Wednesday, October 12, 2016

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
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
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.

Sunday, October 2, 2016

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.

Thursday, September 29, 2016

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.