

• The present value of future employer matching contributions to the 401(k) plan
• The present value of proceeds from future home sales. 

Betsy’s Assumptions:

For present value calculations, Betsy, with assistance from her financial advisor, has selected these assumptions:

• Annual discount rate of 4%
• Annual rate of inflation of 2%
• She expects her employment will continue until she retires, and her gross pay will increase annually at the rate of inflation (2%)
• She expects to contribute, into her employer’s 401(k) plan, at least the minimum to receive the maximum matching contribution ($2,100 in the current year increasing by 2% per year).  She uses the Present Value Calculator in this website to estimate the present value of the matching contributions to be about $29,000.
• She expects her existing home mortgage will be paid off by the time she retires.  She expects to sell her home when she enters an assisted living facility and she expects that the value of her home will earn 4% per annum.
• She expects to live until age 95
• She expects her future essential expenses (excluding health related expenses) will increase with inflation, that her future essential health related expenses will increase with inflation +2% and her future non-essential expenses will remain constant in nominal dollars.  Based on her expected distribution of such expenses, she believes her total annual recurring expenses in retirement will increase by inflation minus 0.5% each year after retirement.
• She expects that she will have to live the last three years of her life in an assisted living facility.  She estimates the current cost of a three-year stay in her geographic area at $170,000 and she believes this cost will increase in the future by inflation plus 2% each year.  Based on the approximation technique outlined in our post of January 12, 2016 to reflect the reduction in other recurring expenses, she estimates a present value of her long-term care costs at $102,000 (60% of $170,000).
• She estimates the present value of her future unexpected expenses to be $25,000
• She estimates that $200,000 (in nominal dollars) will be sufficient to cover her funeral expenses, with any remainder to be left to her son.

Entries in Column B of the Input Tab

   

Row      Entry

7          $100,000 (Betsy’s accumulated savings)

9          $46,900 (Betsy’s projected Social Security benefit as developed above)

11        20 (the number of years before expected commencement of her

            benefit)

25        $250,000 (the present value of her home sale proceeds)

27        4% (Betsy’s expected rate of return on her investments/discount rate)

29        45 (Betsy’s lifetime planning period—95 minus her age)

33        $200,000 (The amount desired to be left at the end of Betsy’s lifetime

            planning period)

35        2% (the expected annual rate of future inflation)

The result in Row 41 with these input items is $743,813 (the present value of Betsy’s retirement spending budgets based on the input items above).  This amount is carried forward to the new pre-retirement spending and savings tab as the beginning value. 

 

Entries in Column B of Pre-Retirement Spending & Savings Tab

  

Betsy then goes to the Pre-Retirement Spending & Saving tab and makes the following entries:

 

Row      Entry

6          $70,000 (Betsy’s current gross pay)

7          15 (the number of years until her desired retirement age of 65)

8          2% (Betsy’s estimate of the annual future percentage increase in her

            gross pay)

10        $29,000 (Betsy’s estimate of the PV of future matching contributions to

            the 401(k) plan)

13        $102,000 (60% of Betsy’s estimate of 3 years of assisted living cost of

            $170,000)

15        $25,000 (Betsy’s reserve for unexpected expenses)

20        12% (the percentage of her gross pay she intends to save)

23        1.5% (the desired annual increase in Betsy’s recurring retirement

            spending budget)

 

The result shown in E 26 of the new tab with these input items is that if all of Betsy’s assumptions are realized in the future, her expected real dollar spending budget in her first year of retirement (age 65) would be 76.22% of her age 64 real dollar spending budget.   If she only wanted to save 8% of her pay each year rather than 12%, she could still reach her 75% real spending goal by working approximately another two years.  Betsy understands that because she has included the value of her home as an asset for budget purposes, she may have cash-flow problems later in her retirement that might require downsizing her home or taking out a reverse mortgage earlier than she might want.

 

Betsy also understands that (i) she may not be able to continue in her current employment until her desired retirement age, (ii) her estimated Social Security benefit may be reduced as a result of impending Social Security reform and (iii) some of her other assumptions may also turn out to be optimistic.  For this reason, she decides that she will try to save at least 15% of her pay each year just to be a little safer.  Of course, she will monitor her actual savings and spending each year and revisit this process every year to make sure she remains on track to meet her financial goals.

We’ve Updated the Present Value Calculator and Added a New Member to Our Team

Present Value Calculator

As discussed in our previous post, the fundamentals of the actuarial approach advocated in this website involve calculating the present values of future sources of revenue and future expected expenses.  We have developed two Excel spreadsheets to help our readers with these calculations:

• the Actuarial Budget Calculator (ABC) and
• the Present Value Calculator (PVC).
  

These spreadsheets can be found in the “Articles/Spreadsheet” section of our website.  Like the previous version of the PVC, the updated version (1.1) will permit you to calculate present values of future streams of annual payments or single payments, starting immediately or at a specified time in the future.  For simplicity’s sake, all steams of future payments are assumed to be made at the beginning of each year.  The updated version will also enable you to calculate the present value of a single payment to be made in the future, with the value of that payment assumed to increase by k% per year.

As always, we solicit your feedback for ways to improve our spreadsheets.  Please let us know how our spreadsheets can be improved and we will try to accommodate your requests.

New Team Member

I’m pleased to announce that Bobbie Kalben, FSA, has joined Kin Chan (our tireless web guru) and me in our quest to help retirees and pre-retirees (and their financial advisors) develop reasonable spending budgets.  Bobbie is another retired pension actuary whose specialties include communicating complicated subjects.  Bobbie’s self-described mission for this website is to translate some of the “actuarial-eze” that I too frequently use into plain English and to make some of the more complicated material here a little more accessible.  While Bobbie has already been helping me out for a couple of months, the updated PVC represents her first effort at making our spreadsheets a little more user-friendly.  She has also ambitiously agreed to update the ABC next.  Before she completes that task, however, I wanted to release a new version of that spreadsheet that includes a new tab to help pre-retirees develop a spending/savings budget.

We encourage you to use these spreadsheets in your financial planning, and if you like them, to recommend them to your friends.