One of the first issues a retirement planner has to deal with is answering the question, "How long will I need to fund my retirement?"
Of course the answer to this question is, "As long as you live." And how long will you live? Although most of us don't know the answer to that question, insurance companies are very aware of the distribution of longevity of the overall population. We can use that information to help define the probabilities that we live for X years longer.
If you have no significant others, heirs, or dependents, you can estimate the length of time you need to fund retirement using uniform lifetime tables like those available in Chapter 1 Section 3 (Annuities):
http://www.golio.net/Chapter1.html
Some longevity calculators use perturbation analysis to estimate how personal habits and diet impact longevity. There are several links to various types of longevity calculators under Section 1.3 at the url:
http://www.golio.net/Chapter1.html
Knowing how much longer the average person your age will live is better knowledge than nothing, but there are still important problems that knowledge does not address.
1) You don't care about the average person, you care about you. Although the average 50 year old will live another 33.7 years, ten percent of them will live another 47.3 years. If you planned to retire at age 50 and fund only 33.7 years, you could get really hungry and uncomfortable during the next 10 or 20 years. Being one of the fortunate people who live long lives could seem like something other than a blessing if you didn’t plan for it.
2) If you want to plan for your spouse or other dependents, you are more concerned with joint life expectancy. On average, a 50 year old will live for 33.7 years, but if there are two 50 year olds, on average at least one of them will live another 40.4 years. If you plan your and your spouse's retirement based on uniform lifetime expectancies, make sure you die first. The last 6 or 7 years could get uncomfortable for the survivor.
The best link I have found to look at joint life expectancy is the Vanguard Joint Life Expectancy Calculator. You can find a link to it under Section 1.3 of the url:
http://www.golio.net/Chapter3.html
This calculator gives you probabilities that two people of same or different ages live X years longer. For retirement planning purposes, this is pretty useful.
You can get the official government joint and last survivor tables from a few places online. These tables are necessarily very long. You have to scroll through a lot of pages to find the one that has both you and your joint survivor’s ages in a top row and 1st column. Also, this tells you the 50% probability only. As mentioned, for retirement planning, you might want to plan for better than the 50 percentile problem.
IRS publication 590 includes a joint and last survivor table in Appendix C, Table II. For the IRS form, this table is not used unless spouses are separated by more than 10 years of age, but the data you are interested in is available in the table. The same government table that covers joint life expectations for ages 0 to 115 can also be found in the document available in Chapter 1 Section 1 (Publication 590 IRAs):
http://www.golio.net/Chapter1.html
The joint life tables start on page 104 of that document and continue to the top of page 126. To use any of these tables you need to find your age along the top row and your joint survivor’s age along column 1. The number in the intersection is the life expectancy from the present (ie. one of you is likely to live that many more years).
Use of the longevity tables described above helps provide guidance regarding the length of time your retirement plan should target.
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Sunday, January 27, 2008
Friday, January 18, 2008
Family Equivalence Scale
The US Bureau of Labor Statistics (BLS) has developed an estimate of how family size and type affects budget. You can use their estimates to evaluate cost of living changes along a typical family life cycle. All estimates are normalized to the costs for a family of four (two adults and two children). All other budget entries represent the normalized funding required for the specified family to maintain an equivalent lifestyle to the base family.
Family Type--BLS Normalized Family Budget
Single Adult--0.360
Two Adults--0.600
Two Adults, One Child--0.820
Two Adults, Two Children--1.000
Two Adults, Three Children--1.116
One Adult, One Child--0.570
For a single young person prior to marriage the cost of living is 36% that of a normalized family of four. The cost of living for a married couple increases to 60% of the normalization base. When one child is added, the family budget is at 82% of the base. A second child puts the family at base budget level. A third child places the couple at 111.6% the cost of a family of four. For cases not shown in the table, the equivalence family budget can be roughly approximated using the expression:
E = [(A + pK)^F]/2.751
where A is the number of adults in the family, K is the number of children, p=0.92 and F=0.75.
The USBLS equivalence scale indicates how difficult it is for a family to grow, maintain a lifestyle threshold, and continue to save for future retirement. If you hope to maintain a constant lifestyle, your family of three (two adults and one child) requires a 36.7% higher budget than a married couple with no children. If you (and your working spouse if he/she works) earn a salary increase of 5% over inflation per year, your income does not reach a level to support a first child until you’ve worked for more than 7 years. To achieve an income that would support a second child at the same standard of living would take an additional 4 years on the job.
A single engineer who wants to marry, or a couple that desires children have other options. You can choose to lower your lifestyle and carry on with family plans. You can choose to invest less money toward retirement, maintain your standard of living with family additions, and work more years before retirement. You can do a combination of both. When going from single to married, a couple consisting of two wage earners might easily exceed the required 66.7% income increase implied by the table simply by combining salaries. Although two cannot live as cheaply as one, two wage earners can live a more comfortable lifestyle or can save more toward their long-term goals.
