Budgeting for Real-World Situations

This post is a follow-up to our post of March 3, 2018 where we discussed the distinction between Systematic Withdrawal Plans (SWPs) and Sustainable Spending Plans (SSPs).  In that post, we discussed why we believe it is important for you (or your financial advisor) to develop a SSP (and not use a SWP), particularly if your situation differs from the frequently overly-simplified situations assumed by many SWP advocates, academics and other retirement experts.  This post will discuss how the Actuarial Budget Benchmark (ABB) can be used together with our recommended smoothing algorithm to help you develop a robust SSP to properly handle most real-world situations.  We will also present an example to demonstrate how this SSP can work over a ten-year projection period and will encourage you (or your financial advisor) to model what your future spending budgets might be under reasonable assumptions so that you can test your financial plan.

Unfortunately, Good Budgeting is Not That Simple

Developing a reasonable spending budget is not as simple as we are sometimes led to believe.  Real-world complications frequently ignored by retirement researchers and other retirement experts include:

• Many individuals are part of a couple and plan as a couple 
• The individuals in a couple may not be the same age and may not retire at the same time 
• Income sources before retirement don’t always stop the same time and income sources after retirement don’t always start (or stop) at the same time 
• Couples generally don’t live the same period of time and income needs will frequently change upon the first death within the couple 
• Future expenses may not be the same each year.  Some expenses may be non-recurring, some may be recurring, some may increase at a rate higher than general inflation and some at a lower rate.  
• Some income sources in retirement may be paid in fixed dollars and some in inflation-adjusted dollars 
• Individuals will generally not spend exactly their spending budget each year.  
• Individuals experience one pattern of future investment returns, not an average of 10,000 patterns generated for Monte Carlo modeling based on historical returns
  

Because SWPs don’t coordinate with other sources of income and are simply drawdown algorithms, their use is frequently inconsistent with a couple’s (or single individual’s) retirement goals in these real-world situations.  Since SSPs focus on spending and not withdrawals from accumulated savings, they can be tailored to address these real-world situations to better meet retirement objectives.  And while the SSP we discuss below is more complicated than most simple SWPs, you can use our spreadsheets to perform the annual present value calculations necessary to make it work and obtain a better result. 

Using the ABB and Our Recommended Smoothing Algorithm to Develop a SSP

As discussed in the Overview sections of our Actuarial Budget Calculators, the ABB is an important “data point” in the budget development process, but it can sometimes produce volatile results from year to year primarily due to asset fluctuations.  As discussed in our post of January 2, 2017, these undesirable fluctuations can be mitigated by smoothing the results.  The smoothing algorithm that we recommend involves taking the recurring spending budget amount from the previous year, increasing that amount by the desired increase in spending budget for the previous year (generally the actual increase in general inflation for the previous year) and testing that the resulting amount is not more than 110% of, and not less than 90% of, the ABB for recurring expenses.  If the previous year’s adjusted value falls within this corridor, that adjusted value becomes the recurring spending budget for the current year.  If the previous year’s adjusted value falls above or below the corridor limit, the applicable corridor value is used as the current year’s budget.

Using the ABB and our recommended smoothing approach will help you achieve the goals discussed in our March 3, 2018 post:

• Maximizing current levels of spending without jeopardizing ability to meet future anticipated expense needs 
• Not spending too much and not spending too little 
• Avoiding year to year spending volatility 
• Having spending flexibility 
• Leaving approximately desired amounts to heirs at death
  

Example:  10-Year Projection of Spending Budgets

To illustrate how this SSP works to achieve these goals, we performed a ten-year projection of spending budgets for a hypothetical couple, Bill and Betty.  We will warn you in advance that this example is fairly complicated because it involves making “valuation assumptions” to be used in calculating the ABB in each year of the ten-year projection period and different “projection assumptions” with respect to “actual” experience during this period.

Data/Goals

Bill is currently age 65 and Betty is age 60.  Bill has retired from his previous employer and plans to work in part-time employment for five years.  He will be earning $15,000 in the current year for his part-time employment.  Betty is still employed and is currently earning $50,000 per annum.  Based on their current year’s valuation inflation assumption of 2% per annum, Bill has projected his age 70 Social Security benefit to be $30,000 per annum and Betty projects her age 65 Social Security benefit to be $20,000 per annum.  Bill also has a company sponsored pension benefit that currently pays him a fixed amount of $1,000 per month for the rest of his life with no benefit upon his death to Betty. 

Bill and Betty currently have $750,000 in assets, invested fairly aggressively. 

