Sadly, our friend Dirk Cotton passed away on January 28 at age 68. You can find many of his sage thoughts on retirement planning in his blog, The Retirement Cafe. While we never met Dirk, we traded many emails and spoke on the phone frequently. We were big fans of Dirk and his ideas. If you search our website, you will find 15 of our previous posts that referenced his posts.
In this post, we are going to revisit the piece of advice Dirk offered that most resonated with us, and, in fact, became the foundation of our recommended actuarial financial planning approach. In his posts of February 4, 2019, “Honey What’s Our Retirement Plan?” and March 3, 2019, “Negotiating the Fog of Retirement Uncertainty” (both of which were also published in Forbes), Dirk boldly described “the most important decision you will make in retirement planning” as follows:
“The most important decision you will make in retirement planning is how much of your resources to allocate to the upside and floor portfolios” and “The correct balance [between the upside and floor portfolios] will depend on how willing you are to risk losing your standard of living for the chance of having an even higher one.”
As an homage to Dirk, in this post we are going to reiterate the relatively simple steps we believe you can take to help you make this “most important decision.” We will also include a few tips and an example involving using our Actuarial Budget Calculators (ABCs) for this purpose.
Building Your Floor Portfolio
Step 1—Estimate your current Essential Expenses (both recurring and non-recurring). While this step seems relatively straight-forward in principle, it may not be so straight-forward in practice. One person’s needs may be another person’s wants, and vice versa. Our recent COVID-19 lock-down experience has given us some useful data for determining which expenses may or may not be “essential.” Also, since this decision has potential impact on how much of your assets may be invested in low-risk vs. higher risk investments, you may also want to work backwards from your current asset mix to test how much essential expenses you can support with your current low-risk investments. This exercise may be a better indicator of how much risk you are willing to assume than some risk tolerance questionnaires.
Step 2—Calculate the Present Value of Your Future Essential Expenses. This step is relatively easy accomplished in our ABC workbooks by first entering your data in the Input & Results tab and then entering additional data and assumptions in the Asset Reserves by Expense Type tab. Some of the additional data for this tab will be developed in Step 1 above and some may be found in the PV Calcs tab.
Our hypothetical couple (see screen shot below) has total assets of $2,073,455, consisting of $1,000,000 in investible assets and $1,073,455 as the present value of their Social Security benefits (from the PV Calcs tab). For purposes of developing the present value of your essential expenses, we recommend that you use the default assumptions in the Input & Results tab as they are consistent with the low-risk investments that will be used to fund these essential expenses.
They enter their estimated current recurring expenses and assumed rates of future increases for these expenses in rows 6, 7 and 8, columns C and D. For purposes of future increases, we recommend assuming general levels of inflation for non-health related expenses and somewhat higher levels for health-related expenses. And while data shows that expenses in retirement decrease with age, we are not convinced that this will necessarily be the case with essential type expenses.
Our hypothetical couple has assumed that their home equity will cover their long-term care expenses, so they have previously entered “0” for this cost in the Input & Results tab and this amount is carried forward to row 13 of the Asset Reserves by Expense Type tab. Since they entered three non-recurring expense items in the Input & Results tab (for mortgage, new cars and travel), they go to the PV Calcs tab to determine what percentage, of the total present value of those non-recurring expenses of $396,175, they consider to be “essential.” In this example, they consider their non-recurring future expenses of $95,082, attributable to their future mortgage payments, to be essential and enter 24% as the percentage of non-recurring future expenses as essential. They considered their future car purchases and future travel expenses to be discretionary. The total present value of their essential expenses, using these inputs and default assumptions, is $1,408,354.
Here is a screen shot of the Asset Reserves by Expense Type tab for our hypothetical couple.
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Step 3—Compare the present value of your non-risky investments with the result of Step 2, and adjust your asset mix if necessary. As developed in the PV Calcs tab, the present value of our hypothetical couple’s Social Security benefits under the default assumptions is $1,073,455, or about $335,000 less than the present value of their essential expenses of $1,408,354 calculated in Step 2. Following the Safety-First investment approach, this implies that our couple should have at least 34% ($335,000 / $1,000,000) of their investible assets in relatively low-risk investments or guaranteed investments such as annuities. This will leave them with approximately 66% of their investible assets to invest in riskier investments, such as equities (their upside portfolio). They can also be more aggressive with how they spend their upside portfolio assets.
That’s it! Three simple steps to sleep better at night knowing your essential expenses are funded, and still have plenty of flexibility to spend on discretionary items.
Conclusion
We will miss Dirk Cotton and his sage retirement advice. We encourage you to follow his advice and use our ABC workbooks to develop what you consider to be the “appropriate balance between your upside and floor portfolios.”
