Case Study #4: Consumption Smoothing

Joe and his wife, Jane, are both 50 years old, both are working and hope to begin a traditional retirement when they reach age 60. By then, their mortgage should be paid off and their two kids should be finished with college. Anticipating many grandkids and lots of family activities at their house, they do not plan to down-size; additionally, they do plan to do quite a bit of international travel in their retirement years. Clearly, they’ll need a good deal of income to support their retirement. Still, though, they wish to maximize their standard of living in the meantime. Their big question is: how can they accomplish these somewhat competing goals without having to get into a mode a worrying excessively about whether their money will outlast them?

The answer can be discovered via an analysis involving consumption smoothing, and the Pralana Gold retirement calculator is an excellent tool for this. Let’s assume the following in doing this exercise:

- Inflation is 3%
- Joe’s life expectancy is 90 and Jane’s in 95
- Joe earns $100K per year and Jane earns $50K per year, and they will receive a 3% COLA each year up to their retirement in 10 years. They’ll both contribute 10% of their salary to their respective tax-deferred accounts but neither will receive any company matching. Joe is expecting to receive a $40K pension that begins upon his retirement with a 50% survivor option.
- Joe’s Social Security benefit is $30K at FRA and Jane’s is $25K. Joe will wait until age 70 to begin his benefits but Jane will begin hers at age 67.
- Joe has $500K in his IRA and Jane has $250K in hers, and they have $125K in regular investment accounts along with $25K in a joint checking and savings accounts. Let’s assume the IRA’s and the regular investment accounts earn a real return of 4% (7% nominal) and the checking and savings earns zero.
- Their house payment is $1500 per month (principal and interest, fixed) and will be paid off in 5 years, and taxes, insurance, utilities and maintenance cost another $1250 per month, all increasing at the rate of inflation.
- Their healthcare expenses are $3000 per year now, increasing at the rate of inflation, but will double when they retire at age 60 and will remain at that level until they go on Medicare at age 65. Their plan also includes $75,000 per year for long term care beginning when they reach age 85, then dropping to $50,000 per year when Joe dies at age 90. In conjunction with Joe’s death, the house will be sold.
- Their son still has two more years of college at $30K per year and their daughter is just beginning a four-year degree that will cost them $30K per year. Joe and Jane are paying for this as they go (i.e., they have no 529 plans and no student loans).
- All of their other essential expenses total $40K and are expected to increase at the rate of inflation.
- This does not include any discretionary expenditures for vacations or luxury items or any contingency spending such as support for family members.

To establish a baseline we enter all of this information into Pralana Gold and get an initial analysis that looks like this:

The red line is the fixed rate projection and the blue bands are Monte Carlo analysis results depicting the distribution of results in bands each equivalent of 10 percentile points. Joe and Jane appear to be off to a great start with their plan because it has a 100% success rate based on Monte Carlo analysis but it doesn’t allow for any luxury or contingency spending. The burning question they’re still needing an answer for is: how much more can they spend and still be reasonably confident that they run out of money. For this, we’ll utilize Pralana’s consumption smoothing algorithm with the Monte Carlo analysis option to calculate the additional annual spending that can be supported and still retain a 90% success rate. This calculation yields two values: $10,700 for the next 10 years in which Joe and Jane and still making contributions to their IRA’s and then $25,700 annually for the rest of their lives as can be seen in this tabular projection (note the column entitled Non-Specific Discretionary Spending):

Finally, the overall analysis is repeated with this additional spending to yield this long term result:

This provides a strong indication that Joe and Jane can increase their current spending by over $10,000 annually between now and the time they retire in 10 years, then increase their spending by another $15,000 (i.e., $25,000 above the baseline level) for the rest of their lives and still have a 90% chance that they won’t run out of money. Of course, it’s highly advisable that this calculation be revisited on a regular basis to ensure that they’re maintaining this position.

Another way for Joe and Jane to view their future is NOT TO PLAN to increase their spending but, rather, to understand that their baseline plan has a significant amount of margin in it; specifically, $10,000 per year for the next 10 years and then $25,000 per year thereafter. With that knowledge, they have a good mechanism for going forward, retiring with confidence and sleeping well regardless of nearly any contingency.

The key takeaway from this article is that Pralana’s consumption smoothing algorithm has the ability to help raise your standard of living by calculating a constant level of discretionary spending that your plan can support despite the ebbs and flows of your income and non-discretionary spending WHILE TAKING INTO ACCOUNT SEQUENCE-OF-RETURNS RISK.

Pralana Consulting LLC, Plano, TX

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