A Single's Spaghetti Budget

Day 25. Investment risk al dente

Two months ago, I introduced subscribers to Ben Shipley, who needed a budget. We gave him a budget based on how Nobel laureate economists would do it: a budget that achieves Ben’s highest living standard, given what we know about his current financial circumstances and prospects based on consumption smoothing theory.

Ben earns $54,000 gross, lives in Michigan, and has a 401(k) to which he and his employer contribute 2% of gross income, which is then invested.

Ben’s projected lifetime earnings are $1.8 million if he retires at age 66, and today’s value of his Social Security retirement benefits is projected to be $321,740.

Ben’s economics-based budget for the next year is below. The spending breakdown includes housing, his 401(k) contribution, and the estimate for all of his taxes. Ben’s magic number for next year is $54,872. Most important to determining Ben’s highest living standard is “Discretionary spending.” Discretionary spending is critical to defining Ben’s magic number and his total spending cap this year. It is the economics-based budgeting solution built into MaxiFi Planner software. You might think, “Ben’s magic number is higher than his income.” It is. What you don’t know is that Ben has a small amount of non-retirement bank checking and savings that earns interest, which helps fund his short-term living standard.

Ben’s budget cap isn’t guesswork. Ben’s sustainable living standard is too important to arm-wave about how Ben should spend. Your living standard is, too. How Ben spends under the cap is his choice after his fixed commitments to housing, retirement contributions, and taxes.

Last point. I use “magic number” for pedagogical reasons to explain the best budget. It is better than writing something like, “Ben’s total annual expenses for the current year depend on his discretionary spending, the value of which is determined by an optimization engine that uses dynamic programming mathematics.”

The Real-World is Risky

The good news is that we have a sophisticated way of determining Ben’s budget for next year. But, it was done under laboratory conditions. Ben was assumed to earn a fixed return on his bank checking/savings and his 401(k). It is time to turn the real-world crank and embed the risk of financial assets.

Ben has two types of assets to invest: non-retirement assets like bank checking, savings, and brokerage account holdings, and his employer-sponsored 401(k) account. The goal remains to find Ben’s magic number for next year and all future years’ discretionary spending.

A technique commonly used by financial advisors simulates future investment returns given how those same investments performed historically. I do that here for Ben and consider two ways Ben can invest.

1. Lower-risk strategy: regular assets and 401(k) assets are 100% invested in a lower-risk total U.S. bond market index fund

2. Higher-risk strategy: regular assets and 401(k) assets are 100% invested in a higher-risk total U.S. stock market index fund

For each strategy, Ben’s annual discretionary spending number, in today’s dollars, is traced from the current year to his assumed max age, 95. There are four strands of spaghetti, two for each investment strategy. The “5th” and “95th” are percentile numbers. The way to think about two strands of similar color, for instance, blue is the higher-risk strategy, is that 95% of the simulated discretionary spending numbers are above the 5th percentile, and 95% of simulated discretionary spending numbers are below the 95th percentile. At age 70, the 5th percentile discretionary spending amount is $30,302, and the 95th percentile discretionary spending amount is $113,466. In other words, Ben's discretionary spending falls between these two numbers 90% of the time.

The comparable range for the lower-risk strategy is much tighter at age 70. There is less risk with bonds, after all. From a 5th percentile value of $21,899 to a 95th percentile value of $27,745 for the entirety of his life.

Which Investment Strategy is Right for Ben?

Ben’s tolerance for stock market risk plays a role, but even a moderately risk-tolerant Ben would have difficulty avoiding the risky strategy. From age 24 to 44, both strategies produce comparable discretionary spending amounts. At Ben’s age 70, the floor of Ben’s risky strategy lies about the ceiling of his lower-risk strategy. After age 70, the 5th percentile risky strategy is below the 95th percentile lower-risk strategy but still mainly above the basement for the lower-risk strategy.

One driver of Ben’s outcomes is hidden here: his forecasted Social Security retirement benefits. Under current law, they are indexed for inflation. Regardless of 401(k) investment performance, these benefits provide Ben a floor to his living standard.

Next Step for Ben

Go live for a year after making investing decisions for regular assets and the 401(k). Be sensitive to the optimal budget cap, and don’t spend more than the magic number. The beauty of an economics-based financial plan is it produces a simple number that is easy to understand from a complex methodology “under the hood.”