Smooth Standard of Living (SOL) vs. SOL change with age
Until recently, I’ve always used the default settings for the SOL index (ie, a constant 100% SOL for my & my wife’s early retirement at age 58 through 100). However, after a lot of thinking and reading (1 – see note below), I’m now firmly convinced I get a more realistic model by changing the SOL index as follows:
Age band 58-64: 100% SOL
Age band 65-74: -2% decrease per year (ie, SOL index of 98%, 96%, 94% etc thru age 80 when SOL is 80%)
Age band 75-84: drop to 75% SOL and maintained at 75% thru age 84
Age band 85+: increase to 90% (to account for increased expenditures on health care- I did have this set to return to 100%, but that seemed unreasonable for reason's I won' go into)
In addition to the above, I’ve entered increased special expenditures at ages 58-62 (for a post-retirement ‘spending splurge’ to take care of moving expenses, a splurge in travel, etc) and again at age 90 ($150,000 for medical issues).
By modelling SOL as above, the “Annual Suggestions” and other outputs show some significant changes (that are reasonable and favorable), so before I rely on those recommendations I‘d like others opinions on any pitfalls I’m overlooking by veering away from assuming a smooth SOL.
(1) I’ve created my SOL index based on observations from the following: Wade Pfau, Somnath Basu, David Blanchett, Katherine Roy, and my favorite – Robert Carlson. Also, I’ve personally observed significant spending decreases with age for my parents and in-laws (even accounting for medical expenditures.
(2) I do understand the value of consumption smoothing, so I have and will always maintain for comparison a “base profile” set to defaults, including the constant 100% SOL.
Sun, 09/07/2014 - 12:56
I can see why you'd want to
I can see why you'd want to do this, and I don't see any problems necessarily. So I'd just throw out the following: We might think that we can or should either enter special future expenditures OR we can increase our standard of living, but realize that there's no reason to do both. Some people might leave their living standard indexed at 100% and then NOT enter those special expenditures. That makes sense to me too depending on how speculative those expenditures are.
I've been of the view that we trade one kind of expense for another--or that I'd be happy to give away money. This approach perhaps appeals to me because I'm not particularly trying to raise my current standard of living--which is one effect of lowering your future standard of living.
I think bracketing a range of possibilities is a good practice since we need to know how things look within a range of what's possible. I think the precision of ESPlanner can be a little bit of a vice when we start to dictate to reality 20 years from now. So keep in mind that you take an accounting of things each year and make adjustments.
But with those thoughts, I still like or appreciate the kind of thinking you are doing there and don't see any problems as long as you remember that what you have there is a "model" and not necessarily the "facts" about the future, which has its way of introducing new variables as we go! :)
Tue, 09/09/2014 - 12:43
Consider an explicit "safety
Consider an explicit "safety factor" to give yourself a cushion in case actual events are tougher than your ESPlanner assumptions. Of course, this depends on how much of a cushion you already have and how conservative/realistic your assumptions are.
I use an SOL approach to do this. This should be described more fully in another forum post, but basically inputs a large SOL for the last few years of life. Perhaps ~200 for a couple of years, although you'll have to experiment to see what works best for you. You should be able to calculate the "safety factor" that this creates for all future years (either $ or %) or can aim for say a 5% safety factor or more complex settings (e.g. 10% for 2 years, then 5% for Y years, etc.). Anyway, this is very flexible and can be adjusted to meet your needs.
Wed, 09/10/2014 - 13:23
Brian, if using Monte Carlo,
Brian, if using Monte Carlo, doesn't the spending behavior setting provide that safety factor cushion? Of course, if not using MC, that's not an option.
Wed, 09/10/2014 - 15:04
For me it mostly comes down to risk. How to measure/estimate your risk(s)? What investing/health/long-term care/job/pension/longevity/insurance/social security/taxes/inflation/unknowns are applicable to your specific situation? And given your best understanding of these risks and probabilities, can you attempt to insulate yourself against some or all of these? If you can insulate yourself/family, then how to do this and, ultimately, should you do this?
From the original post above, reducing SOL over time will boost income now for a few years while reducing their risk "cushion" later in life. I've considered this myself and seen much of the same research the poster mentions. Not knowing anything else about the original poster's situation, the safety factor approach is sort of a general purpose risk cushion that can be used to essentially self insure against some of the risks mentioned above.
A more comprehensive approach to risk might be a better choice given a person's specific situation and comfort with different types of risk. For example, Dr. Kotlikoff has written several times about downside protection. Some people have very little and can experience a huge drop of their actual SOL if certain things go wrong. Others have great downside protection and are in a much stronger position. Also, the first decade of retirement is highly correlated with long-term retiree success or failure. If you can get through this period in good shape, the odds for your long-term financial health are much higher than those who don't.
Overall, there seems to be increased uncertainty compared to a few decades ago. To cope, ESPlanner users can take a number of steps including:
1. Setting Monte Carlo spending behavior to cautious or conservative. However, the limited data underlying many MC portfolios leads to additional risks as future events may be very different from historical returns and correlations.
2. Researching and setting "reasonable and conservative" assumptions throughout ESPlanner inputs.
3. Sensitivity testing to determine which choices (or combinations of choices) result in positive or negative outcomes along with increasing/decreasing risk.
4. Contingency planning.
5. Explicitly including healthcare and long-term care inputs (e.g. through special receipts/expenditures and contingency plans).
6. Modeling "what if" scenarios (e.g. gain/lose assets, higher/lower rates of returns, inflation, potential tax increases and Social Security cuts, temporary job loss, etc.). Some of these can hit in combination and understanding your personal range of "reasonable" ESPlanner estimates can help you understand your downside risk and margin of safety along with other factors.
7. Various forms of insurance including life insurance among others.
8. Using the safety factor approach or other methods including reserve funds, etc.
9. Understanding which safety cushions are implemented in your profile. These can be modeled to estimate how large a cushion you have along with opportunity costs.
10. Of course, adjusting real life financial, health, job, housing, insurance, etc. decisions and associated actions.
Anyway, this is far too long and assumes the person is interested and able to sacrifice some standard of living to protect against these risks so won't be relevant to everyone. Hope this is helpful.