Modern retirement theory assumes that all assets on an individual’s retirement sheet[1] (financial capital, social contract, human capital) should be used for their definitional highest and best purpose. To determine the highest and best purpose of retirement sheet assets, goals are prioritized and assets and liabilities are matched.
The difference in Base (mandatory or essential expenses) and Discretionary (voluntary or non- essential) expenses in retirement is fundamental and consequential. In practice, the distinction between Base and Discretionary expenses may be the most important decision a retiree must make to use assets efficiently and effectively in retirement income planning. Some advisors fail to highlight the difference between expense categories and claim that clients do not see food, shelter, insurance differently than country club dues or vacation cruises, hence the expense categories are combined and called ‘lifestyle expenses’. In our view, this is a distortion of affluence. ‘Lifestyle expense’ is an unfortunate term applied to these categories of expenses (Essential vs. Discretionary) and promotes the idyllic sense that to live the lifestyle one wishes these expenses should take on the same priority funding importance. Expense distinction is the most critical issue to maximize the best use of retirement assets to cover the Base (essential). The 3S model[2] posits net cash flow (Base Income) should cover Base expenses with sources of income that are simultaneously secure, stable and sustainable.
Advisors should always look for ways to add value to clients, especially if the advisor is operating under a fiduciary standard. An overlooked area for value-add in retirement planning is in the area of expense type or categorization. Many advisors in the planning industry question whether we should distinguish between types of expenses for planning purposes. The typical salvo is that clients don’t want to distinguish between food and country club dues, so why should we force them into expense categorization? If we fail to advise on this distinction, we miss a significant opportunity to properly frame client decision making. If the distinction has the potential to add value and improve outcomes, should not advisors, as a best practice, parse these expenses in planning? We make distinctions between different kinds of stocks (small, large, value, growth) or bonds (corporate, sovereign, or high yield), so why the push back on acknowledging expense types? The short answer is that if we push this conversation with a logical framework, we can increase client sustainability and add value.
The most important retirement finance input is a retiree’s monthly base expense calculation. All other retirement calculations and measures or tests of sustainability are derivatives of this single number. Retiree outcomes can be enhanced by focusing on what the retiree can control beginning with their base expenses. Intentional retirement budgeting can improve sustainability through generating the highest net cash flow from available retirement assets while preserving other assets for funding individually unknowable future needs.
Retirement income planning should start with the cash flow required to cover budgeted essential expenses. Rather than beginning with income replacement, start with necessary expenses, then build stable, secure, sustainable income (3-S income) through liability matching. Income replacement ratios are too simplistic and no substitute for detailed budgeting over time. The goal of generating retirement income is to attain the highest net cash flow, i.e. asset to income evaluation for its income producing value after taxes.
The retirement decision framework offered by modern retirement theory places Base or Essential expenses as the first priority to solve for in retirement, followed by Contingencies, Discretionary and finally Legacy. The rationale for establishing this hierarchy of funds is derived from the two unknowable questions for individuals that must be addressed by Advisors and Clients. The first unknowable question is longevity - how long an individual client will live, thereby requiring income to fund base expenses in an unknowable context. The second unknowable question is contingencies - expenses that are unknowable during the remaining lifespan. For the individual retiree, these two unknowable conditions form the planning context for retirement income.
The following table presents contrasting rationales to encourage clients to thoughtfully categorize Base (Essential) vs Discretionary expenses.
|
Criteria
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Base Expenses
|
Discretionary Expenses
|
|
Definitional distinctive and Expense Goal
|
Required Living Expense:
(cost to live)
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Optional Lifestyle Expense:
(optional cost in excess
of cost to live)
|
|
Payment Priority & Cycle
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Due upon receipt (Monthly, Quarterly, Annual, On-going)
|
Delayable (Randomized, at will)
|
|
Coverage Ratio
(Liability Matched)
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1:1 Perpetual
[$1 3-S Income to $1 Base Expense]
|
Optional expenses as resources permit
|
|
Modern Retirement Theory priority placement
|
Base Fund
|
Discretionary Fund
|
Definitional Distinctive and Expense Goal
First, there is a definitional distinctive between Base and Discretionary expenses. This distinctive gives rise to important decisions about which assets to convert to income and each asset’s income producing value (IPV) and conversion costs. We view Base expenses as those that are required to live in a modern society. Base expenses are aligned with the Consumer Expenditure Survey[3] including food, clothing, housing, utilities, taxes, healthcare, insurance, transportation and unique expenses to individual clients. While many in the adviser industry will disagree with how expenses should be funded in retirement, agreement that there is something fundamentally different in providing income for food vs. income for vacations should be universal and withdrawals from portfolios should reflect this. We suggest this is a valid distinction recognized by many retirees - they just need a better framework to view this issue. Vacations are an important part of life, yet they do not rise to the priority funding requirement level of a balanced diet.[4]
The client impact of this discussion and distinction between Essential and Discretionary is profound. Retirement income must be put in place that is simultaneously stable, secure, and sustainable (3S Model) to pay for Base expenses for as long at the retiree lives. Discretionary expenses are not held to the same rigorous standard - they can be funded with income from other sources, even one-time sources, and can, by definition, be deferred until a later time. The impact on a client’s assets may be profound as well by deferring assignment of certain assets for income until a later time (e.g. bond ladder to delay Social Security until age 70).
