Is it Time for a 2016 Spending Check?

The last thing I want to do with this post is put a damper on your holiday season, but we only have two months left in the calendar year, and for many retirees, the holiday season can involve increased expenses.  Before you generously shower gifts on your family and friends this year, you might want to check to see how you are doing so far with your 2016 spending and investments. 

As discussed in our post of September 4 of last year, if you are using the Actuarial Approach to determine your spending budget, there is a relatively easy process you can use to check to see how you are doing in terms of meeting your spending and investment targets for the year.   The Runout Tab of the Actuarial Budget Calculator you used to determine your 2016 spending budget showed your expected accumulated savings at the beginning of year 1 (2017) if all assumptions were realized and you spent exactly your 2016 spending budget.  

To see how well you have done so far for 2016, you will need to

• estimate your spending and income for the final two months of 2016 and 
• compare your estimated end-of-year accumulated savings with the beginning of year 1 (2017) amount shown in the Runout tab of the 2016-year calculation.

If your estimate of year-end accumulated savings is significantly lower than the expected value (either because of over-spending or lackluster investment returns (or a combination of the two), you might want to consider reducing some of your expenses for the remainder of the year if you can.  To see the impact of over-spending or under-earning on your 2017 actuarially determined spending budget (before any smoothing you might choose to use), just enter your end-of-year accumulated savings estimate in the spreadsheet and pretend you are doing the calculation at the beginning of 2017. 

Focus on Your Spending Budget in Retirement–Not How Much You Can Withdraw from Your Investment Portfolio

It seems like every other week some retirement expert, financial planner or investment firm is coming out with their recommendation for the best withdrawal strategy to use to tap one’s savings in retirement.  The new and improved strategy may be “fixed”, “variable,” or a hybrid of the two.  It may be a “safe” withdrawal rate (as contrasted with one that is unsafe?)  It may have “guardrails.”  It may involve using the Excel PMT financial function.  It may be a rate that retirees should “feel free” withdrawing, or it may be one of the many approaches that adjusts the 4% Rule in some manner to supposedly make it better.  I refer to these systematic withdrawal approaches as “rule of thumb” (RoT) approaches.

All of these RoT approaches miss the point.  The point of the exercise is to determine approximately how much you can afford to spend each year while meeting your financial objectives, not how much to withdraw.  Sometimes adding the amount you can withdraw under these RoT approaches to other income you may be receiving for a given year will give you something close to a reasonable spending budget for that year, and sometimes it won’t.

The current widely-followed practice of first determining how much can be withdrawn from savings and then adding that amount to other available income for the year is just bass-ackward and, in my opinion, should be changed.
 

The process recommended in this website involves

• first determining a reasonable spending budget based on sound actuarial principles and 
• then subtracting other available income for the year to determine how much, if any, should be withdrawn from accumulated savings.

Thus, the reasonable actuarially-developed spending budget and the other income you may be receiving during the year determines how much you should  withdraw from your accumulated savings, not some RoT approach that doesn’t even consider how much other income you may or may not be receiving that year.

Under the Actuarial Approach, withdrawals from savings may be much greater than or much less than withdrawals suggested by RoT approaches, and this situation may change over the period of retirement.  An example of the former situation is when income in retirement is deferred (such as when Social Security or income from an anticipated home sale is deferred).  An example of the latter situation is when income in retirement is front-loaded (such as when a retiree works in part-time employment or receives other income for a temporary period of time).

Note:  It is certainly possible that the annual income from various sources in retirement may even temporarily exceed the year’s actuarially calculated spending budget.  In that event the withdrawal from accumulated savings for that year will be negative.  In other words, instead of withdrawing and spending x% from savings that year as the retiree may do under a RoT approach, under the Actuarial Approach she would actually be saving to fund future spending needs.

If you (or your financial advisor) are currently using a RoT approach to develop your spending budget, I strongly recommend that you change your mindset (as suggested in the graphic above) and consider the Actuarial Approach as a better alternative.  At a minimum, we encourage you to compare the spending budgets developed under your approach with that developed under the Actuarial Approach and make sure you are comfortable with any significant differences.

For those of you still wondering about the graphic above:  No I am not calling for a small change (20 cents) in practice.  I am calling for a paradigm shift.

Development of Betsy’s Pre-Retirement Spending/Savings Budget

In our post of September 29, we introduced a new tab in the Actuarial BudgetCalculator (ABC) to help pre-retirees develop a reasonable spending budget in order to achieve their financial goals. That post discussed how to use the Input tab and the Pre-Retirement Spending & Savings tab of the ABC for this purpose and promised to include an example in a future post. This post includes the promised example for a hypothetical pre-retiree named Betsy.

