Inspiration for this post was the June 19, 2020 Forbes article by Megan Gorman entitled, How the Covid-19 Crisis Experience Can Help You Plan A Better Retirement. In her article, Ms. Gorman indicates that a critical part of financial planning is for individuals and couples to estimate and categorize their expected spending in retirement. She says:
“The Covid-19 crisis may have allowed you to uncover some important truths about your spending patterns. For many, the crisis will change their outlook on retirement. It is important to understand exactly what you need to spend versus what you want to spend in retirement. You might just find that a successful retirement is more attainable than you had expected.”
We agree with Ms. Gorman. In fact, the first three steps of our Recommended Financial Planning Process involve estimating and categorizing future expenses in retirement. In addition to separating needs from wants (expenses we call essential and discretionary), we also encourage you to estimate expenses that you believe will last most of your retirement (recurring) vs. those that you believe won’t (non-recurring).
As a reminder, here again is a summary of our 7-step planning process.
Recommended Financial Planning Process
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 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 present value of your assets with total actuarial reserves needed as calculated in Step 4.
If the total present value of your assets is less than total actuarial reserves needed:
- 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.
If the total present 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.
Step 6: Develop a Liability Driven Investment (LDI) strategy consistent with floor and upside portfolio calculations in Step 4, where investments in low-risk assets (the floor investments) are anticipated to be sufficient to fund future essential expenses and investments in risky assets (the upside portfolio) are used to fund future discretionary expenses.
Step 7: Repeat above steps at least once a year
Example – Bill and Gail
Now let’s apply our 7-step planning process to the hypothetical couple, Bill and Gail.
Bill and Gail’s Data
| Item | Bill | Gail | Total |
| Age | 65 | 62 | |
| Annual Social Security at Desired Commencement age | $28,000 at age 70 | $19,00 at age 66 | |
| Annual Pension | $24,000 at 65 | ||
| QLAC | $20,000 at age 85 | ||
| Accumulated Savings | $650,000 | $300,000 | $950,000 |
Bill and Gail also own a home with substantial equity that, for simplicity purposes, we will assume they plan to use to pay for uninsured long-term care costs. Also, for simplicity purposes, we have ignored the present value of future increased Social Security benefits payable after the first death within the couple.
Bill and Gail’s Estimated Spending Liabilities
Based on an average of their last three years’ expenses, they have completed the following chart of their expected expenses in retirement, until the first death within the couple. Based on their recent Covid-19 experience, they have carefully categorized their expected essential vs discretionary and recurring vs non-recurring expenses.
Bill and Gail’s Estimated Expenses
| Expense Category | Essential Recurring | Essential Non-Recurring | Discretionary Recurring | Discretionary Non-Recurring | Total | |
| Taxes | $ 36,000 | $ 0 | $ 0 | $ 0 | $ 36,000 | |
| Housing | 6,000 | 20,000 | 0 | 0 | 26,000 | * |
| Food | 5,500 | 0 | 3,000 | 0 | 8,500 | |
| Clothing | 800 | 0 | 2,800 | 0 | 3,600 | |
| Healthcare | 10,000 | 3,000 | 0 | 0 | 13,000 | ** |
| Transportation | 2,000 | 0 | 2,000 | 0 | 4,000 | |
| Entertainment | 2,000 | 0 | 1,000 | 0 | 3,000 | |
| Travel | 2,000 | 0 | 0 | 15,000 | 17,000 | *** |
| Charity | 0 | 0 | 2,400 | 0 | 2,400 | |
| Other | 0 | 0 | 2,800 | 0 | 2,800 | |
| Total | $ 64,300 | $ 23,000 | $ 14,000 | $ 15,000 | $116,300 |
* Expected to decrease by $20,000 per annum after 4 years
** Expected to decrease by $3,000 per annum after 3 years
***Expected to decrease by $15,000 per annum after 15 years
Bill and Gail’s Non-Recurring Expenses
In addition to their recurring expenses, Bill and Gail estimate that they will have the following non-recurring expenses:
- Home mortgage payments of $20,000 per year are essential for four years.
- Gail’s essential medical costs will decrease by $3,000 when she becomes eligible for Medicare.
- They would like to travel while they are young, so they plan to spend about $15,000 per year as discretionary expenses until Bill reaches age 80.