Visit my site: http://www.golio.net/
Family Type--BLS Normalized Family Budget
Single Adult--0.360
Two Adults--0.600
Two Adults, One Child--0.820
Two Adults, Two Children--1.000
Two Adults, Three Children--1.116
One Adult, One Child--0.570
For a single young person prior to marriage the cost of living is 36% that of a normalized family of four. The cost of living for a married couple increases to 60% of the normalization base. When one child is added, the family budget is at 82% of the base. A second child puts the family at base budget level. A third child places the couple at 111.6% the cost of a family of four. For cases not shown in the table, the equivalence family budget can be roughly approximated using the expression:
E = [(A + pK)^F]/2.751
where A is the number of adults in the family, K is the number of children, p=0.92 and F=0.75.
The USBLS equivalence scale indicates how difficult it is for a family to grow, maintain a lifestyle threshold, and continue to save for future retirement. If you hope to maintain a constant lifestyle, your family of three (two adults and one child) requires a 36.7% higher budget than a married couple with no children. If you (and your working spouse if he/she works) earn a salary increase of 5% over inflation per year, your income does not reach a level to support a first child until you’ve worked for more than 7 years. To achieve an income that would support a second child at the same standard of living would take an additional 4 years on the job.
A single engineer who wants to marry, or a couple that desires children have other options. You can choose to lower your lifestyle and carry on with family plans. You can choose to invest less money toward retirement, maintain your standard of living with family additions, and work more years before retirement. You can do a combination of both. When going from single to married, a couple consisting of two wage earners might easily exceed the required 66.7% income increase implied by the table simply by combining salaries. Although two cannot live as cheaply as one, two wage earners can live a more comfortable lifestyle or can save more toward their long-term goals.
Visit my site: http://www.golio.net/
Monday, January 7, 2008
Planning a Retirement Budget
Once I learned a minimal amount about investments, risk and inflation, I came to believe that the biggest unknown facing the retirement planner (at least this retirement planner) was trying to predict the budget they would need in order to support a satisfying retirement.
The first step in getting a better grip on this is to understand how much you are spending today and on what. A lot of affluent technical professionals make enough money that they don't track expenses very well if at all. That’s the reward for all that hard work studying math and science in college. You don’t have to budget. But the absence of an accurate expense record makes this problem even tougher. If you know how much you spend today on each aspect of your life, you can go down the list and estimate whether you are going to spend more or less on that item in retirement. Finally, you can estimate how much more or less you expect to spend.
Here's a starting list for expense tracking from the US Bureau of Labor Statistics:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses.
One advantage of using a list that conforms to the USBL list is that you can monitor inflation rates by spending category more easily. This allows you to estimate your own personal rate of inflation relative to the published CPI-U. Many people feel that the inflation rate they experience is very different than CPI-U because their purchases do not conform to the category mix used by the Bureau.
If you have a thorough understanding of what each category and sub-category costs you today, you can start to make a pretty good estimate of how much you might spend in retirement. Go through the categories one at a time.
The FOOD AND BEVERAGE category may not change much in retirement if you think your eating habits will remain the same. On the other hand, if you dine out a lot today because you’re too busy to prepare food and do dishes, you might reduce this category by quite a bit in retirement. Or maybe you want to spend more time dining at gourmet restaurants and expect this expense to rise.
HOUSING, utilities and home insurance may not change much unless you are planning on moving from your current conspicuous McMansion to a smaller retirement home. If so, make sure you capture that savings in your estimates.
APPAREL expenses may decrease a little since you won’t have to dress for the office.
TRANSPORTATION costs are likely to change significantly – either reduced because you can eliminate an expensive commute, or increase because you plan on traveling extensively when you retire.
MEDICAL CARE is a very important category to consider. If you are retiring with a paid medical insurance benefit from your ex-employer, consider yourself extremely lucky. That will help keep this cost manageable. If not, plan on an insurance expense that will rise more than the inflation rate every year. This is a tough cost to gauge with our current medical situation in the U.S.
A RECREATION budget is clearly very important to most retirees and possibly the most difficult to anticipate. Prior to retirement I knew exactly what I was spending on recreation, but that did not help me much when it came to planning that budget for retirement. While working, I only had weekends and vacations to spend any serious time on recreation. How much more time would I need to devote to this category to create a satisfying retirement? While working, I often spent money on recreation/travel services in order to save my precious, but limited vacation time. In retirement, I can choose to do many things more slowly (and less expensively).
Because I planned on traveling a lot, I broke out VACATION & TRAVEL as a separate item. I looked at several different kinds of trips I make: 1)day-long field trips, 2)camping trips, 3)road trips (travel to sites and stay in low-cost accommodations) and 4)city visits (air travel, city hotel rates, rental cars, etc). Then made an estimate of how often I thought I would want to make each type of trip, and budgeted accordingly. I then split the vacation & travel sub-budget into appropriate categories: mostly TRANSPORTATION or RECREATION.