Bill and Betty have five years remaining on their home mortgage, but want to treat this cost (estimated to be a fixed amount of $18,000 per year) as a non-recurring expense.  Additionally, they would like to travel over the next 15 years and have estimated that they might spend an extra annual amount of $15,000 (in real dollars) for these non-recurring travel expenses.
Both Bill and Betty plan to fully retire in five more years.   Bill has decided to defer commencement of his Social Security benefit until age 70, while Betty has decided to collect hers at age 65 when she retires.  Bill and Betty have determined that the equity in their home should be sufficient to cover their anticipated long-term care costs.  They have also set aside sufficient separate reserves for unexpected expenses and burial expenses.  They have no desire to leave a large estate to their children. 

Projection Assumptions

For the ten-year projection, we will assume Bill and Betty’s employment earnings will increase with general inflation each year and they will both fully retire in five years as they plan.  We also assume that Bill and Betty’s pre-commencement Social Security benefits will be adjusted for higher than initially assumed levels of actual inflation and their post-commencement benefits will be increased by “actual” inflation.  Assumed future rates of inflation for projection purposes are shown in Column C of the chart below and future rates of investment return are shown in Column Q.  We also assume that neither Bill nor Betty would die during the 10-year projection period.

Calculations/Valuation Assumptions

We have used the Actuarial Budget Calculator (ABC) for Retired Couples to calculate Bill and Betty’s current year spending budget and their ABB for the current year and each of the next ten years.  For purposes of determining their current year spending budget, Bill and Betty decided to use the current default assumptions (4% investment return/2% inflation/2% future spending budget increases/lifetime planning period based on healthy, non-smoker with a 25% probability of survival), except they believe their current investment mix will produce at least a 3% real rate of return over their expected retirement rather than the default assumption of 2%.   To calculate their current and future projected ABBs, we assumed that the current default assumptions will remain unchanged during the projection period.  We also assumed Bill and Betty are comfortable assuming their recurring expenses will increase with general inflation in future years and decrease by 33% upon the first death within the couple.  Finally, we used the Present Value Calculator workbook to calculate the present values at the beginning of each year of the 10-year projection period of Bill and Betty’s future mortgage payments, travel expenses and estimated future Social Security survivor benefits payable to Betty upon Bill’s expected earlier demise.

(click to enlarge)

Results

The above chart shows that:

• While the ABB for recurring expenses (in Column J) may bounce around a bit from year to year depending on  projected investment returns and inflation, Bill and Betty’s recurring spending budget (in Column L) is expected to remain constant in real dollars over the next 10 years under these projection assumptions (as the ratio of the preliminary recurring spending budget to the ABB for recurring expenses shown in Column K does not fall below 90% and does not exceed 110% over the projection period).  Note that this result could be different under different projected investment experience, but the recommended smoothing algorithm is effective in avoiding year to year spending budget volatility, while at the same time keeping spending on track. 
• By treating their home mortgage and travel expenses as non-recurring expenses, Bill and Betty have maximized their recurring expense budget without jeopardizing their ability to meet future recurring expenses.  The Total Spending Budget in Year 1 dollars in Column O shows that they have “front-loaded” their total spending budget to cover these non-recurring expenses without unnecessarily increasing their expected future recurring expense budgets.  
• They have flexibility to deviate from their annual spending budget.  Column P shows that, like most real-world couples, they are sometimes going to spend more than their spending budget and sometimes less.  
• Withdrawals from accumulated savings in Column S are equal to the total amount actually spent by Bill and Betty in Column P minus their income in Columns F, G and H.  Contrary to results obtained using systematic withdrawal plans (SWPs), there is nothing “systematic” about Bill and Betty’s withdrawals from savings under this sustainable spending plan. 
• Under these projection assumptions, the ABB combined with our smoothing algorithm SSP produced results consistent with Bill and Betty’s spending goals.  However, they may wish to look at projections involving longer (or more pronounced) investment boom and bust cycles to further stress test their SSP. 
  

Conclusion

Developing a reasonable spending budget is not necessarily a simple task for “real-world” people in “real-world” situations.  While the calculations necessary to develop a reasonable budget in these circumstances may be complicated, we have simplified this process for you by providing Actuarial Budget Calculators (ABC) and Present Value Calculator (PVC) spreadsheets for you to use annually to calculate the necessary present values and ABBs.  We encourage you to use our workbooks to develop your own sustainable spending plan.   We also encourage you to model what your future spending budgets may be under reasonable projection assumptions for the future.  
 
If you are a financial advisor, we encourage you to kick the tires on this SSP to see if it just might do a better job of developing spending budgets for your “real-world” clients (and therefore benefit your bottom line).  At a minimum, you may wish to consider using this more robust SSP as a spending algorithm in your Monte Carlo models.