 

Since release of the latest version of the ABC last month, we have decided that eventually we will probably develop separate ABC spreadsheets for pre-retirees and retirees as the current version is somewhat “clunky.”  For the time-being, however, pre-retirees can use this somewhat more clunky version. 

 

While most retirees know approximately how much their Social Security benefit is or will be in the future, some younger retirees and many pre-retirees may not have a good idea of how much they should input in our spreadsheets for their benefit.  This post will describe a process that can be used for this purpose. 

 

Betsy’s Financial Goals

  

• Betsy wants to retire from her current job at age 65 with no part-time employment thereafter
• Betsy would like her real dollar first year post-retirement spending to be no less than 75% of her real spending in her final year of employment
• Betsy has no other financial goals, such as paying for her son’s college expenses
• Betsy doesn’t want to over-save or under-save for her retirement.  In other words, she would like to maintain a reasonable balance between her pre- and post-retirement lifestyles.
• Betsy doesn’t want to become a burden on her son, but doesn’t feel a need to leave him a large estate. 

Betsy’s Data

  

• Betsy is age 50 and is divorced
• She is employed and her current gross pay is $70,000 a year
• Her employer matches her 401(k) contributions $.50 for each dollar up to 6% of pay
• The current value of her home is $250,000

Betsy’s Assets:  

  

• Accumulated savings, 401(k) and personal assets, of $100,000
• The present value of her future employment income
• The present value of her estimated future Social Security benefit of $46,900 per year commencing in 20 years at age 70.  Betsy develops her estimated age 70 Social Security benefit of $46,900 using the following process:

Step 1:  Betsy goes to the Social Security Quick Calculator on the Social Security website.

Step 2:  She enters her date of birth, gross pay in the current year and her desired future benefit commencement date.  She also indicates that she wants her benefit estimate to be in current dollars and submits her request.

Step 3:  She multiplies the resulting monthly benefit estimate by 12 and divides the result by her annual gross pay.  This gives Betsy a replacement ratio.

Step 4:  She multiplies the replacement ratio developed in Step 3 by her estimated pay in the year preceding her retirement (and if this date precedes her Social Security benefit commencement, by the anticipated increase in inflation for the bridge period).  Her estimated pay in the year preceding her retirement is based on her assumption for future pay increases as discussed in the assumptions section below. 

 

Betsy follows the process above and develops a replacement percentage of 46%, which she multiplies by her gross pay of $70,000 and 19 years of 2% per annum increases (a factor of 1.457) to produce an estimated annual age 70 benefit of about $46,900. 

• The present value of future employer matching contributions to the 401(k) plan
• The present value of proceeds from future home sales. 

Betsy’s Assumptions:

For present value calculations, Betsy, with assistance from her financial advisor, has selected these assumptions:

• Annual discount rate of 4%
• Annual rate of inflation of 2%
• She expects her employment will continue until she retires, and her gross pay will increase annually at the rate of inflation (2%)
• She expects to contribute, into her employer’s 401(k) plan, at least the minimum to receive the maximum matching contribution ($2,100 in the current year increasing by 2% per year).  She uses the Present Value Calculator in this website to estimate the present value of the matching contributions to be about $29,000.
• She expects her existing home mortgage will be paid off by the time she retires.  She expects to sell her home when she enters an assisted living facility and she expects that the value of her home will earn 4% per annum.
• She expects to live until age 95
• She expects her future essential expenses (excluding health related expenses) will increase with inflation, that her future essential health related expenses will increase with inflation +2% and her future non-essential expenses will remain constant in nominal dollars.  Based on her expected distribution of such expenses, she believes her total annual recurring expenses in retirement will increase by inflation minus 0.5% each year after retirement.
• She expects that she will have to live the last three years of her life in an assisted living facility.  She estimates the current cost of a three-year stay in her geographic area at $170,000 and she believes this cost will increase in the future by inflation plus 2% each year.  Based on the approximation technique outlined in our post of January 12, 2016 to reflect the reduction in other recurring expenses, she estimates a present value of her long-term care costs at $102,000 (60% of $170,000).
• She estimates the present value of her future unexpected expenses to be $25,000
• She estimates that $200,000 (in nominal dollars) will be sufficient to cover her funeral expenses, with any remainder to be left to her son.

