Inflation - how to treat in retirement projection

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Inflation - how to treat in retirement projection

Postby Prudence » Thu May 09, 2013 10:46 am

I have a 30-year spreadsheet for retirement planning. It assumes our stock/bond portfolio will yield 2% every year and it assumes that our expenses (all in including taxes) will grow at 2% a year due to inflation. According to the spreadsheet, a $2 million portfolio with starting expenses of $120,000 per year will run out in about 17 years. (This excludes everything else including social security, pension etc.)
Questions:
1. Is this about right?
2. What is a better way to do this?
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Re: Inflation - how to treat in retirement projection

Postby TomatoTomahto » Thu May 09, 2013 10:50 am

Better way is using something like ESPlanner. It isn't free, but it is pretty deep in how you can plan.

FIREcalc is free.
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Re: Inflation - how to treat in retirement projection

Postby The Wizard » Thu May 09, 2013 10:51 am

Better way to do it is probably along the lines of having a larger nest egg with a higher percentage of discretionary expenditures, so you can "hunker down" for a year or two if conditions demand.
So if you can survive on $60K per year and that $120K simply allows more extravagance, you should be good to go...
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Re: Inflation - how to treat in retirement projection

Postby Dandy » Thu May 09, 2013 11:13 am

By holding expense and portfolio growth at 2% you are essentially dividing the 2 million by 120,000. Others can suggest better tools to project. My opinion projecting for 30 years out is not worthwhile. Studies have indicated that an initial 4% withdrawal dollars, in your case $80,000, the dollar amount adjusted for inflation each year is likely to last 30 years (assuming I believe a 60% equity allocation).
That guideline was made when bond and money market interest rates were much higher. Many suggest a relatively safe withdrawal rate now is 3% or 3.5% to start. But really, the best method is to start at say 4% and then check your portfolio each year and try to adjust your living expenses and withdrawal amount when your portfolio takes a large hit.

So, by the 4% guideline you are $40,000 short ($120,000 need and $80,000 "safe" withdrawal). I don't think any reasonable projection tool will indicate that a $120k withdrawal rate on a $2 million portfolio will last for 30 years. That is a 6% withdrawal rate - your might get some that indicate 5% which is very aggressive.

Remember, if you run out of money early there is no one to blame but yourself and bad luck. You can't say "but the xyz projection tool said $x per year was safe". To me there is no set it and forget it.
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Re: Inflation - how to treat in retirement projection

Postby TomatoTomahto » Thu May 09, 2013 12:13 pm

Maybe I misunderstood the question. I took it to be asking how best to be running projections, and I based my answer on that.

OTOH, if the question was about a 6% WR, I think that's overly optimistic. I personally prefer a 2-3% WR (2% should be safe, 3% is probably safe).
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Re: Inflation - how to treat in retirement projection

Postby cheese_breath » Thu May 09, 2013 12:44 pm

I also have an Excel long range projection spreadsheet, but I do a few things different. First, I group my expenses into a few major categories (e.g. medical, utilities, property taxes, etc.) and apply a separate inflation factor to each Category. Second, I consider all my other income (e.g. pensions, social security) in determining how much I will have to withdraw from my investments. Third, I factor in my anticipated effective tax rate to determine the effect of taxes. I maintain the spreadsheet on a monthly basis. At the end of each month I update it with my actual expenses for that month and the month-end value of all my investments. Since the spreadsheet is in Excel it will then ‘automatically’ update my long range projections.

Regarding your numbers, I’m using 4% inflation factor for most of my categories and 10% for medical expenses. If they’re too high, that OK. I’d rather err on the high side and have some left over than rely on government figures and fall short. I’m using 3% as my investments growth rate, but I can’t fault you for using a smaller number.
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Re: Inflation - how to treat in retirement projection

Postby whomever » Thu May 09, 2013 12:47 pm

It assumes our stock/bond portfolio will yield 2% every year and it assumes that our expenses (all in including taxes) will grow at 2% a year due to inflation. According to the spreadsheet, a $2 million portfolio with starting expenses of $120,000 per year will run out in about 17 years.


With return equal to inflation, you're just dividing nest egg/annual expenses.

Whether that's a valid prediction depends on the volatility of your portfolio. It's a very accurate prediction if your portfolio is 100% I-bonds or other low volatility investment. OTOH, if your portfolio is 100% stocks and the first year involves a 50% drop in portfolio value, the $120k you spend that year isn't 1/17th of your net worth, it's 2/17ths. Having stocks jump 100% in year 16 won't make up for that.
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Re: Inflation - how to treat in retirement projection

Postby YDNAL » Thu May 09, 2013 1:35 pm

Prudence wrote:According to the spreadsheet, a $2 million portfolio with starting expenses of $120,000 per year will run out in about 17 years. (This excludes everything else including social security, pension etc.)
Questions:
1. Is this about right?
2. What is a better way to do this?