You can continue through the remainder of the items in a similar fashion. For each category that you think might change significantly, you need to estimate the expected change. If you have the figures on your current spending by category, that’s not too difficult. When I was in doubt, I would simply guess that a 10% perturbation on the current cost was a good guess. Being an engineer, I over estimated my cost increases and underestimated my cost savings by a little. On the other hand, so far I’ve traveled a lot more than I thought I would in retirement.
Some people recommend using some simple rule-of-thumb guessing for your budget. For example, you might read that you will spend 80% as much in retirement as prior to retirement, or that you should plan to need 70% of your pre-retirement take-home pay to live off in retirement. I don't think it is wise to approach the problem this way. Those rules certainly didn't work for me – not even close.
For those who have not yet developed a detailed accounting of where their current spending is going, you may want to check out the url: http://www.golio.net/Chapter3.html
Scroll down to Section 3.3 and click on “download all excel spreadsheets”. There are also several other budget tools available through that page.
Return home: http://www.golio.net/
The first step in getting a better grip on this is to understand how much you are spending today and on what. A lot of affluent technical professionals make enough money that they don't track expenses very well if at all. That’s the reward for all that hard work studying math and science in college. You don’t have to budget. But the absence of an accurate expense record makes this problem even tougher. If you know how much you spend today on each aspect of your life, you can go down the list and estimate whether you are going to spend more or less on that item in retirement. Finally, you can estimate how much more or less you expect to spend.
Here's a starting list for expense tracking from the US Bureau of Labor Statistics:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses.
One advantage of using a list that conforms to the USBL list is that you can monitor inflation rates by spending category more easily. This allows you to estimate your own personal rate of inflation relative to the published CPI-U. Many people feel that the inflation rate they experience is very different than CPI-U because their purchases do not conform to the category mix used by the Bureau.
If you have a thorough understanding of what each category and sub-category costs you today, you can start to make a pretty good estimate of how much you might spend in retirement. Go through the categories one at a time.
The FOOD AND BEVERAGE category may not change much in retirement if you think your eating habits will remain the same. On the other hand, if you dine out a lot today because you’re too busy to prepare food and do dishes, you might reduce this category by quite a bit in retirement. Or maybe you want to spend more time dining at gourmet restaurants and expect this expense to rise.
HOUSING, utilities and home insurance may not change much unless you are planning on moving from your current conspicuous McMansion to a smaller retirement home. If so, make sure you capture that savings in your estimates.
APPAREL expenses may decrease a little since you won’t have to dress for the office.
TRANSPORTATION costs are likely to change significantly – either reduced because you can eliminate an expensive commute, or increase because you plan on traveling extensively when you retire.
MEDICAL CARE is a very important category to consider. If you are retiring with a paid medical insurance benefit from your ex-employer, consider yourself extremely lucky. That will help keep this cost manageable. If not, plan on an insurance expense that will rise more than the inflation rate every year. This is a tough cost to gauge with our current medical situation in the U.S.
A RECREATION budget is clearly very important to most retirees and possibly the most difficult to anticipate. Prior to retirement I knew exactly what I was spending on recreation, but that did not help me much when it came to planning that budget for retirement. While working, I only had weekends and vacations to spend any serious time on recreation. How much more time would I need to devote to this category to create a satisfying retirement? While working, I often spent money on recreation/travel services in order to save my precious, but limited vacation time. In retirement, I can choose to do many things more slowly (and less expensively).
Because I planned on traveling a lot, I broke out VACATION & TRAVEL as a separate item. I looked at several different kinds of trips I make: 1)day-long field trips, 2)camping trips, 3)road trips (travel to sites and stay in low-cost accommodations) and 4)city visits (air travel, city hotel rates, rental cars, etc). Then made an estimate of how often I thought I would want to make each type of trip, and budgeted accordingly. I then split the vacation & travel sub-budget into appropriate categories: mostly TRANSPORTATION or RECREATION.
You can continue through the remainder of the items in a similar fashion. For each category that you think might change significantly, you need to estimate the expected change. If you have the figures on your current spending by category, that’s not too difficult. When I was in doubt, I would simply guess that a 10% perturbation on the current cost was a good guess. Being an engineer, I over estimated my cost increases and underestimated my cost savings by a little. On the other hand, so far I’ve traveled a lot more than I thought I would in retirement.
Some people recommend using some simple rule-of-thumb guessing for your budget. For example, you might read that you will spend 80% as much in retirement as prior to retirement, or that you should plan to need 70% of your pre-retirement take-home pay to live off in retirement. I don't think it is wise to approach the problem this way. Those rules certainly didn't work for me – not even close.
For those who have not yet developed a detailed accounting of where their current spending is going, you may want to check out the url: http://www.golio.net/Chapter3.html
Scroll down to Section 3.3 and click on “download all excel spreadsheets”. There are also several other budget tools available through that page.
Return home: http://www.golio.net/
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