Payment Cycle
Base Expenses are on-going for as long as the retiree lives. The form of expenses may change but the essential nature of the expenses will not change. For example, a house payment or rent may change form later in life to a payment to a long term care facility, but the ongoing nature of the expense will not change. Everyone will pay for a place to live for as long at they live. These types of expenses will occur monthly, quarterly, semi-annually or annually. Frequencies of individual expenses may change over time, but they will continue as essential expenses of living.
In contrast, discretionary expenses will occur on a non-regular, client determined basis. For example, traveling could be planned by the client, but the exact timing of a trip may vary or not occur at all depending on how market-based portfolios perform.
Payment Priority
Base expenses are due on a regular, systematic basis. They are due upon receipt and cannot wait to be paid until funds are available. Therefore, Base income must be put in place that is stable, secure and sustainable to cover the Base expenses of life. To depend on unreliable sources or sources of income that can be uncertain or volatile does not constitute fiduciary advice nor a sound planning recommendation.
Discretionary expenses are on the polar opposite of the payment priority scale. By definition, discretionary expenses are just that - optional and can be funded when and if funds are available. Advisors should acknowledge expense priority as directly affecting retirement sustainability. By paying attention to types of expenses advisors add value to clients by increasing sustainability. The expense planning factor can be controlled, whereas market returns cannot. By focusing on what can be controlled, advisors are proactively empowering clients to take ownership of their financial decisions.
Framing an ongoing expense in terms of a net present value through life expectancy can be eye opening. The magnitude of a monthly expense can be expressed as the net present value on the retirement sheet. For example, a couple who is 65 and has a $237 monthly expense is the equivalent of having or needing $50,000 in assets. If on-going, monthly Base expenses are cut by $237, the effect is that $50,000 less of lifetime assets are required.
Coverage Ratio (Liability Matched)
The coverage ratio is the sum of all coverage contributions compared to Base Fund expenses. The theoretical goal is to have base expense liabilities covered by 3S base income sources at a 1:1 ratio. Practically, we suggest 1.05 or 1.1 to 1 liability. Creating slightly higher than required income vs expected expenses accomplishes the goal of not generating too high an income that is eroded by taxes, but also leaves a gap in the event of an intra year increase in essential expenses, e.g. short-term spike in inflation. A coverage contribution is the measure of total Base Expenses covered by net income produced by an asset. Discretionary expenses can be covered as resources allow. For example, a retiree’s social security income covers their base expense needs by 45%, so the coverage contribution of one asset, social security, would be .45.
Conclusion
When developing a retirement income plan, advisors should begin with a focus on actual client expenses. Expenses should be evaluated according to categorical assignment so that a priority of expense can be established. Base expenses are definitionaly different than other expense types. Matching up the required retirement income with Base expenses can lead to great tax efficiency, as well as greater asset sustainability over time.
[1] Retirement Sheet is a snapshot of assets, liabilities, income and expenses. It frames an individual’s balance sheet and cash flow statement. A Retirement Sheet includes Social Security benefits, pensions, not simply housing wealth and portfolio assets. The Retirement Sheet is a comprehensive income snapshot: Human Capital, Financial Capital, Social Contract.
[2] Crafting Retirement Income that is Stable, Secure, and Sustainable. Branning and Grubbs. Journal of Financial Planning. December 2017.
[3] https://www.bls.gov/cex/
[4] https://corporate.morningstar.com/ib/documents/methodologydocuments/researchpapers/blanchett_true-cost-of-retirement.pdf
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