Brutal Facts of Retirement Budgeting

By Henry K. (Bud) Hebeler

4-22-04

This is a subject that everyone hates. Not only is it an obnoxious and time consuming task, it is almost universally misunderstood. Weíre going to show you how the disciplines should be applied. Itís up to you to overcome the time and psychological barriers to do the work.

Items with high inflation rates:

The first thing to recognize is that some budget items have extraordinary inflation increases. Everyone who has to pay health insurance certainly recognizes this, but itís also true of a number of other items such as energy costs and local taxes. There is a simple approximation that you can use to determine the real cost you should budget for items subject to high inflation rates. It is:

Actual Cost x (1 + A x 0.5 x L)

In the equation above, A is the incremental inflation rate, so that if you expected your health insurance costs to increase at 5% a year while normal inflation would be 3%, then A would be 5% - 3% = 2%. The L term in the equation represents the remaining years in your life. If you expect to live 20 more years, then L = 20.

Using these example values, letís determine the budget for a $400 a month medical insurance bill. That would be:

$400 x (1 + 2% x 0.5 x 20) = $400 x (1 + 0.02 x 0.5 x 20) = $480.

This means that you would budget $480 which would be split into two parts when actually making the payment. $400 would be the actual cash outlay for the bill and $80 would go into savings so that you would build up a reserve for the future inflation increases. Repeat this every year. As that reserve builds, together with the interest it earns, it will fully compensate you for the future costs which will far exceed $400. The savings from the $80 need not be in a separate account as long as your input into a retirement planning program assumes that the cost is really $480.

 

Replacement Cost Budgeting

If you thought that ordinary budgeting was an obnoxious task, this is even worse, because it will force you to face the real cost of things that wear out and need to be replaced. In order to do this, you will need to make an estimate of the number of years the expensive things around your home will last. At best, this is not a precise estimate. You cannot expect that, when the time comes to replace something, its cost and your trade-in value will be close to your budgeting assumptions. Nevertheless, replacement cost budgeting is an infinite improvement over doing nothing.

Whatís really important about replacement cost budgeting is that it will save you a ton of money in the long run. You will have the cash in your savings to buy large value items outright instead of having to get a loan. Youíll be paying yourself the interest instead of paying someone else the interest!

Itís likely that your most expensive thing will be an automobile. Letís assume that you generally replace your vehicles every six years, and that if you went to a dealer today, you would have to pay $18,000 after trading in your old vehicle. This means that the vehicle capital cost (not its operating costs) will be $18,000 divided by six years, or $3,000 a year. This would be your replacement cost budget. Every year you would make a new calculation and make a deposit to an account for large item purchases.

In the case of large value items like this, it is a good idea to keep a separate reserve account for that purpose. This should be in investments that are liquid, not something like a stock fund or real estate which might be difficult to get as much as you want when you need it. This account can be a theoretical part of the rest of your investments as long as you donít count it as a part of the investments used to determine how much you can otherwise spend for normal retirement expenses.

There is another shock coming. Thatís what the size of your replacement reserve should be today. Letís suppose that you have owned this automobile four years already. That means your reserve should already be 4 x $3,000 = $12,000. Very young people consider this kind of computation to be absurd. By the time they add up all of the items requiring existing reserves, they have nothing left in their savings for anything else, much less retirement.

On the other hand, retired people really should have such reserves if they want to save the interest costs on all of these replacement items. At current interest rates, even retired people want to dismiss this subject. Iíve heard the argument many times that, "I can buy a car with zero interest payments, why should I pay cash?" The answer to this, of course, is that you are paying the interest cost whether you like it or not. You have to pay more for the car than if you could pay cash. Thatís because the seller is financing the sale and has to pay the interest to a lender somewhere plus a lot of bookkeeping costs and still make a profit. That difference in price more than makes up the interest you will earn by keeping the cash in your account unless you are very lucky with your investments.

Items you should consider for replacement cost budgeting are things like your automobile, roof, furnace, water heater, carpets, exterior painting, interior painting, drapes, and electronics like computers, large screen TVs, etc.

Total the numbers:

The final task is to add things up so that you get three totals: (1) Your actual cash expenses in retirement, (2) the amounts you must add to reserves each year for high-inflation items and replacement reserves, and (3) the amount you calculate you should already have in replacement reserves. Then you have to do some comparisons. Your actual income must be greater than the sum of (1) plus (2). If you are not yet retired you must add another element. Thatís your savings for retirement accounts. The other comparison you have to make is the size of your current investments with the amount in (3). A retirement planning analysis should not include the amount that you have to set aside for (3).

This is tough financial love, but in the long run, itís well worth the agony! See the free programs on www.analyzenow.com that make easy work of this.

 

RETURN