This post is a follow-up to our post of April 16, 2022 regarding planning for non-recurring expenses in retirement, with emphasis in this post on long-term care costs. We also build on the example discussed in our previous post.
Expenses in retirement are not generally linear from year to year. That is why simple spending rules of thumb like the 4% Rule (with or without guardrails), or even more sophisticated Monte Carlo models that develop probabilities that a household can spend $X per year in real dollars, frequently fail to reflect real-world spending in retirement and are, therefore, likely to miss the mark. Developing and maintaining a robust spending plan in retirement is a classic actuarial problem involving the time-value of money and life contingencies. This problem is easily solved utilizing basic actuarial principles, including periodic comparisons of household assets and spending liabilities.
In our previous post, we discussed the example couple of John and Mary (two 65-year-old retirees) originally introduced by Justin Fitzpatrick of Kitces.com. In his article, Mr. Fitzpatrick indicated that, based on their assets and some undisclosed assumptions, there was a relatively high probability that John and Mary could afford to spend about $117,600 per year in real dollars with $39,600 coming from annual withdrawals from their portfolio (almost 4% of their initial $1,000,000 portfolio).
Using the Actuarial Financial Planner for Retired Couples (AFP) and our default assumptions (and an 80%/20% split of essential vs. discretionary recurring spending), we determined that John and Mary’s Funded Status (comparison of assets and spending liabilities) was 100.87%, or somewhat less robust than the financial picture painted by Mr. Fitzpatrick. But, as noted in our previous post, Mr. Fitzpatrick did not plan for any future non-recurring expenses for this couple. Let’s see what would happen to John and Mary’s Funded Status if they decided to plan for future long-term care costs in addition to their annual recurring spending.
Example
The AFP has 6 buckets for determining the present values of future non-recurring expenses. It also has 5 “other income” buckets that can also be used to calculate present values of future non-recurring expenses by entering negative amounts. These 11 buckets can also be used to calculate the present values of almost any other non-linear stream of future expenses or sources of income.
To estimate the present value of their future long-term care costs, John and Mary visit the Median Cost Data Tables at the Genworth Cost of Care website and look up median costs for assisted living and nursing home care for their current state of residence, which we will assume is California. They find that for 2024, the median annual cost for assisted living in California is $75,000 and the median annual nursing home cost for a semi-private room is $136,875.
John and Mary decide to plan on 2 years of assisted living and 1 year of nursing home care to occur at the end of Mary’s lifetime planning period. The average cost for that 3-year period (in today’s dollars) would be $95,625, but they expect that their recurring expenses would be reduced by $30,000 (in today’s dollars) for this three-year period. Thus, they plan on incurring 3 years of extra expenses of $65,625, in today’s dollars, at the end of Mary’s life.
They enter the following amounts into row 41 of the AFP:
Annual Amount | Deferral Period (yrs) | Payout Period (yrs) | Annual Rate of Increase | % Essential (Liabilities) |
$150,145 | 28 | 3 | 3% | 100% |
The assumed cost starting in year 29 (the $150,145 annual cost in future dollars shown above) is determined by increasing the average current net cost of $65,625 developed above with their estimate of annual increases in long-term care costs of 3% per year for 28 years ($65,625 X 1.03 **28). The annual rate of increase of 3% entered in the spreadsheet applies for the years once payments are assumed to commence. John and Mary determine, for their planning purposes, that these long-term care expenses are not expenses they can simply reduce or eliminate if they choose to (i.e., not discretionary), so they classify them as “100% Essential”. This choice affects the discount rate used in the present value calculations.
The AFP determines the present value of this assumed stream of payments under the default assumptions to be $112,728 (as shown in the PV Calcs Tab). This amount is added to their liabilities and their revised Funded Status drops from 100.87% to 96.75% as a result of recognition of this future cost. John and Mary wonder if there are other non-recurring expenses they might encounter over the next 30 years that should also be built into their plan, such as:
- Purchase of new cars
- Luxury Travel
- Support of aging parents or children
- Unexpected home repair or desired home improvements
They also wonder if they should use the AFP to model possible future decreases in their Social Security benefits or the future sale of their home that were not reflected in their financial advisors model.
Static Monte Carlo and 4% Rule Approaches vs. The Dynamic Actuarial Approach
In some ways John and Mary prefer the simplicity of their financial advisor’s proclamation that they have a high probability of being able to spend $117,600 in real dollars for the rest of their lives. They can simply increase their spending budget each year with inflation, and they don’t have to deal with annual budget calculations and possible adjustments in spending. John complains that the Actuarial Approach requires periodically thinking about their future spending, re-entering revised data every year into the Actuarial Financial Planner and possibly make spending adjustments based on their annually recalculated Funded Status.
Mary reminds John that:
- It may not be reasonable to simply trust their financial advisor as he does guarantee his results
- Their advisor’s assumptions about the future are unlikely to be 100% accurate and some adjustments will likely be required over the next 30 years to keep their spending on track
- Their spending is not likely to be the same real dollar amount from year to year, and
- It is a good idea to periodically revisit their plan and discuss their spending, and it will probably take no more than one hour at the beginning of each year to recalculate their Funded Status and document their annual planning valuation.
Mary convinces John that the Actuarial Approach is the more prudent approach for achieving their goals in retirement and for keeping their spending on track.
Conclusion
Good financial planning during retirement involves periodic (we recommend annual) re-measurement of the household Funded Status and adjustments in spending when necessary. The re-measurement does not have to involve simulations but it should involve estimating future expenses, be they recurring or non-recurring in nature. If your financial advisor’s plan does not anticipate non-recurring expenses, like long-term care costs, you should consider using the AFP annually to measure your Funded Status.