Entries in Column B of the Input Tab

   

Row      Entry

7          $100,000 (Betsy’s accumulated savings)

9          $46,900 (Betsy’s projected Social Security benefit as developed above)

11        20 (the number of years before expected commencement of her

            benefit)

25        $250,000 (the present value of her home sale proceeds)

27        4% (Betsy’s expected rate of return on her investments/discount rate)

29        45 (Betsy’s lifetime planning period—95 minus her age)

33        $200,000 (The amount desired to be left at the end of Betsy’s lifetime

            planning period)

35        2% (the expected annual rate of future inflation)

The result in Row 41 with these input items is $743,813 (the present value of Betsy’s retirement spending budgets based on the input items above).  This amount is carried forward to the new pre-retirement spending and savings tab as the beginning value. 

 

Entries in Column B of Pre-Retirement Spending & Savings Tab

  

Betsy then goes to the Pre-Retirement Spending & Saving tab and makes the following entries:

 

Row      Entry

6          $70,000 (Betsy’s current gross pay)

7          15 (the number of years until her desired retirement age of 65)

8          2% (Betsy’s estimate of the annual future percentage increase in her

            gross pay)

10        $29,000 (Betsy’s estimate of the PV of future matching contributions to

            the 401(k) plan)

13        $102,000 (60% of Betsy’s estimate of 3 years of assisted living cost of

            $170,000)

15        $25,000 (Betsy’s reserve for unexpected expenses)

20        12% (the percentage of her gross pay she intends to save)

23        1.5% (the desired annual increase in Betsy’s recurring retirement

            spending budget)

 

The result shown in E 26 of the new tab with these input items is that if all of Betsy’s assumptions are realized in the future, her expected real dollar spending budget in her first year of retirement (age 65) would be 76.22% of her age 64 real dollar spending budget.   If she only wanted to save 8% of her pay each year rather than 12%, she could still reach her 75% real spending goal by working approximately another two years.  Betsy understands that because she has included the value of her home as an asset for budget purposes, she may have cash-flow problems later in her retirement that might require downsizing her home or taking out a reverse mortgage earlier than she might want.

 

Betsy also understands that (i) she may not be able to continue in her current employment until her desired retirement age, (ii) her estimated Social Security benefit may be reduced as a result of impending Social Security reform and (iii) some of her other assumptions may also turn out to be optimistic.  For this reason, she decides that she will try to save at least 15% of her pay each year just to be a little safer.  Of course, she will monitor her actual savings and spending each year and revisit this process every year to make sure she remains on track to meet her financial goals.

We’ve Updated the Present Value Calculator and Added a New Member to Our Team

Present Value Calculator

As discussed in our previous post, the fundamentals of the actuarial approach advocated in this website involve calculating the present values of future sources of revenue and future expected expenses.  We have developed two Excel spreadsheets to help our readers with these calculations:

• the Actuarial Budget Calculator (ABC) and
• the Present Value Calculator (PVC).
  

These spreadsheets can be found in the “Articles/Spreadsheet” section of our website.  Like the previous version of the PVC, the updated version (1.1) will permit you to calculate present values of future streams of annual payments or single payments, starting immediately or at a specified time in the future.  For simplicity’s sake, all steams of future payments are assumed to be made at the beginning of each year.  The updated version will also enable you to calculate the present value of a single payment to be made in the future, with the value of that payment assumed to increase by k% per year.

As always, we solicit your feedback for ways to improve our spreadsheets.  Please let us know how our spreadsheets can be improved and we will try to accommodate your requests.

New Team Member

I’m pleased to announce that Bobbie Kalben, FSA, has joined Kin Chan (our tireless web guru) and me in our quest to help retirees and pre-retirees (and their financial advisors) develop reasonable spending budgets.  Bobbie is another retired pension actuary whose specialties include communicating complicated subjects.  Bobbie’s self-described mission for this website is to translate some of the “actuarial-eze” that I too frequently use into plain English and to make some of the more complicated material here a little more accessible.  While Bobbie has already been helping me out for a couple of months, the updated PVC represents her first effort at making our spreadsheets a little more user-friendly.  She has also ambitiously agreed to update the ABC next.  Before she completes that task, however, I wanted to release a new version of that spreadsheet that includes a new tab to help pre-retirees develop a spending/savings budget.

We encourage you to use these spreadsheets in your financial planning, and if you like them, to recommend them to your friends.

How Much Do You Really Need to Save Each Year to Achieve Your Financial Goals?

