In our post of May 9, 2022, we questioned whether it was perhaps too early to consider reducing 2022 discretionary spending in light of unfavorable 2022 stock market performance to date. In that post, we suggested several alternatives to reducing already-budgeted discretionary spending for 2022, including:
- Deciding to wait until next year to worry about investment losses incurred during 2022,
- Dipping into one’s Rainy-Day fund to cover the losses,
- Taking a part-time job to cover the losses, or
- Smoothing the losses over several years
In this post, we will discuss a slightly different alternative to reducing current discretionary spending—keeping current year recurring discretionary spending unchanged but effectively reducing future planned recurring discretionary spending by assuming smaller annual future rates of increases in such expenses. While this approach technically still involves reducing discretionary spending, it may be more palatable to retirees who believe their discretionary spending will probably decrease as they age.
Example
Let’s use an example to illustrate this different approach. Let’s assume we have a 65-year-old male named Bob who expects to experience a $70,000 loss (the actual return minus his assumed 6% return) on his upside portfolio assets during 2022. He doesn’t have a significant rainy-day fund to dip into and does not want to take a part-time job to make up this loss or smooth the loss over several years. He doesn’t have any non-recurring discretionary expenses, so he wants to see how much he may need to reduce his current year recurring discretionary spending for 2022 (or 2023) to cover this expected investment loss.
At the beginning of 2022, his recurring discretionary spending budget for 2022 is $18,169 and he assumed that his future annual recurring discretionary expenses would increase by the default inflation assumption of 2% per year. Under the AFP default assumptions for determining the present value of future recurring discretionary spending (shown in the PV Calcs tab), this present value was $317,333. If all planning assumptions are realized, Bob’s expects his future recurring discretionary spending to remain constant at $18,169 in real dollars over his entire 28-year lifetime planning period.
However, as noted above, Bob expects to incur a $70,000 loss on his investments in 2022. To keep his 2022 Rainy-Day Fund unchanged, Bob decides to reduce the present value of his recurring discretionary spending by $70,000 to cover the expected loss on his investments in 2022. The table below shows some of Bob’s options. If he wants his recurring discretionary spending to increase with assumed inflation of 2% each year, he would reduce such spending by $4,015 ($18, 169 - $14,154). However, if he could live with 0% annual future annual increases, he would only need to reduce his recurring discretionary spending by $764 ($18,169 - $17,405). He notes that under this latter option, his expected real-dollar discretionary spending would be only $10,197 in his final year rather than $14,154.
Bob’s Current and Final Year Expected Discretionary Spending under Different Annual Future Assumed Rates of Increases
Current Year Recurring Discretionary Spending | Assumed Annual Increase % | Present Value under Default Assumptions | Expected Real Dollar Spending in Year 28 |
$21,000 | -2% | $247,333 | $7,130 |
$19,163 | -1% | $247,333 | $8,559 |
$17,405 | 0% | $247,333 | $10,197 |
$15,734 | 1% | $247,333 | $12,059 |
$14,154 | 2% | $247,333 | $14,154 |
The table illustrates the basic principle of spending in retirement—You can spend it now or your (or your heirs) can spend it later. The corollary to this principle is the more you spend today, the less you will have to spend tomorrow, all things being equal.
Of course, Bob can always wait until the beginning of 2023 (or even later) to make his decision regarding how he will or will not adjust his discretionary spending for investment losses he may incur during 2022. At that time, he can also consider the option described above of being more aggressive with respect to assumed future increases in such expenses.
Using the AFP to Calculate Spending Budgets
The AFP can provide you with the numbers to help you (and Bob) make spending decisions. You can either use an iterative process by changing the inputs for recurring discretionary expenses and annual increase assumptions and noting the impact on the Actuarial Balance Sheet and current year spending, or you can input the desired annual rate of increase in the input tab and go to the PV Calcs tab, calculate the desired percentage reduction (or increase) in the present value of recurring discretionary expenses and apply the same percentage reduction (or increase) to the annual amount to determine the current year discretionary spending amount (annual payment). In the example above, Bob notes that a $70,000 decrease in the present value of his recurring discretionary expenses would necessitate a 22.1% decrease ($247,333/$317,333). Therefore, if he doesn’t change his assumed annual rate of recurring discretionary spending increases of 2% per year (default inflation), his current year discretionary spending will also need to be reduced by 22.1% (from $18,169 to $14,154).
In addition to changing the assumed rates of future increases (or decreases) in future recurring discretionary expenses, retirees can also effectively front-load their discretionary spending by using more aggressive assumptions applicable to discretionary spending in the AFP. This may be done by using AFPs override assumption features.
Conclusion
Many retirees believe that their annual recurring discretionary spending will decrease (either in real dollar terms or in nominal dollars) as they age. Some retirees even think that their annual recurring essential spending will decrease as they age. We are less comfortable with assuming future decreases in recurring essential spending than we are with assuming future decreases in recurring discretionary spending. As noted in our post of December 11, 2021, recent research has shown that “when households have assets and their health, they keep real consumption [spending] relatively flat over their retirement.” Ultimately, it is up to you as part of your plan to determine whether you are comfortable front-loading your expected spending and assuming it will decrease (in real or nominal dollars) as you age.
