Estimating a Retirement Budget

August 11, 2009 · by Austin Frakt · Posted in Personal Finance · 2 Comments

This post has been cited by the Carnival of Personal Finance #218, hosted by Budgets are Sexy.

This is the fifth in a series of posts on investment planning. For those who haven’t read that first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts (numbers 6-8 to appear in subsequent weeks):

So far in this series on investment planning I’ve been vague about the event for which one might be planning. Everything has been completely general. That ends here. I’m now going to focus on investment planning for retirement because it is something everyone should do and it is the most challenging investment planning problem most of us face (second would be saving for a child’s college education, which isn’t something everyone needs to consider). Nevertheless, many concepts illustrated in subsequent posts are applicable to non-retirement investing.

Retirement funding is about your budget, not today but in many years when you’re no longer working. If you’re going to be rational about planning for retirement you need to estimate that budget. The best place to start is your current budget (for advice constructing a current budget, see this prior post). By going through your current budget item by item and adjusting the entries so they correspond to expected values in retirement, you can estimate a retirement budget. Here’s an example:

This spreadsheet includes the same figures as in the current year sample budget described in a prior post. I’ve added columns for estimated amounts in retirement (all in current dollars). I’ve also added one row for health care. Recall from my prior post that I assumed payment of health insurance premium was included in the current net paycheck for this example budget (your budget may differ). In retirement that’s not going to be the case so a new entry for this expense is required. In your own retirement budget you may want to add other entries for expenses you expect in retirement but do not have now (e.g. tourism costs, boat payments).

One entry you may want to add is for income tax. The retirement income entries in my sample budget do not include the effects of taxation. Including taxes is tricky because (a) not all your retirement income will be taxed (e.g. Roth distributions are not taxed) and (b) you may not know what your tax rate will be years in advance. If you do want to estimate your retirement income taxes keep in mind that non-wage income does not include payroll taxes (Social Security and Medicare taxes). Also, do not confuse your marginal tax rate from your average tax rate. Even if your marginal rate is substantial your average tax rate will be lower. For simplicity I have ignored income tax.

Let’s go through my example and describe how retirement column entries are estimated. The first row is for non-investment income like that from Social Security and pensions. There are a variety of ways to estimate a value for this income. If you have a pension benefit you’ll have to find out the details on your own, as they will vary by company. As for Social Security, one estimate is the value contained in the statement you receive annually from the Social Security Administration. Another estimate can be obtained from this calculator (which I have not used). Use your own judgment about the likelihood of receiving the level of Social Security or pension benefit currently promised (better to be a bit conservative here).

The second line in my example is for investment income (which could include the consumption of principal). Since this is what we’re solving for in this budget exercise, we’ll fill it in later so as to obtain zero on the TOTAL line for the “retired amount pro-rated to month” column. Going through the list of expenses in the example budget, many are zeroed out in retirement. When retired, one is unlikely to pay for child care, life insurance, or a mortgage (but if you expect to, don’t zero them out in your budget). It is reasonable (but not necessary) to keep values for the other expenses the same in retirement as in the current year budget except for health care, as described above. For that entry in the example I put in an estimate based on this value from Fidelity, inflated by ~50% to be conservative.

After tweaking all the entries in the example I went back to the second line labeled “income: other” and inserted a value that caused the TOTAL to go to zero. This is the amount required from investment income to meet the estimated retirement consumption needs in the example. The value is $1,567 per month. Since the current monthly income is $6,917 (=$5,417+$1,500), income required from investments in retirement is just 23% of current income in this example. This is suggestive of how far off one might be by applying (or misapplying) a standard rule-of-thumb of the need for 70% of current income in retirement. Of course I have not included any margin for error in the retirement budget. As explained in the first post of this series, this is an important point but one I do not dwell upon.

Your retirement budget will tell you how much investment income you will require (in current dollars) to meet your necessary retirement expenses. Your goal is to save enough to generate this income. Your retirement investment planning problem is to figure out how. The next post provides some guidance.