Since its inception in 2010, this website has been primarily focused on helping retirees develop a spending budget in retirement.  We have advocated using several basic actuarial principles to do this.  The first basic actuarial principle involves matching your assets with your spending liabilities using this balance equation:

Accumulated savings

+

PV future income

=

PV expected non-recurring expenses

+

PV future spending budgets

A second basic actuarial principle is to revisit this calculation periodically (we recommend annually) to maintain the actuarial balance in the equation above.  Actuaries call this basic principle “annual actuarial valuations.”

Most of the calculations required to match one’s assets with one’s spending liabilities involve making assumptions about the future, and calculating PVs of streams of payments.  Our website includes a Present Value Calculator spreadsheet for this purpose, and the ABC spreadsheet that anticipates some of the more common PV calculations for individuals, and is thus designed to reduce much of the math burden for users.  When in doubt, however, it is always wise to go back to the basic principle embodied in the equation above.

While we have focused on helping retirees determine how much they can afford to spend in retirement, these same actuarial principles (including the asset/liability matching equation above) can be applied to the question of:

• how much a pre-retiree can afford to spend and 
• how much he or she should be saving in order to meet financial goals. 

This post will discuss how pre-retirees can use the new Pre-Retirement Spending Savings tab we have added to the ABC spreadsheet to develop a reasonable pre-retirement spending/savings budget.  An example of how to use our new tab will be included in a future post. 

How Much Do You Need to Save?

So, how much do you really need to save each year to achieve your financial goals?  Most “experts” recommend saving as much as possible or some rule of thumb percentage.  For example, a recent Nerdwallet study suggests that 22% of income may be the new retirement saving target for millennials.  Our advice is that it depends on many factors, including:

• Your financial goals 
• Your accumulated savings 
• Your other expected sources of income 
• How much your assets will earn, how long you will live, and the rate of future inflation and its impact on your expected future expenses 
• Other non-recurring expenses you may have 
• How long you want (or will be able) to work 
• Your capacity and willingness to save, etc.

The new Pre-Retirement Spending Savings tab in our revised ABC spreadsheet gives you the ability to model the impact, on your expected retirement spending budget, of variations in your assumed future savings rate, as well as variations in the items above.  If you are already retired, you can continue to use the ABC spreadsheet and simply ignore the new tab. 

How to Use the New Pre-Retirement Spending Savings Tab in the ABC

In order to determine how much of your current gross pay you can afford to spend while saving the remainder in order to accomplish your financial goals, we expanded the PVs in the equation above to cover both pre-retirement and post-retirement periods.  The ABC already considers post-retirement, so the new tab includes assets and liabilities for the pre-retirement period.

The first step in this process is to determine the PV Future (Retirement) Spending Budgets, by entering data into the Input tab of the ABC spreadsheet:

• Accumulated savings (cell B7) 
• Estimated amounts of future retirement income, such as Social Security (cell B9) and any life annuity (cells B13, B17 or B21), and expected commencement of such income (cells B11, B15, B19 or B23) 
• The PV other sources of income in retirement, including proceeds from asset sales or reverse mortgages, income from part-time employment, rental income, etc. (cell B25) 
• Assumptions about the future, including future investment returns (cell B27), future rates of inflation (cell B35), and lifetime planning period (pre-retirement period + expected payout period) (cell B29), and Desired amount remaining at end of lifetime planning period (cell B33)

Note:  If you have an estimate of your Social Security benefit payable at some age in the future that is in current dollars, you will need to increase that estimate based on future pre-retirement inflation.

The significant result of inputting these items is the PV Future (Retirement) Spending Budgets found in cell B41 (row 41 and column B) of this Input tab of the ABC spreadsheet, which becomes the starting value on the new Pre-Retirement Spending Savings tab.  Once you have completed this first step, proceed to the new Pre-Retirement Spending Savings tab.

In Step 1 of the new tab, PV future gross pay (cell C9) is developed, which, when added to the PV other pre-retirement income (such as employer contributions to a defined contribution plan) (cell B10) becomes PV Pre-Retirement Assets (cell C11).  This is added to the starting value of PV Future (Retirement) Spending Budgets (cell D3).  If you anticipate working on a part-time basis after retirement, that expected PV should be entered as part of PV Other Sources of Income (cell B25) of the Input tab, not here.  Also note that Social Security applies an earnings test to employment earnings prior to your Social Security Normal Retirement Age.  Therefore, you need to coordinate the Desired number of future years until retirement (B7) with the Social Security benefit commencement year (cell B11 on the Input tab).

