This post is a follow-up post to our post of August 22, 2017. In this post, we will discuss how you can use our Recommended Financial Planning Process to avoid over-saving/under-spending before and after retirement.
Many researchers have noted that retiree spending tends to decrease in real dollars as retirees age. This research calls into question the general financial planning assumption used by many financial advisors and individuals that total retiree spending will increase with inflation each year. The researchers argue that given the observed decreases in real spending, financial plans that anticipate annual inflation increases in total spending may be too conservative.
We agree, but we believe it is likely that much of the observed decrease in spending is comprised of Discretionary and Non-Recurring Expenses, rather than Recurring Essential Expenses. As a result, we believe that a prudent, cost-efficient financial plan should address this potential over-saving issue by:
- Using potentially different assumptions to estimate the Actuarial Reserves required to fund different types of expenses, and
- Utilizing specific anticipated payment periods to develop Actuarial Reserves for expected future Non-Recurring Expenses rather than assuming they will be paid for the entire remaining lifetime of the retiree (or couple).
Exploring Retirement Under-Consumption
Recently, the Retirement Research Center of the Defined Contribution Institutional Investment Association (DCIIA) released “Right-Sizing Retirement—Exploring the Retirement Consumption Gap in Early Retirement.” The primary authors of this research were Warren Cormier of the DCIAA and David Blanchett of Morningstar. Sharp-eyed readers of our blog will note that we have been discussing Dr. Blanchett’s fine research fairly regularly in recent posts.
In their research, the authors note that:
“Errors in key assumptions around retirement spending could lead to over- or under-saving. For example, spending is commonly assumed to increase with inflation during retirement, despite empirical evidence that retiree spending tends to decline (in real terms). If a household bases saving decisions on the assumption that spending will increase annually by inflation during retirement, but it eventually does not, it may over-save, on average.”
“The fact spending declines for households even for those who are not resource constrained (i.e., have funded ratios exceeding one) suggests that assuming retirement spending increases annually is something that should be reconsidered by financial planners.”
We agree with the authors’ conclusions. Assuming retirement spending increases annually can result in over-saving and/or under-spending either before or after retirement. To address this potential issue, we believe it is important to estimate future expenses by type and make reasonable (possibly different) assumptions to develop estimates of the Actuarial Reserves necessary to fund each different expense type. We repeat our recommended process for doing this and discuss possible assumptions for different expense types below.
Recommended Financial Planning Process for Retirees and Near-Retirees
Step 1: Based on a review of your current expenses, 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 4: Using one of our Actuarial Budget Calculator (ABC) workbooks for retirees, determine the Actuarial Reserves (budget buckets) theoretically needed to separately fund your future Essential Expenses and your future Discretionary Expenses. Note that more aggressive assumptions may be used in determining the Actuarial Reserves needed to fund future Discretionary Expenses than Essential Expenses, as discussed in our post of June 23, 2020.
Step 5: Compare the total current value, or Present Value (PV), of your assets with total Actuarial Reserves needed as calculated in Step 4. If the total PV of your assets is greater than the total Actuarial Reserves needed, you can:
- increase your current and future spending budgets,
- increase your rainy-day fund or
- increase some combination of the two.
If the total PV of your assets is less than total Actuarial Reserves needed, you can:
- 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.
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 Portfolio) 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 and periodically model
deviations from assumed experience by stress testing significant
assumptions for the purpose of modifying your plan to mitigate risks.
Assumptions for Recurring Essential Expenses
Given the importance of Essential Expenses and the general reluctance/inability of individuals to reduce them, we believe the assumptions used to develop the Actuarial Reserves necessary to fund them should be conservative and, at a minimum, should anticipate future increases at least equal to increases in general levels of inflation. It may also be prudent to assume higher levels of inflation for certain types of Essential Expenses, such as medical costs (which our workbooks anticipate).
Assumptions for Non-Recurring Expenses, both Essential and Discretionary
As discussed in our post of February 7, 2019, if you aren’t separately budgeting for Non-Recurring Expenses, you probably don’t have a robust retirement spending budget. The primary reason for this is that it is much more cost efficient to fund expected Non-Recurring Expenses over their expected payment periods rather than assuming they will be paid over the entire remaining Lifetime Planning Period (LPP). For example, if you only have five years left on your mortgage, you don’t need to build 30 years or more of mortgage payments into your financial plan Actuarial Reserves.
Assumptions for Discretionary Expenses, both Recurring and Non-recurring
As noted in our post of June 23, 2020, it may be reasonable to assume higher investment returns and/or lower future expense increases to develop the Actuarial Reserves necessary to fund future Discretionary Expenses.
Summary
Unlike other financial planning approaches, our Recommended Financial Planning Process advocates separating future estimated expenses in retirement into at least the following four categories:
- Recurring Essential Expenses
- Recurring Discretionary Expenses
- Non-Recurring Essential Expenses, and
- Non-Recurring Discretionary Expenses
where Recurring Expenses are expected to be incurred for most of your lifetime planning period and Non-Recurring Expenses are not. Pre-retirees who are not near retirement may need to estimate the percentage of their retirement expenses that they expect to fall into each category. Individuals in retirement or near-retirement should be able to better estimate these types of expenses by evaluating both their recent spending and near-term future spending goals.
To avoid over-saving/under-spending both before and after retirement, we recommend:
- following our Recommended Financial Planning Process,
- developing an expected Actuarial Reserve for Non-Recurring Expenses that reflects the expected payout period of the expense rather than your remaining LPP, and
- making reasonable assumptions to develop Actuarial Reserves for each different type of expense.
Many financial advisors use sophisticated Monte Carlo models to develop financial plans for their clients. Many of these models are not developed by the financial advisor, but instead are developed internally by larger firms or purchased from software vendors. There is considerable competition in the planning software market, including marketing claims to be the “next gen” approach that employs the most complicated Stochastic assumptions. This raises the legitimate question of how much your financial advisor actually understands about the model he or she uses to develop your financial plan.
If your financial advisor develops a financial plan for you that uses a complicated Monte Carlo model, we suggest that you ask your advisor, at a minimum, how his or her model handles Non-Recurring vs. Recurring Expenses
and whether your advisor has “reconsidered” the model assumption that
expenses will increase in retirement in light of respected research
showing the contrary. Finally, we suggest that you (or your advisor)
compare the advisor’s model results with the results obtained using our
recommended financial planning process.