Tags: <budget, investment planning, summer project>

Budget Tracking and Projections (with Quicken Tricks)

July 28, 2009 · by Austin Frakt · Posted in Personal Finance · Comment

This post has been cited in the Carnival of Personal Finance published on 3 August 2009.

This is the third in a series of posts on investment planning. For those who haven’t read that first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts (numbers 4-8 to appear in subsequent weeks):

I assume all readers of this post have constructed a descriptive household budget with positive cash flow (if not, see the prior post). The bottom line of such a budget is a monthly (or other period) average net income. That is, it is income less all necessary, regular expenses. For simplicity, I will call this amount your surplus and I will assume it is a monthly value (this is not important; if you prefer a yearly value, that’s fine).

Your surplus represents how much you can spend on extra stuff or invest per month. Therefore, if you have a goal, like saving $20,000 for a new car, you can use your surplus value to see how many months it will take you to do so. If you have multiple goals you can set up a spreadsheet to allocate fractions of your surplus to each of them and then compute how long it will take to reach those goals (or vice versa: set the time by which you need to reach the goal and compute what fraction of surplus is required). These examples illustrate that surplus is the key to investment planning. I’ll have a lot more to say about that in subsequent posts. First, let’s apply our budget to the fundamental problems of budget tracking and projection.

I use Quicken to track and project my budget, but you can do all of the following with other software. (Until five or so years ago I used Excel for these functions exclusively. Now I use Quicken 2007.) Since I hate to read software guides I’ve made this entire approach up myself. It would not surprise me if there were other ways to do the following in Quicken (feel free to suggest them or provide links to such things).

I use Quicken as an electronic checkbook. Since I write checks or have electronic payments drawn on and deposited into two accounts, a checking account with Bank of America and a taxable money market account at Vanguard, those are the only two real-world accounts I bother to track (i.e. download/reconcile) in Quicken. Thus, the sum of values of those two accounts is all that is relevant for tracking actual net household cash flow. Let’s call this sum my actual balance. All the other investments I have are not relevant and we can ignore them for this post.

In addition to these two accounts in Quicken, I have set up a third, which I will call my projected balance. This projected balance account is fictitious in that it does not correspond to any real-world account. Using Quicken’s functionality to schedule automatic bills and deposits I have translated my budget (see spreadsheet example) into automatically recurring Quicken transactions into and out of my projected balance account. I have set the timing to correspond to when such payments are actually made in the real world.

At any point in time I can compare my actual balance with my projected balance. The former reflects my real-world income and payments. The latter reflects my budget. The two should match, or at least be close. If they are not, it indicates a problem (e.g. bank error) or, more likely, that I forgot about a big purchase or a large financial gift. When the two are off by more than about $1,000 I search my brain and records for the source of the discrepancy. This doesn’t happen often and when it does it doesn’t take much time to find the source. Then I adjust my projected balance accordingly to bring it back in line with reality.

This real-time budget tracking is very handy. I can always tell if my household is overspending or if we’re saving at a greater rate. This really puts my budget to work.

Another way to use Quicken to put your budget to work is to use it for projections. The “Overview” tab of my projected balance account has an “Account Balance” graph with an “Options” menu. One of the options is to “Forecast my future account balances.” By entering my budget into this tool I can immediately see my projected surplus growth path. It also automatically calculates the monthly surplus (Quicken calls it “net savings”). In fact, I don’t use a spreadsheet for budget projections anymore. I only made this one for illustrative purposes for this investment planning series of posts. It is based on the information I’ve already entered into Quicken. (One gripe I have with Quicken is that it doesn’t seem to be able to base its forecast on the transactions I’ve already entered in my projected balance account. I have to reenter them in the forecasting tool. If anyone knows how to connect the two explicitly please let me know.)

As I said, one can do all of the above with other tools. Being able to reconcile one’s real-world cash flow with one’s budget and to forecast surplus are worthwhile capabilities. In subsequent posts in this series I will show how to use these capabilities in the service of investment planning.