Next, in Steps 2 and 3 input expected PV Long-term Care Costs (cell B13) and the PV Unexpected Expenses (cell B15).  The program then subtracts these amounts from the remaining PV from the previous step.  If there are other expected non-recurring expenses, such as expected college expenses, add the PV of such items in one of these two steps.  (See our post ofJanuary 12, 2016 for a discussion of how you can modify your estimate of Long-term Care Costs to reflect a reduction in normal annual expenses associated with moving into an assisted living facility.)

In Step 4, the spreadsheet calculates PV Pre-Retirement Spending and subtracts it from the remaining PV from the previous steps.  It does this by asking you to input the percentage of your pre-retirement gross pay you intend to save this year and every year until you retire, Desired percentage of annual gross pay savings (cell B18).  This percentage multiplied by your gross pay is your savings budget.  The remainder of your pre-retirement gross pay constitutes your pre-retirement spending budget, and is intended to cover all your expenses including taxes.

In Step 5, the spreadsheet takes the amount of remaining PV after Step 4 (cell D20) and spreads it over your expected period of retirement (your lifetime planning period (Input tab B29) minus the Desired number of years until retirement (cell B7)), based on the input desired annual increase in post-retirement spending budget (cell B23).  As discussed in previous posts, if most of your expenses in retirement will be essential expenses, you will probably want your post-retirement spending to keep up with inflation.  If a significant portion of your post-retirement expenses are discretionary, it may be ok to assume future spending increases less than assumed inflation.

These calculations produce a retirement spending budget replacement ratio (ratio of first year retirement spending budget to final working year spending budget, in real dollars (cell E26) under the assumptions entered into the spreadsheet.  It is not unrealistic to plan on some decline in real dollar spending in the first year of retirement, as taxes will generally be lower, work-related expenses will be lower and mortgages may be paid off.  How much of a reduction in your pre-retirement standard of living you are comfortable with is, of course, the purpose of this exercise.  For example, if you are not comfortable with the estimated decrease in your post-retirement spending, you may need to increase your Desired percentage of annual gross pay savings (cell B18) or increase your Desired number of years until retirement (cell B7) or both.  Or you may need to increase the PV of post-retirement part-time work you entered in cell B25 of the Input tab.  There are many levers in this spreadsheet you can vary in your pre-retirement spending/savings budget planning.

Caution: Note that the Runout, Inflation Adjusted Runout, 5-year Projection and Budget by Expense-Type tabs in this spreadsheet will not be valid for this pre-retirement spending/savings budget exercise.  They were developed to provide additional information to retirees who have commenced spending their retirement assets.

Got Those “Conflicting Social Security Deficit Estimate” Blues Again

This post is a follow-up to my post of January 22, 2016, where I noted that relatively small tweaks in assumptions about the future appeared to have a fairly large impact on Social Security’s 75-year actuarial balance calculation, and my post of July 30, 2016, where I called upon the actuarial profession to advocate adoption of automatic approaches to maintain Social Security’s actuarial balance as part of the next round of system reform to enhance the system’s sustainability. 

This week, Keith Hall, the Director of the Congressional Budget Office (CBO), appeared before the House Subcommittee on Social Security to explain why CBO’s calculation of Social Security’s 75-year actuarial deficit was so much higher than the deficit calculated by Social Security’s actuaries and included in the official Trustee’s report.  Here is a link to his testimony.  Mr. Hall explained that by tweaking a few assumptions, the CBO calculated the 2016 75-year actuarial deficit to be 4.68% of the system’s taxable payroll vs. the 2.66% figure calculated by the Trustees.  In other words, the CBO calculated deficit, when measured as a percentage of taxable payroll was about 75% higher than the deficit calculated by the Trustees.  It is also important to note that neither of these two calculations recognizes the significant deficits projected for years after the 75-year projection period under current law, and therefore both actually understate the long-term problem.

As discussed in my post of January 22, I have no idea whose assumptions are more accurate, and frankly that is not the point of this post anyway.   The point is that no one can predict the next 75 years accurately, and it is just foolish to believe that changes made today, tomorrow or five years from now based on 75 years of assumptions about the future are definitely going to solve the system’s long-term funding problems for 75 years or more.  Yet that is just what we heard when Congress supposedly solved the system’s problem for 75 years back in 1983, and that is just what we heard more recently from the Bipartisan Policy Commission when they proudly announced that, “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…”  Statements such as these are conditioned on future experience closely following the assumptions made by the Trustees.  So, if actual future experience is just a little worse (say like experience assumed by the CBO), all bets are off.  

