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:
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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