Comparison of Retirement Spending Budget Calculation Approaches

Since our blog is all about helping people develop a robust spending budget, in this post we are going to do a deeper dive into the approaches generally used today by retirees (or for retirees) to develop their spending budgets.  We acknowledge up-front that not everyone actually feels the need to calculate a spending budget, so this post is focused on comparing the approaches generally used by those who do.

In this post we will:

• Briefly discuss each of the common approaches
• Discuss real world complications that may or may not be considered by the various approaches
• Present our scorecard of spending budget approaches, and
• Discuss our conclusions

Common Spending Budget Calculation Approaches

Maintain Your Principal.  Perhaps the most commonly used approach today (in addition to just winging it, or not developing a spending budget at all), this approach adds current year income expected from Social Security and other sources to interest, dividends, and other income expected on invested assets.  Research by the Society of Actuaries and others has consistently shown that many individuals and couples are reluctant to spend their principal (or nest egg) in retirement and therefore use this approach or something like it.

Dynamic Strategic Withdrawal Plan (SWP).  This approach anticipates a systematic drawdown of invested assets.  Instead of adding interest, dividends, and other income expected on invested assets to expected income from Social Security and other income sources, in this approach the amount of “income” anticipated based on the SWP algorithm.  Dynamic SWPs apply the algorithm each year to the individual’s (or couple’s) total account balance, and thus go up or down with investment gains or losses.  Examples of this approach include an X% of account balance drawdown or the IRS RMD (Required Minimum Distribution) approach.

Static Strategic Withdrawal Plan (SWP).  This approach is similar to the Dynamic SWP but it anticipates a “safe” systematic drawdown of invested assets, so the annual drawdown amounts are not dependent on the current value of invested assets, but instead are based on the amount of invested assets at commencement of retirement, increased by some algorithm (usually inflationary cost of living increases).  Examples of this approach include the 4% Rule, or X% Rule.

Monte Carlo Modelling.  This approach is frequently used by financial advisors.  It uses stochastic assumptions and many simulations to project future spending scenarios.  Those scenarios are then used to develop ranges of possible future spending levels and probabilities of being able to spend at least $X per year for life based on specific investment strategies.  For example, the financial advisor may tell her client couple that, based on:

• current invested assets of $A
• the agreed upon investment strategy
• Social Security benefits of $B and
• other sources of income,

there is a 90% probability that they will be able to spend $C (generally real) dollars per year for 30+ years.  Because it generally involves high probabilities of spending certain levels, there is an implication that such a spending level is “safe” and not likely to require adjustments in the future.  Thus, this approach is similar to the static SWP approaches in this respect.

Actuarial Approach.  While the approach outlined in this website could be implemented with stochastic assumptions, the spreadsheets we make available employ deterministic assumptions to make it more accessible and understandable to users.  It anticipates an annual valuation of total family assets and spending liabilities to develop a total spending budget “data points” for the year, comprised of a spending budget for non-recurring expenses and a spending budget for recurring expenses.  While the process is dynamic, the recurring spending budget can be smoothed from year to year.  You can read more about the Actuarial Approach by clicking here.

Real World Complications that May or May Not be Considered by the Various Spending Budget Calculation Approaches

All of the approaches discussed above may work reasonably well in fairly simple situations where all income is payable commencing today and is expected to be payable for the individual’s life in inflation-adjusted dollars (lifetime real dollar income) and the same real dollar level of expenses is expected to be payable for the entire retirement period (lifetime real dollar expenses).  Unfortunately, actual real-world situations can, and generally will, be more complicated.

Income may start and stop at different times during retirement and may not be payable in real dollars throughout retirement.  We call these sources of income “lumpy income.”

Examples of lumpy income include:

• Deferred Social Security benefits (you or your spouse)
• Deferred pension benefits (you or your spouse)
• Fixed dollar pension or annuity income
• Part-time employment
• Inheritance
• Alimony
• Sales of assets (including homes, businesses, boats, art, etc.)
• Loan repayments from family members
• Installment payments from defined contribution plans
• Deferred annuities (QLACs)
• Payments after first death within a couple, including Social Security survival benefits
• Life insurance payouts, etc.

Expenses may also start and stop at different times during retirement and may increase or decrease in real dollars in the future.  We call these types of expenses “lumpy expenses.”

Examples of lumpy expenses include:

• Health insurance premiums prior to Medicare eligibility
• Uninsured long-term care costs
• Unexpected expenses
• Expected expenses for non-recurring items such as new cars, home improvements, etc.
• Travel expenses
• Short-term family assistance
• Mortgage payments
• Desired bequest amounts
• Expenses after first death within a couple, etc.

Most of the simpler budget calculation approaches do not coordinate with lumpy income sources and none of the approaches other than the Actuarial Approach coordinates with lumpy expenses.  As discussed in our post of January 7, 2019, we believe it is important to separately budget for non-recurring lumpy expenses, as it is simply inefficient to fund the same as for recurring lifetime expenses if they will not actually be payable for life.

Spending Budget Calculation Approach Scorecard

Here is our scorecard of today’s generally used spending budget calculation approaches:

(click to enlarge)

Conclusion

As shown in our “totally unbiased” scorecard above, the Actuarial Approach recommended in this website appears to be the most robust of the spending budget approaches currently being used today, particularly for individuals and couples who live in the real world, where income can start and stop at different times during retirement and/or where expenses are not expected to last for the entirety of retirement.  We leave it up to you to decide which approach is most appropriate for your situation.

Most financial advisors and surprisingly, even some actuaries, believe that Monte Carlo Modelling is somehow more appropriate for developing a spending budget because it uses stochastic assumptions and involves 10,000 or more simulations of the future.  Strangely, these actuaries also believe that the appropriate spending budget approach for a particular retiree will depend on whether the retiree has a financial adviser.  As discussed in our previous post, we encourage you to own your own retirement process and not simply rely on what your financial advisor recommends.  Whether you have a financial adviser or not, using our spreadsheets (available to you or your financial adviser for free on our website), or your own spreadsheets, provides you with additional data points that we believe will enable you to make better financial decisions.