Common sense tells us that rather than waiting to have Congress make very significant changes to the Nation’s retirement program every thirty years or so to put it back into actuarial balance, it would be preferable to have minor changes made on a more frequent basis.  This why I have recommended consideration of automatic adjustments to the system’s tax and/or benefit structure to maintain the system’s actuarial balance.  This is what they do in Canada for the Canada Pension Plan.  This is what is done in almost all financial programs funded using basic actuarial principles.   I believe that adoption of such an automatic adjustment approach would go a long way to enhancing the sustainability of and faith in this critical program.

So, in my post of July 30, 2016 I called on my profession to fulfill its duty to the public and advocate automatic adjustments to maintain the program’s actuarial balance.  I also sent a link to my post to all of the leaders of all of the U.S. actuarial organizations.  Despite my many years of volunteering for most of these organizations, I received essentially no response, and certainly nothing resembling an explanation of why the profession wouldn’t even consider suggesting or recommending such an approach to Congress. 

I believe that the actuarial profession fumbled the Social Security football back in 1983.   With potential and significant Social Security reform on the horizon, it looks like the actuarial profession will be given another chance to carry the ball.  Unfortunately, based on actions I’ve observed to date, it appears the profession will once again fumble the ball.  One has but to look at the American Academy of Actuaries’ Social Security Game for an example.  Simply make a couple of changes in the current tax/benefit structure to solve the 2015 Trustees estimate of the 75-year actuarial deficit and the Game congratulates you for winning the Game by fixing Social Security.  If only it were that easy.

Recommended Assumed Annual Rate of Investment Return Lowered Again

From time to time I look at immediate annuity purchase rates for the purpose of possibly revising my recommendation for the expected annual rate of investment return assumption and the rate of inflation assumption to use in the Actuarial Budget Calculator.   The assumption for the expected annual rate of investment return is also referred to as the discount rate as it is the rate used in the Actuarial Budget Calculator to discount future expected payments to obtain present values.  Readers of my blog know that I like to recommend a discount rate that is roughly consistent with the discount rate implied in immediate annuity purchase rates, as this rate is approximately the discount rate at which a retiree could settle some or all of his or her retirement liabilities (generally the present value of future spending budgets).  It also gives a retiree a pretty good estimate of the relatively low-risk cost to fund their retirement.  Yes, investment in risky assets may result in higher investment returns (and a potentially higher discount rate), but risky assets also carry greater risk.  Therefore, while I don’t make recommendations on how you should invest your assets, I do recommend that you assume that your assets will earn a fairly conservative rate.  If your assets actually earn more than this conservative rate in the future, you can increase your future spending budgets (or you can increase your rainy day fund as discussed in our post of July 4, 2016). 

Historically, I have also recommended using a future inflation assumption that is 200 basis points below the discount rate as this is roughly the historical difference between inflation and returns on bonds; the investments used in annuity products.

Only the actuaries at the actual insurance companies know the assumptions and methods they use to price their immediate annuity products.   These assumptions and methods include mortality, mortality improvement, anti-selection, interest rates and other factors, such as desired levels of insurance company profits, commission schedules and whether they have already written their quota of business for the year.  So, I don’t claim to really know the discount rate (or more likely different discount rates by year) assumption they use.  I can only make a crude educated guess.   Historically in prior posts, I have done that by solving for the discount rate that is approximately consistent with age 65 annuity purchase rates using the age 65 life expectancy for a 65-year old male (22.9 years) or a 65-year old female (24.9 years) under the 2012 Society of Actuaries’ Individual Annuity Mortality Table with 1% per year mortality improvement. 

Recently I looked at how much monthly immediate fixed dollar annuity income could be purchased for $100,000 in California by 65-year old males and females from the following three online sources:

• Immediateannuity.com 
• Incomesolutions.com 
• Annuityquickquote.com
  

The table below shows the highest quoted monthly income for age 65 males and females and the respective implied discount rate for each quote based on the methodology described above. 

(click to enlarge)

As shown in the table, the annuity quotes and implied discount rates from annuityquickquote.com appeared to be significantly higher than those from incomesolutions.com, which, in turn, appeared to be higher than those from immediateannuities.com.  The annuity quotes from immediateannuities.com list the actual insurance company and their AM Best rating, while the quotes from the other two online sources do not.  For example, the quote from Met Life on immediateannuities.com on September 3rd for a 65-year old male was $490 per month and was $467 per month for a 65-year old female.  Under the methodology described above, this translates into about a 2.74% annual discount rate for the male annuity and a 2.84% annual discount rate for the female annuity offered by Met Life.  