- They have set aside $25,000 for unexpected essential expenses.
- They have allocated $25,000 in today’s dollars for future funeral costs, 25% of which are essential. They don’t plan for any other estate at their deaths.
While Bill and Gail have several financial goals for their retirement, they agree that it is most important to preserve their basic standard of living (essential spending) during retirement (which they estimate to ultimately be about $64,000 per year in today’s dollars). Given their need to pay off their mortgage, they also understand that preserving their basic standard of living will not involve constant real dollar spending in the first few years of their retirement, and they will have to front-load their essential spending during this period. Given their desire to travel, they also understand that they will be front-loading their discretionary spending on travel (when it again becomes safe to do so).
Bill and Gail enter their data into the ABC for Retired Couples
Using the default assumptions and assuming a 33% decrease in expenses on the first death within the couple, the develops the following Input and Results tab:
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They then go to the Asset Reserves by Expense Type tab, where they enter their expense data from the estimated expenses chart above and their assumptions for future increases in these expenses. This produces the following:
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| (click to enlarge) |
They note that results from Asset Reserves by Expense Type tab differ slightly from the results in the Input and Results tab because they assumed different rates of increase for future expenses in the two different tabs.
Takeaways from Bill and Gail’s Actuarial Budget Calculator Results
- Based on the default assumptions, Bill and Gail’s current assets appear to be sufficient to fund their future essential and discretionary expenses with a relatively small unallocated present value amount ($25,451) left over.
- Their current year spending budget is $116,300 and is comprised of a recurring spending budget of $78,300 and a non-recurring spending budget of $38,000.
- If they spend their current year spending budget this year, they will withdraw about $92,000 from their accumulated savings. They expect to withdraw significant amounts from their accumulated savings during the first few years prior to commencement of their Social Security benefits and Gail’s pension.
- The present value of Bill and Gail’s essential expenses is about $1,765,00 and the present value of their discretionary expenses is about $553,000.
- The present value of Bill and Gail’s low-risk lifetime payment streams is about $1,368,000 (from PV Calcs tab), which leaves about $397,000 ($1,765,000 - $1,368,000) of Bill and Gail’s total accumulated savings of $950,000 that could be invested in low-risk investments to fully fund their floor portfolio with the remainder ($553,000) to be invested in their upside portfolio of riskier assets.
As discussed in our post of November 12, 2019, many individuals believe our default assumptions are too conservative for pricing discretionary expenses that can be funded with an upside portfolio comprised mostly of equities. As shown in the example in that post, using alternative assumptions about the future that “pre-recognize” favorable investment returns expected from equities or that assume shorter lifetime planning periods can increase one’s current discretionary spending budget (and decrease future spending budgets all things being equal). You can re-run the calculations in the spreadsheet with alternative assumptions, or you can simply increase your spending budget attributable to discretionary expenses by about 1% of the amount of upside portfolio assets. In this case, if Bill and Gail want to spend even more aggressively than the amounts developed using the default assumptions, they could increase their total current spending budget by about $5,500 (1% of $553,000) to $121,800.
Comparison with Monte Carlo and Sum of Retirement Income Generators (SORIG) Approaches
As discussed in our post of June 14, 2020, the SORIG approach fails to coordinate withdrawals from invested assets with lumpy income sources and with lumpy expenses. Bill and Gail have both lumpy sources of income and lumpy expected expenses. Therefore, without significant modifications, the SORIG approach is unlikely to meet their spending goals.
As discussed in our post of June 4, 2020, the Monte Carlo approach fails to coordinate with lumpy expenses. Since Bill and Gail have expected non-recurring expenses that they don’t want to fund over their entire retirement, their advisor’s conclusion that they have a 90% probability of being able to spend $90,000 per year, given their assets and a 60% equity/40% fixed income investment strategy, is also not consistent with their spending goals.
Summary
We agree with Ms. Gorman that successful financial planning starts with examining your current spending habits. We encourage you to fill out your own family expense chart (similar to the one above) showing expenses you believe to be essential or discretionary and whether you believe these expenses to be recurring or non-recurring. Once you have done this, we encourage you to use our workbooks to develop a robust spending and investment strategy that meets your spending goals.
