The FI forum contains a great deal of discussion about how much to save (the typical recommendation is 50% of gross pay or more) and calculators designed to help FI’ers determine when they can stop working and “FIRE.” Most of the ‘how much is enough” discussion focuses on whether you should have 25 times annual expected expenses in retirement (based loosely on the 4% Rule) or more in order to FIRE. This post will approach the how much is enough question from an actuarial perspective using the basic actuarial and financial economics principles we advocate in this website in order to give FI’ers and others a different approach to use in their planning process. We will illustrate our suggested approach with an example. While everyone’s financial goals and personal situation are different, and it can be dangerous to generalize, we conclude from our example that the 25 times annual expected expenses rule of thumb may not be all that bad for someone who wants to retire prior to age 50.
Basic Actuarial Equation
Readers of this blog have grown accustomed to seeing the following equation in our posts.
Items on the left-hand side of the equation are the individual’s (or couple’s) assets and the items on the right-hand side of the equation are future spending liabilities. “PV” stands for present value. We have developed Excel workbooks to perform the present value calculations anticipated in this equation. For today’s post, we are going to use both the Actuarial Budget Calculator (ABC) for single pre-retirees and the general PV calculator (PV Calculator V 1.1), which can be downloaded (for free) from the “Spreadsheets” section of our website.
Our Hypothetical Hyper-Saver
Mary is a 25-year old single female who has paid off her college loans but currently has no accumulated savings. She currently earns $100,000 per year and her goal is to retire at age 45 in 2038. She has no children to educate and she plans to continue renting her apartment. She participates in her employer’s 401(k) plan that matches her contributions $.50 for each dollar up to 6% of her pay. She will contribute at least 6% of her pay each year to receive the maximum employer match.
She lives very frugally and believes that she can save 50% of her compensation. She currently pays about 30% of her gross pay in taxes (FICA, FIT and state taxes). This leaves about 20% of her gross pay (100% - 50% savings and 30% taxes), or currently about $20,000, for her basic living expenses (food, housing, transportation, entertainment, travel, health costs, etc.).
Mary’s Expected Post Retirement Expenses
As a first step in Mary’s planning process, Mary estimates her post retirement expenses. She expects that some of her pre-retirement expenses will decrease and some will increase when she retires. At a minimum, Mary estimates that her taxes will be cut in half, but her basic living expenses (other than those discussed below) will be largely unchanged (in real dollars).
Mary determines that she currently pays about 1/3rd of her current healthcare costs (about $3,000 per annum) and her company subsidizes about 2/3rds of this annual cost (about $6,000). She understands that if she retires early, her retirement spending budget will need to consider this extra expense, and it will be payable probably until she becomes eligible for Medicare, which she assumes will be increased from age 65 under current law to age 70 before she becomes eligible.
Mary also wants to travel after she retires. She budgets $10,000 per year in today’s dollars for this additional expense, which she anticipates will apply to each of her retirement years prior to age 80.
She plans to self-insure her long-term care costs rather than buy insurance for this purpose and budgets a present value of $50,000 for this future expense. She also budgets a present value of $25,000 for unexpected expenses and a small amount ($25,000 in today’s dollars) for burial expenses.
Other than the $25,000 budgeted for unexpected expenses (to be used either before and after her retirement), she doesn’t budget any expense other than her basic living expenses prior to retirement.
Mary’s Assumptions
Mary plans to invest her accumulated savings aggressively and expects to earn more on her investments than if she invested more conservatively. Still, she knows that investing aggressively carries more risk and decides to price the cost of her future expenses using assumptions consistent with current inflation-adjusted annuity costs. Thus, she uses the default assumptions in the ABC for pre-retiree workbook: a 4% discount rate, a 2% annual rate of inflation and a lifetime planning period equal to 74 years (based on the 25% chance of survival from the Actuaries Longevity Illustrator for a non-smoking female in excellent health). She also assumes that her gross pay will increase by 3% per annum, or 1% above assumed inflation.
Mary assumes that future medical costs will increase by inflation plus 1% (3%) each year and all her other future expenses will increase by inflation (2%) each year.
