Retirement Planning with Annual Available Spend

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Sound financial planning requires neither the determination of safe withdrawal rates nor the use of Monte Carlo simulations. Relying on the past to predict the future is unnecessary. Instead, one must focus on how much can be spent each year, given expected returns and inflation, and then consider how negative and worst-case scenarios would affect retirement planning. That is the basis for the annual available spend (AAS) methodology I describe here.

I developed the retirement-planning methodology and model described in this article to assist me with my retirement planning. I have been using this model for four years, and it provides with what I need to plan my retirement. I hope that others will also find it helpful.

My general investment philosophy is passive, following that of Jack Bogle, Bill Bernstein and Larry Swedroe. These individuals generally agree with Bernstein's caveat in the Retirement Calculator from Hell, Part III: any estimate of long-term financial success greater than about 80% is meaningless. Given this uncertainty, my approach relies less on science and more on judgment applied to a thorough understanding of the client's facts.

My initial focus was solely on my specific situation, so I was particularly careful to obtain all relevant and material information. Detailed focus on the specific client situation is essential. I have implemented the model in an Excel spreadsheet and have included examples from it.

General framework of methodology

Implementing the AAS requires a six-step procedure:

  1. The advisor will work directly with the client to determine all parameters of his or her expected spending needs during retirement.
  2. The advisor will obtain a complete analysis of all sources and types of the client's income. Each of these items will constitute a different column in the model. All items will be entered after tax, so it is necessary to have a full understanding of the client's income tax position.
  3. Fundamental returns and inflation will be applied. A conservative year of death will be included. The model will then compute the base-case annual available spend – the amount that can be spent each year, with the value of the investment portfolio decreasing to zero in the year of death.
  4. Negative and worst-case scenarios will be entered into the model. The scenarios chosen will be keyed to the specific situation of the client.
  5. The AAS model can be set to automatically adjust for market value changes and recompute the base-case AAS. Cash and portfolio quantities can be updated monthly. The advisor must determine if and when the base case or negative assumptions should be revised.
  6. The advisor will review the AAS scenarios with the client and evaluate the client's spending and investment plan on a periodic basis. Changes will be made as necessary and appropriate.

Let’s look at each of those steps in more detail.

  1. Spending needs

Determining the retirement spending needs of the client is, of course, a routine exercise in retirement planning. The client should keep a monthly record of expenditures, with or without a detailed budget. Large or exceptional items should be noted. As part of this methodology, income taxes should be eliminated from annual spending totals, since they are netted against income in the model. Of course, the more prior years included, the better the feel for required and discretionary spending. Consideration should also be given to unusual and contingent future expenditures.

Just as clients differ with regard to investment risk tolerance, they will differ with regard to spending tolerance. Some may feel very strongly about maintaining certain minimum living standards, while others may be much more flexible regarding their ability to cut back if the need arises. Attention to these and other behavioral issues is essential.

  1. Income analysis

In order to properly evaluate the client's situation, it is necessary to obtain a full analysis of all types of client income – pensions, annuities, deferred compensation, Social Security, taxable investments, tax-deferred investments, Roth IRAs, required minimum distributions (RMDs), etc. Each of these items will be included in a separate column of the Excel model. Income taxes are netted against the various income items. The estimated taxes need not be precise, but they must be materially correct. It is necessary to compute both base tax and marginal tax. Make sure that the total differential between all items of gross income and after-tax income included in the model is materially the same as taxes computed using TurboTax or a similar application.

Program the model to properly source the income for spending from the appropriate pots of income. Typically, income will first come from deferred comp, pensions, annuities and Social Security, followed by RMDs, taxable investments or Roth and tax-deferred accounts.

  1. Base-case AAS model

Following is an example simplified base-case AAS model:

simplified base-case AAS model