Tags: <budget, investment planning, summer project>

Household Budgeting the Easy Way

July 21, 2009 · by Austin Frakt · Posted in Personal Finance · 7 Comments

This post has been cited by the 215th edition of the Carnival of Personal Finance, hosted by Good Financial Cents.

This is the second in a series of posts on investment planning. For those who haven’t read that first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts (numbers 3-8 to appear in subsequent weeks):

The internet and book stores are loaded with advice on creating a household or family budget. There are two fundamental approaches: proscriptive (or normative) and descriptive (or positive). A proscriptive budget is one that conveys how you ought to allocate your money. Someone in debt or struggling to live within his means would benefit from a proscriptive budget the following of which would deliver him to a debt free life.

Since I do not have a problem with debt or living within my means I do not have much need for a proscriptive budget. On the other hand, a descriptive budget that illustrates with reasonable accuracy how my household finances are allocated to investments and consumption is very handy. As I will show in subsequent posts in this series, a descriptive budget is the basis for investment planning. In the remainder of this post I provide an easy way to construct a descriptive budget.

One can find many web pages and books devoted to descriptive budgeting. What I don’t like about most of them is the suggestion of the need for great detail. How much do you spend on food? On clothes? On gas? On entertainment? And so forth. For me, and I suspect many others, a budget at this level of detail is not necessary or helpful. (It is necessary and helpful for proscriptive budgeting or for the very frugal or intensely curious.)

Since my goal is an easy, high level (but accurate) descriptive budget, I take as a starting point that I spend the “right” amounts on each of the subcategories listed above (food, clothes, gas, entertainment, and so on). Therefore, a simple way to build a descriptive budget is to base it on the lumpy institutional structure that underlies one’s actual cash-flow: paychecks and bills.

This is easy. Take out a representative and recent set of paychecks and bills or go online and download them. Write down values for average payments (as illustrated in this spreadsheet). To make things simple, when entering your paycheck amount, use the amount you receive net of all deductions (e.g., for state and federal taxes, health, disability, life insurance, 401(k) contributions, and so on). This works fine if you’ve set your tax withholding properly (see IRS withholding calculator). Also, notice that this document-based approach has you entering in your budget a representative amount for your credit card bills but does not drill down into the bills to allocate payments by type (food, gas, clothes, etc.). As already mentioned, that detail is not necessary for this type of budget.

This approach is particularly easy if your payments do not vary much. In my case this is true for most bills because either they just don’t vary (e.g. mortgage, life insurance, internet, cable, and others) or because I’ve set up “budget payments.” A budget payment option is often available from utility companies: each utility estimates a yearly amount and you pay an average monthly value independent of your use. Then you settle up at the end of the year. After an adjustment period, the estimates get more accurate and the settling up is a small transaction that can be ignored in the budget.

The biggest variation for me is in my credit card bills. Nevertheless, upon examining a representative set (6-12 months worth, say), I have found it possible to settle on a reasonable average figure. In following this approach it is important to omit or adjust payments for months of credit card bills corresponding to unusual, one-time, enormous payments not reflective of usual spending habits (e.g. a huge payment for wedding catering).

The accompanying spreadsheet includes the list of items in my budget with fictional but representative figures and frequencies. Your list may differ. If you spend a lot of cash or make many check or debit purchases you may need entries to account for those sources of expenditure. Since I pay almost everything by credit card, I don’t have such a line. Be sure to prorate everything to the month (or year or week if you like) and total it. If the total is less than zero then you have negative cash flow and you may need a proscriptive budget get back on track. I will assume you have positive cash flow in this positive (descriptive) budget. The total line represents what you have left to spend on more stuff or to save/invest (though, recall, 401(k) investments are included in our net paycheck). In subsequent posts I will call this (assumed positive) total amount the surplus.

That’s it. We’re done. Was that hard? I don’t think so. Yet, we now have a budget that is perfectly adequate for a variety of investment planning purposes. Greater detail is not necessary. But if you want greater detail, it will not hurt to have it. It will just take you more time to construct such a budget and to use it for tracking. I will explain that concept and put our budgets to work in the next post.

Tags: <budget, investment planning, summer project>