Social Security
Following the example in our March 26, 2017 post (and as discussed in our Overview tab), Mary goes to the Social Security Quick Calculator, enters her information (including an assumed retirement year of 2038) and requests an estimate in future dollars. She then adjusts her projected earnings to be consistent with her 3% future wage increase assumption by decreasing the future wage assumption used in the program by 1% per year. The program tells her that if she stops working in 2038, her Social Security benefit in future dollars payable at her age 62 in 2055 under current law would be $6,202 per month. She notes that this estimate is not a lot lower than if she continued to work until age 61. She knows that the System faces changes as a result its financial condition and decides to assume that she will only receive 60% of the amount indicated by the program, or $3,721 per month. She enters the annual amount of $44,652 in cell E(18) and 37 years in cell G(18) of the ABC for single pre-retiree workbook.
Mary does not anticipate receiving any retirement income from sources other than her accumulated savings and Social Security.
PV Expected Future Non-Recurring Expenses
As discussed above, Mary has budgeted a present value of $50,000 for her long-term care expenses, a present value of $25,000 for unexpected expenses and $25,000 in today’s dollars for her future funeral expenses. Her next step is to determine the present values of her expected additional medical costs and travel expenses. She uses our PV Calculator V 1.1 workbook for this purpose.
For her additional future medical expenses Mary enters $10,837 ($6,000 increased by 3% per year for twenty years) deferred 20 years, payable for 25 years and increasing by 3% per year. The total present value of these expected expenses under Mary’s assumptions is $110,378.
For her retirement travel expenses, she enters $14,859 ($10,000 increased by 2% per year for twenty years) deferred 20 years, payable for 35 years and increasing by 2% per year. The total present value of these expected expenses under Mary’s assumptions is $173,919. Thus, she enters $309,297 ($25,000 for unexpected expenses plus $110,378 for additional medical expenses plus $173,919 for travel) in cell C(24).
Projected Recurring Annual Spending Budgets at Retirement
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The screenshot above shows the Input & Results tab from the ABC for single pre-retirees based on Mary’s entries. Cell M(21) in the amount of $57,225 shows the expected first year of retirement spending budget (before extra medical expenses and travel expenses payable from Mary’s non-recurring spending budgets) in nominal dollars and cell M(23) shows this amount in real dollars ($38,511). While the $38,511 real dollar spending budget is projected to only be about 64% of Mary’s spending (including taxes) in her final year of employment, it is still projected to be greater on an after-tax basis ($23,511) than Mary’s current after tax spending budget of $20,000.
Mary’s total spending budget in real dollars for her first year of retirement (including amounts to be withdrawn from the extra medical cost and travel spending budgets) is projected to be $55,804 ($38,511 plus $7,293 for extra medical cost plus $10,000 for travel). At retirement, Mary expects to have accumulated savings $1,428,170 in today’s dollars (from the inflation adjusted run-out tab) in addition to her Social Security. This amount of real accumulated savings is about 25.6 times her total annual spending budget for her first year of retirement of $55,804. Therefore, accumulating about 25 times expected annual retirement expenses may not be a bad target for Mary. Of course, she plans to revisit her calculations annually to see if her assumptions about the future change or she remains on track to meet her goal.
Mary can also use our workbook to see the effect on her retirement plans of, for example,
- working part-time in retirement,
- Changing assumptions for amounts or expected durations of extra pre-Medicare medical expenses or travel expenses
- Targeting a declining real dollar recurring spending pattern after retirement,
- increasing or decreasing her savings rate,
- increasing or decreasing expected non-recurring expenses,
- deferring her retirement, etc.
This post shows how FI’ers (and other not-as-hyper savers) can use the Actuarial Approach and our workbooks to develop another data point in their retirement planning. And while we recommend a spending replacement target of about 85% for regular savers, hyper-savers like Mary may be able to aim for a lower spending replacement target. Depending on assumptions made for Social Security, increased pre-Medicare healthcare costs, travel plans, etc., a target of 25 times expected annual recurring expenses in retirement may not be unreasonable for those who want to retire at or before age 50.