Based on the data in the table above, I have decided to lower my recommended discount rate and inflation rate by 0.5% to:

• Recommended discount rate: 4.0% 
• Recommended inflation rate:2.0%

I would certainly not argue with you, however, if you wanted to use a lower discount rate and a consistent assumed rate of inflation.

What are the implications for your spending budget of using a lower assumed discount rate?  All things being equal (i.e., your future inflation assumption remains unchanged), it means that your spending budget will decrease somewhat, as the anticipated cost of your retirement will be more expensive.  If your assumed inflation assumption is reduced by 50 basis points as well, however, your spending budget may actually increase depending upon how much fixed dollar income you anticipate receiving and how you plan to spread the present value of your future spending budgets. 

Planning for Constant Real-Dollar Spending in Retirement — Is It Setting the Bar Too High? Part II

This post is a follow-up to my post of March 31 of this year in which I encouraged you (or your financial advisor) to use the Budget by Expense-Type Tab of the Actuarial Budget Calculator to develop a reasonable spending budget that more closely meets your spending objectives with respect to the various types of expenses you expect to incur in the future.

Initial Spending Budget
 
Developing an initial spending budget using the Actuarial Approach is a two-step process:

• The first step in the process is to determine the total present value of the assets you have to spend.  This present value includes your current liquid assets, the present value of your Social Security benefits, the present value of your defined benefit plan benefits, the present value of any annuity income you may have, the present value of non-liquid assets you may own that you plan to sell in the future, the present value of rental income from properties you may own, the present value of future wages you may earn, etc. 
• The second step in the process is to determine how you want to spread this total present value of assets over your expected payout period.
  

The result, Current Year's Total Actuarial Spending Budget based on annual desired increase (shown in row 42 of the Input Tab of the Actuarial Budget Calculator spreadsheet), shows this year’s actuarially determined spending budget:

• if you decide to spread the total present value of your assets, less Desired amount of savings remaining at death (input in row 33), over 
• the Expected payout period (input in row 29), based on the assumption that future spending budgets will increase each year by the Annual desired increase in future budget amounts percentage (input in row 31).
  

If the same assumption is input for the Annual desired increase in future budget amounts (in row 31) as is input for Expected annual rate of inflation (in row 35), you are essentially planning for constant real-dollar spending throughout your retirement:

• assuming all the assumptions input in the spreadsheet (including the mortality assumption) are exactly realized (and unchanged), and 
• your actual spending exactly matches your spending budget each year.
  

We know, however, that all of the assumptions you input in our spreadsheet won’t be exactly realized (and/or unchanged) each year, and your actual spending will probably not be exactly equal to your spending budget.  That is why we added the 5-year Projection Tab, so that you could see how variations in investment returns and actual spending could affect your future spending budgets.

We also know that not all of your future expenses are likely to increase at the same rate, which is why we added the Budget by Expense-Type Tab to the spreadsheet.  This tab gives you the ability to spread the present value of your assets (which is also equal to the present value of your future spending budgets) between five different types of expense:

• long-term care 
• unexpected 
• essential non-health (ENH) 
• essential health (EH) 
• non-essential (NE)
  

and to make different future increase assumptions for these expenses:

• essential non-health (ENH) 
• essential health (EH) 
• non-essential (NE)
  

This is one of the many benefits of using the Actuarial Approach that you just don’t get with many other approaches — the flexibility to decide how you want to budget the spending of your retirement assets.

Planning for Constant vs. Decreasing Real-Dollar Spending
 
And the foregoing brings us to the inspiration for today’s post (with my apologies for taking so long to get here).

Three of retirement researcher Wade Pfau’s recent articles,

• Retirement Spending Increases and Decreases Over Time 
• What Is the “Retirement Spending Smile?” 
• What Is Age Banding And What Does It Mean For Retirees?
  

note that average spending appears to decrease consistently during retirement, until individuals become quite old, at which time their expenses (mostly health-related) increase.  Therefore, according to Dr. Pfau and other researchers, “Suggesting that retirees should plan for constant inflation-adjusted spending may overestimate the required retirement savings that many households will require for a successful retirement.”  Stated in another way, this research appears to support some degree of “front-loading” of the early years’ real-dollar spending budgets, relative to later years (i.e., larger early year budgets than later year budgets, measured in real dollars).  In his “Smile” article, Dr. Pfau cites research from David Blanchett that shows that real-dollar spending for a retiree whose initial spending is about $100,000 is expected to decrease by about 1% per year until the retiree reaches her early 80s, at which time health-related expenses will tend to increase real-dollar spending.
 
