Knowing Affordability

Living your best life

Deep into April, Sandra Malley woke up to a late-in-season snow in Park City, thinking about her loneliness and life without her beloved Daniel, who had died two years ago.    There was still occasional mourning as would be expected when life had been spent with one person for fifty-five years, then changed forever by a car accident. While Sandra and Daniel never had children, friendships were many and Sandra could pull herself out of the doldrums with a phone call to Bruce and Jen in Fort Lauderdale or Betsy, who lived in Palm Springs.   Betsy, healthy and active, is Sandra’s best friend.   Betsy has been trying to convince Sandra to move to the desert.   Sandra has wondered whether she could survive the blistering hot summer days, but at age 64, that may be better than six months of freezing conditions at altitude.  

Financial matters are in Sandra’s wheelhouse, a lifelong career as an accountant while Daniel ran his boat repair business in California’s East Bay.   Sandra lives off her financial assets and social security retirement benefits, and the $2 million townhome in Park City is without a mortgage. Nothing like Betsy’s pressure to move while penning a check to the IRS for estimated income taxes to wonder, “Is it time to move?” Health is good. Longevity is hopeful. “Why not?” 

Like most mid to late-life households, economic net worth is less related to the income from a job. Savings and investments sustain life.    Registered investment advisors and wealth advisors find customers like Sandra. RIA’s, PWM’s, wealth advisors, you name it. Their world is asset allocation, and they are on the hunt for customers.

Readers should know that investment selection and performance sit underneath the umbrella of financial planning, yet investment advisers generally fall short on this dimension.

Holistic financial planning is not within an investment adviser’s core competence or aligned with their incentives to generate fees based on products they sell. But without equivocation, investment quantities and recommendations are inextricably related to really good financial planning.    How else does one determine how much to invest for a special project or retirement? If I am a PWM client, I ask my advisor, “How much should I save?” I hope to get sound advice. The response from the advisor should be precise to my goals and standard of living.

The Way to Think about Planning

Daily life gets in the way of a household undertaking its financial planning.

If I asked you to arrive at a single dollar amount that represents your living standard today, the cap on your affordability to spend money, what would you say?

Likely you haven’t thought too much about it, but spend in ways to match your affordability intuition. Fortunately, you are here and we have Sandra to illustrate how to proceed.

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Sandra is retired and has a brokerage account and a rollover IRA with an investment company. The market value of her accounts is $5.5 million. Sandra is receiving Social Security retirement benefits, too, and today’s value of her future benefits is $500,000. Her Park City home is valued at $2 million. She doesn’t have consequential debt, only the occasional credit card balance.    Sandra will always need to live somewhere, so the value of her home will be off the table for living expenses, except in an emergency. For instance, she sells the home and uses the proceeds to buy into a continuum of care community.

The conceptual view of Sandra’s financials for the balance of her life is the roadmap. Household wealth today, age(s) today, and estimated max age(s) of life are the essential guideposts. Low-income, upper-income households with or without children. Sandra’s wealth is higher than most. $6 million on a declining trajectory toward the end of life.    At this terminal point, some amount of money may be left. An inheritance for others, charitable giving, or $0 if one is not inclined. For most, the home no longer needed at death creates a  new asset for others.

The execution of economics-based financial planning takes the wealth starting point and the individual’s expectation for the wealth ending point to determine the highest annual living standard.   Living standard is calculable and represents the amount of money each year the household can spend toward the non-discretionary bills that maintain basic life essentials to the discretionary, “make life fun” expenses.   Investment performance matters and Sandra’s receipt of social security retirement benefits and taxation affect the rate at which financial assets must be sold to support living.     Scary thing is the thought financial assets are sold late in life.   Sometimes, individuals without heirs or charitable interests want a buffer. Others will say, “I don’t need it if I am dead.” Sandra prefers to ensure she always has at least $1 million in financial securities to handle a surprise, a reserve fund to comfort her.

Today, Sandra has $6 million to her name. How should she spend it? Longevity plays a role. If Sandra expects a short remainder of life with a preference to leave $1 million, she has a lot of spending to do. If Sandra hopes for a relatively long life, say to age 90, she has 27 years before her. Her living standard could be $400,000 a year for the next ten years ($4 million total), then life is led with $1 million to spend over 17 years, honoring her preference to leave a $1 million estate at her max age plus her home equity. That mountain of near-term high-living becomes a trickle for 17 of her remaining 27 years. She was gorging, then relative starvation. Plausible but not optimal.

Economists have a solution for the living standard, creating the highest lifetime satisfaction.

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. The highest lifetime happiness level is the annual living standard. The “back of the envelope” optimal living standard for Sandra would take her $6 million starting point, her $1 million reserve preference (ending point) and an expectation of her remaining lifetime (27 years) to arrive at her annual budget, e.g.,

($6 million - $1 million)/27 = $185,185.

Sandra would use this amount to set her budget for the current year.

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Sandra meets her living standard each year with her social security retirement benefits plus the necessary withdrawals of her financial assets.   If her annual social security benefit payout is $36k, then Sandra needs $149,185 from her financial securities, whether dividends or sales, to maintain her living standard. Then, given life and financial changes (investment returns, tax law tweaks, etc.), a new amount is calculated in the forthcoming year. Sandra’s financial plan is updated.

If Sandra wants a higher living standard this year, she needs to sell more financial securities but will fall short of the $1 million goal at her expected max year of life. If she lives at a lower standard this year, she needs less from her financial securities. But, living at a lower standard guarantees a higher reserve fund at the end of life and an increased amount of money left on Sandra’s table. There are always trade-offs.

Reality Can be Solved

The next step for Sandra would be to sell her Park City home, take her proceeds to buy her new spot in Palm Springs, update the market value of her financial securities, and then re-evaluate her optimal annual spending for the forthcoming year. Pretty straightforward. The clarity of Sandra’s simple example is quickly taken to the real level, and details about taxation, inflation expectations, and investment risk are important to arriving at the target living standard for the next year and future years. It is easy enough with software that is available in the market today.

1. Personal Finance Economics is about economics-based financial planning, and several financial planning case studies are in the archive for review. For any financial planning question, the solution invariably involves answers to two important financial planning questions: what is the highest obtainable living standard, and how does one achieve it?

2. Here is some accessible background on the topic.

3. Professor hat on at this point: for ease of explanation, no taxes are involved, but tax liability under the current state of the tax code is easy to consider without changing how one determines the optimal amount of consumption.