ACHIEVING YOUR MAXIMUM STABLE STANDARD OF LIVING
by Stuart C. Matthews, Pralana Consulting LLC
Pralana’s Retirement Calculator (PRC) has the capability to help you identify your maximum sustainable standard of living. This article will describe exactly how to do that but, first, let’s begin with some background on PRC. PRC is designed to take a life cycle approach to financial planning. By this, I mean that it collects detailed information about your income and expenses, creates profiles by projecting your income and expenses out over your life expectancy, determines how your savings and net worth will grow and decline over time, performs “consumption smoothing”, calculates life insurance needs, and so on. To do this, it takes many factors into account, including survivor benefits, inflation, taxes, your plans for purchasing and/or selling property and paying for college educations for your kids, and the expected rate of return on your investments. As your plan is being built, PRC displays the results in both graphical and tabular formats and enables you to make adjustments quickly and easily. At completion, you might end up with graphs like these shown below which indicate a plan wherein the savings outlasts its owner by a large margin (on the graph at the left, the blue spike corresponds to the planned retirement date, the orange spike corresponds to the owner’s life expectancy and the far right side of the graph corresponds to the spouse’s life expectancy).
“Consumption smoothing” is a term used by economists to describe a consistent standard of living for an individual regardless of family size and the ebb and flow of non-discretionary expenses. In other words, it enables you to maintain the same level of discretionary spending (i.e., consumption) while you’re raising a family, paying your mortgage, paying for college educations, when you become empty nesters and when you’re retired. For reference, consumption smoothing is the subject of an excellent and easy-to-read book by Laurence Kotlikoff and Scott Burns entitled Spend ‘til the End. Consumption smoothing is mathematically complex and computationally intensive and is an extremely rare feature in retirement calculators, but Pralana’s Retirement Calculator can do it in a couple of seconds on a modern laptop computer. Armed with this powerful capability, you can raise your standard of living both now and when you retire!
So, here’s how it works. Upon the click of a button in the Non-Specific Discretionary Spending section on the Other Expenses tab, PRC will calculate the maximum constant (in current $) annual discretionary expense that can be supported within your plan for the rest of your life and your spouse's life. Furthermore, PRC gives you control over the amount of conservatism to use while making its calculations: You can select either "Live to 100", "Safe ROR" or "As Specified". If you select "Live to 100", PRC will override the life expectancies you entered on the General tab and make its calculations assuming that you and your spouse both live to age 100. If you select "Safe ROR", PRC will assume all your Savings and Retirement Accounts earn a conservative ROR that you specify. If you select "As Specified", PRC will use all of your inputs as entered on prior tabs. PRC also provides two other controls over this process: 1) the percentage by which you want PRC to reduce the unallocated discretionary expense after the death of the first spouse and 2) if you have a line of credit, you can specify the maximum amount of indebtedness to incur in the course of this process. To carry the process to the maximum extent, you might want to put nothing in any of the other PRC expense tables except for what you consider to be truly non-discretionary expenses, then tell PRC to compute the maximum smooth discretionary expense that can be supported. PRC will insert the computed result into the “Annual Non-Specific Discretionary Spending” field adjacent to the initiate button. A quick glance at the Projection tab will enable you to confirm that PRC has indeed applied this quantity into the Non-Specific Discretionary Expenses column for all future years and a glance at the Graphs tab will show you the overall effect of the new spending level.
At this point you could then choose to decompose and allocate the computed value into specific expenses, enter them into one of the other tables and, finally, clear the entry from this table. PRC provides a function at the bottom of the Other Expenses tab to assist with this process.
You can then initiate a Monte Carlo simulation to assess the probabilities of your money outlasting you. To statistically evaluate your plan, the PRC Monte Carlo analysis executes 500 independent test scenarios with simulated market volatility but with all other facets of your plan unchanged. The graph below is PRC’s Monte Carlo output which depicts the 500 separate projections of your total savings on a year-by-year percentile basis. In statistics, a percentile is the value of a variable below which a certain percent of observations fall. So, you can interpret the lines on the above diagrams as follows: Out of 500 test cases executed, only 5% of cases yielded results below the 5th percentile line, only 25% below the 25th percentile line, 50% below the 50th percentile line, and so forth.
So, in the case depicted in the diagrams above, you could then spend the $43,810 every year regardless of the ups and downs of your non-discretionary expenses (say, house payments and college educations) with greater than a 75% chance of your money outlasting you.
Pralana Consulting LLC, Plano, TX
© 2014 Pralana Consulting. All Rights Reserved.
PRALANA CONSULTING LLC