What do you mean by "excludes SS, pension, etc." ?
  • You take "residual expenses" from the portfolio - meaning AFTER you account for SS and pension income sources. So, if SS and pension provide $60K and total expenses are $120K, then residual expenses are $60K or 3% of $2M portfolio (much more reasonable).
  • Otherwise, a portfolio will have a VERY difficult (if not impossible) time sustaining a 6% withdrawal ($120K / $2M). So, yeah, it is about right that you would run out of money in 17 years.
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Re: Inflation - how to treat in retirement projection

Postby jsl11 » Thu May 09, 2013 2:33 pm

Preparing a 30 year retirement projection is a good thing to do. It gives you some idea of how things will work out, and lets you know if you need to revise your expectations. However, in my experience, it is a mistake to rely on your projections. I have a spreadsheet that I prepared in 2001 to project my finances during a retirement that began in 2005. When I look at that spreadsheet now, I find that all of my projections were wrong, some on the plus side, and some on the minus side. Strangely, the pluses and minuses have canceled each other out, and so far, my projection has turned out to be accurate. However, much of this is just good luck. So, I would recommend that you continue to make your projections as best you can. But be aware that much will change going forward and there is no way you can actually forecast what will happen.

Jeff
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Re: Inflation - how to treat in retirement projection

Postby cheese_breath » Thu May 09, 2013 3:31 pm

jsl11 wrote:Preparing a 30 year retirement projection is a good thing to do. It gives you some idea of how things will work out, and lets you know if you need to revise your expectations. However, in my experience, it is a mistake to rely on your projections. I have a spreadsheet that I prepared in 2001 to project my finances during a retirement that began in 2005. When I look at that spreadsheet now, I find that all of my projections were wrong, some on the plus side, and some on the minus side. Strangely, the pluses and minuses have canceled each other out, and so far, my projection has turned out to be accurate. However, much of this is just good luck. So, I would recommend that you continue to make your projections as best you can. But be aware that much will change going forward and there is no way you can actually forecast what will happen.

Jeff

+1
I started my projection spreadsheet when I retired in 1997, using 1996 expense data as the starting point and reducing it by 20% for the 1997 projection. I assumed a 7% growth factor for my investments, which I thought to be conservative at the time. I also discovered many of my original assumptions were wrong, but cancelled out. My investments haven't grown as fast as I expected, but my expenses are less than expected. And of course, the volitility in first decade of this century played havoc with my straight line projection. I was19% below the original projection in 2002, but am currently only 3% below it and should surpass it in a few years.
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Re: Inflation - how to treat in retirement projection

Postby ourbrooks » Thu May 09, 2013 6:38 pm

A spreadsheet is a good place to start to get a feel for how the numbers affect each other, but it won't give you a very good picture of what's likely to happen.

One big problem, as previous poster has mentioned, is that averages don't account for what really happens. Suppose you make a 2% inflation assumption; you won't get an even 2% year after year. Instead, it might be more like 4%, 4%, 1%, 1%, 0% or 0%, 1%, 1%, 4%, 4% and it makes a difference in which order things happen. High inflation early in retirement means that you'll have to spend more money than if it occurs late in retirement.

One way around this problem is to use a large number of different sequences of return to get an overall picture. That's what Firecalc http://www.firecalc.com/ or Flexible Retirement Planner http://www.flexibleretirementplanner.com/wp/ do. Fidelity also offers a retirement planner. Any one of them will give you a more complete picture than your spreadsheet.
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Re: Inflation - how to treat in retirement projection

Postby Clearly_Irrational » Thu May 09, 2013 7:02 pm

I think I'd be more like to use some form of monte carlo analysis so that I could see the effects of sequence issues. Try to break everything down into separate categories and make different projections for each. Sure, you'll be wrong in many cases but often times your errors will cancel each other out. Always remember that what you're trying to do is ensure you've eliminated the stupid choices, however that doesn't mean that what remains is a good choice, it's just the best you can do with the data on hand.
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Re: Inflation - how to treat in retirement projection

Postby Calm Man » Thu May 09, 2013 8:21 pm

OP, these assumptions are completely reasonable. So are any of an infinite set of assumptions. Let me ask the following: what happens if we enter a 10 year period of inflation of 3-4%, rising interest rates and declining stock markets. I have an old saying in my mind: "Man plans and God laughs". So I would build in a lot of cushion.
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Re: Inflation - how to treat in retirement projection

Postby MN Finance » Thu May 09, 2013 8:49 pm

There are two different issues here. First is how to estimate your expenses. Thats just picking an inflation rate and adjusting for major changes. For that 3% is fine (the market says inflation will be closer to 2%.) As someone already suggested you could also double that number or increase it nominally for something like medical. The second issue is if your portfolio will last. You should probably assume a 4% withdrawal rate, as mentioned that's 80k on 2M. A better way is to use Monte Carlo software to see the range of possible outcomes.
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Re: Inflation - how to treat in retirement projection

Postby Strevlac » Thu May 09, 2013 9:20 pm

Prudence wrote:Inflation - how to treat in retirement projection?


IMO it's a waste of time and energy. I just project expenses in nominal terms and my "best guess" of real investment returns on the total portfolio...4%. Some might see that as aggressive, some might see it as conservative, but it doesn't really matter if one has 30 years until retirement, as long as one is saving as much as they can.
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