While I agree that non-essential expenses are likely to decrease in real dollars as we age in retirement, I also agree with Dr. Pfau that other types of expenses in retirement are likely to remain constant in real dollars or even increase.  It is for this reason that I recommended different rates of assumed increases for

• essential non-health (ENH) expenses, 
• essential health (EH) expenses and 
• non-essential (NE) expenses
  

for determining 2016 spending budgets in my post of December 21 of last year.

It is important to note, however, that if we assume:

• essential non-health (ENH) expenses will increase with inflation in the future, 
• essential health (EH) expenses will increase faster than general inflation and 
• non-essential (NE) expenses will increase at a rate less than inflation,
  

then the expected rate of increase or decrease in the total real-dollar spending budget will depend on the relative levels of these three separate budget components.

The larger the portion of the spending budget that is represented by non-essential expenses (using different rates of assumed increases for essential non-health (ENH) expenses, essential health (EH) expenses and non-essential (NE) expenses), the greater the annual decrease expected in future real-dollar total spending budgets.

Examples using James and Michael

Let’s take a look at two different retirees to illustrate this point.  Both James and Michael are:

• 65-year old males 
• with $20,000 annual Social Security benefits, 
• a $10,000 annual pension benefit, 
• no other sources of retirement income and 
• no bequest motive.
  

The only difference between James and Michael is their accumulated savings:

• James has accumulated savings of $500,000 and 
• Michael has accumulated savings of $1,000,000.
  

Both retirees use the Actuarial Budget Calculator to develop their spending budget for this year and our recommended assumptions of:

• 4.5% discount rate 
• 2.5% inflation 
• expected retirement period equal to age 95 minus attained age or life expectancy if greater.
  

Under these assumptions, the present value of assets are:

• $1,129,966 for James, and 
• $500,000 higher, or $1,629,966 for Michael’s.
  

If these present values are spread over their expected retirement periods as a constant real-dollar amount (increasing each year at the same 2.5% annual rate assumed for inflation), their spending budgets for this year would be:

• $49,156 for James 
• $70,907 for Michael.
  

 
Examples Using Budget by Expense-Type Tab

Both James and Michael have determined their expenses as:

• essential non-health (ENH) expenses for the upcoming year are $30,000 
• essential health (EH) expenses are $7,000 
• essential non-health (ENH) expenses will increase by inflation in the future (2.5% as stated above) 
• essential health (EH) expenses will increase by inflation (2.5%) plus 1.5%, or 4.0% 
• non-essential (NE) expenses will remain constant in nominal dollars
  

For the sake of simplicity, we are going to assume that both have separately set up sufficient reserves for long-term care expenses and unexpected expenses.

If instead of planning for constant real-dollar spending, these retirees use the Budget by Expense-Type Tab of the spreadsheet and the increase assumptions for each budget expense type discussed above,

• James will develop a total spending budget for this year of $51,351 (or about 4.5% greater than his constant dollar spending budget), while 
• Michael’s total spending budget would be $80,725, (or about 13.8% higher than his constant dollar spending budget).
  

The reason for the different rates of increase is that non-essential (NE) expenses represent a much larger proportion of James’ total spending budget than for Michael’s.

Charts
 
The following two charts illustrate this concept by showing expected real-dollar budget components and total spending budgets for the two retirees by age, if all assumptions are realized.

click to enlarge

click to enlarge

It is important to note that we show expected budget components and totals only until age 90.  This is because real-dollar spending budgets developed as the sum of these three budget components under the Actuarial Approach are expected to decrease significantly once the retiree’s current age plus life expectancy starts to exceed age 95.  At that time, however, the retiree presumably has long-term care and unexpected expense reserves to dip into.
 
Over the 25-year period from age 65 to age 90, James’ expected total real-dollar spending budget decreases by about .25% per year, while Michael’s total real-dollar spending budget decreases by about 1% per year.  Thus, the results for Michael are very close to the results for the average retiree with initial income of $100,000 noted by David Blanchett.  However, it is important to look at your own situation to determine what is appropriate for you.