Better Planning Starts with Granular Budgeting, Part II

This
post is a follow-up to our post of November 19, 2024.  In it, we
discuss how updating your spending budget each year is an important step
in the process of successfully managing your finances in retirement.
 We will also provide some tips on how to accomplish this task using the
Actuarial Financial Planner.

For most retired households,
spending is not linear from year to year.  It can vary significantly,
especially if spending on non-recurring items is involved.  Therefore,
static financial planning approaches that assume constant real-dollar
spending from year to year (like the 4% Rule or Monte Carlo models that
develop a probability that the household will be able to spend $X per
year) can lead to under- (or over) spending in retirement, and just as
important, can lead to spending that is inconsistent with household
spending goals.

As part of your planning process in retirement, we
encourage you to annually develop a relatively granular spending budget
consisting of the four general types of spending:

1. Essential Recurring Spending
2. Essential Non-Recurring Spending
3. Discretionary Recurring Spending, and
4. Discretionary Non-Recurring Spending

and
compare the present value of your assets (including present values of
streams of future payments from Social Security, annuities, pensions,
etc.) with the present value of your budgeted spending liabilities to
develop your annual Funded Status.

Here is an example table that you can use to gather your annual spending data:

Spending Data Table

1. Note
   expenses that are either assumed to increase in the future at a faster
   (or slower) rate than assumed inflation. For non-recurring expenses
   expected to commence in a future year, estimate amount of annual expense
   (in future dollars) and note when such expenses are expected to start
   and end.   For non-recurring expenses expected in the current year, note
   when such expenses are expected to end.

Tips for
entering your spending data in the Actuarial Financial Planner (AFP) to
determine present values and to develop your Funded Status

1. Combine
   recurring expenses with the same expected rate of future increases and
   input that amount in the appropriate cell of the AFP. Some recurring
   expenses, like future taxes or future healthcare expenses may be
   expected to increase at a faster rate than general inflation in the
   future.  Other expenses in retirement, like recurring discretionary
   expenses, may be expected to increase at a rate less than inflation (or
   even decrease in real dollars) in the future.  You can combine recurring
   expenses that have equal future assumed rates of increases when
   entering them into the AFP to determine their present values.
2. Expenses
   entered at the beginning of each year are estimated expenses for that
   year and will usually be higher than expenses entered in last year’s AFP
   due to inflation. Also, some non-recurring expenses will no longer
   apply, or will be expected to commence one year earlier or end one year
   earlier than entered in the previous year’s AFP.  Most of the input
   items will change from year to year.
3. Present values of non-recurring expenses are generally entered into the AFP by entering data into the following cells:

Where
“annual amount” is increased by inflation (or some other reasonable
rate) from the current year until the expected year of first payment;
the deferral period is the period in which no payments are assumed;
payment period is the number of expected years of payment for this
expense after the deferral period; annual rate of increase is the
expected rate of increase once payments are expected to commence, and %
upside/% essential is the users estimate of how essential this
particular expense is.   Note that if the user expects to have more than
six non-recurring expenses in retirement, he or she can use one of the
five “other income” cells, except negative annual amounts should be
input.

4. Calculations of the present values of
   non-recurring expenses (as well as recurring expenses) are shown in the
   PV Calcs tab and can be checked there for reasonableness.
5. If your Funded Status is less than 95%, you may wish to revise your inputted desired spending for the year.

Conclusion

As
noted in prior posts, the Actuarial Approach to determining how much
you can afford to spend in retirement is based on the following three
M’s:

• Measuring your Funded Status each year
• Monitoring your Funded Status from year to year, and
• Making changes in your assets or you spending liabilities if your Funded Status falls outside reasonable corridors.

In
addition, we encourage you to periodically stress-test important
planning assumptions to assess possible risks (that your assumptions
won’t be realized in the future) so that you can better Manage such risks. 

At
the beginning of 2025, we will remind you that it is time once again to
re-determine your Funded Status.  If you want to get a jump on this
task, feel free to use the Spending Data Table supplied in this post.