Planning a Budget (and Inflation)

In planning to retire, there are two numbers you need to know: (1) how much money you need on hand to retire in the first place and (2) how much you plan to spend.  While the two numbers are essentially inextricable, I’d say that the latter is more important, as it determines the first question.  You can’t know how much money you actually need until you know how much you plan to spend.  Sure, you can come up with a number and hope it’s good enough – and if it’s high it should be fine – but ideally a little more precision can refine how much you need to save now and how long you have to save before you have enough.

If you’ve never budgeted, the concept seems easy enough.  At its base, budgeting means that your spending does not exceed what you have to spend.  You can look at it two ways: (1) how much you need to spend gives you how much you need to save up, or (2) how much you have dictates how much you can spend and you have to fit your expenses within that.  For most people, budgeting is the top-down approach (i.e., number 2) – you figure out how much you can spend and then fit your expenses into that.  Only the lucky ones can add up what you spend to see how much you need on a regular basis (and for those people, you’re not really budgeting in the true sense of the word).

If you’re budgeting now and you’ve done it before, you know how it goes.  If you haven’t, that’s fine, because we’ll talk about it now and with some trying you’ll see how it can be more difficult than it seems.  That’s because unless we do it meticulously, it can be difficult to see exactly what we spend.  You might cover the major categories of fixed expenses, but there tends to be variable expenses that are more difficult to control and to take into account.

With that, let’s first try to figure out the major categories of expenses that a retiree needs to consider:

• Housing: the cost of the house/apartment itself
• Utilities: TV, internet, electricity, gas, heat, water, phone
• Maintenance of housing: if you own (roofing, pest control, HVAC, cleaning, upgrades, wear and tear, and so on)
• Homeowner’s or Renter’s insurance 
• Car + fuel + insurance
• Other transport: public transportation
• Medical: health insurance plus co-pays, out of pocket, etc.
• Food: the stuff you eat (and drink)
• Entertainment: the whole reason you stopped working, which might include travel
• Taxes: Yes, you have to pay taxes on those gains

The list goes on the more you think about it.  If this is your first time budgeting, you can see how things start to add up.  And some of these categories are virtually unconstrained, like entertainment, especially when you include travel in the mix.

It’s important to estimate how much you need to spend on each of these categories before you try to calculate how much money you need for retirement.  Or, better put, you have to budget and these are your primary categories.  Why is it so important?  Because it’s vital to whether you’ll have enough money to retire in the first place.  Moreover, it’s a good exercise to try to calculate how much money you need to establish the standard of living you hope you attain in retirement.

Imagine you think you need $5,000 per month.  Sends like a pretty high number, all things considered.  When you break it down, you can see what it buys you:

Housing	$1,500
Utilities	$300
Maintenance	$500
Homeowner’s/Renter’s Insurance	$50
Car (plus fuel and insurance)	$300
Transport	$50
Medical	$500
Food	$800
Entertainment	$1,000

Obviously, this will be different for different people.  But, you see that $5,000 per month doesn’t leave much for each category.  And we didn’t include taxes.  If you assume that you’re going to spend $60,000 per year, you’d need to withdraw more than that to end up with $60,000 in cash.  Taxes will vary based on how much of your portfolio counts as return of principal.  But, let’s say that in a given year, you sell off $70,000 of stocks, $40,000 of which is a mix of long and short-term capital gain.  Assuming a blended rate of 25%, you pay $10,000 in taxes, so your $70,000 nets you the $60,000 you need to spend.  

That’s why it’s so important to consider taxes, as it affects your drawdown of funds.  If you figure you can only take out $60,000 per year, then you can’t assume that you’ll have $5,000 per month to spend, because you’ll have to pay some taxes.  If that $60,000 has $30,000 of capital gains with an average rate of 20%, then you’ll pay $6,000 in taxes, leaving you with $54,000 in cash to spend over the year, or $4,500 per month.  You see the impact that has.  

And as you get older, remember that more of the money you withdraw will be gains rather than principal, because (1) you should have more gains as time goes on from compounding, and (2) you probably already returned most of your principal in the earlier years.  You can try to defer some principal return for later years, but you’ll only have so much to work with.

And then there’s one more thing you have to consider when budgeting for the future, and that’s inflation.  Your costs of living will go up due to inflation, regardless of whether you actually buy anything more or enhance your standard of living.  It’s a fact of life.

There are two ways to capture inflation in your projections: (1) by decreasing your anticipated return on investment, or (2) by capturing it in your cost of living.  I prefer the second option, and I’ll explain why.  Below is a chart with the first option:

Year	Market Value	Costs
1	$1,000,000	$60,000
2	$977,600	$60,000
3	$954,304	$60,000
4	$930,076	$60,000
5	$904,879	$60,000
6	$878,674	$60,000
7	$851,421	$60,000
8	$823,078	$60,000
9	$793,601	$60,000
10	$762,945	$60,000

And below is the second option:

Year	Market Value	Costs
1	$1,000,000	$60,000
2	$1,005,800	$61,800
3	$1,010,080	$63,654
4	$1,012,676	$65,564
5	$1,013,410	$67,531
6	$1,012,091	$69,556
7	$1,008,512	$71,643
8	$1,002,450	$73,792
9	$993,663	$76,006
10	$981,893	$78,286

In each of these options, we assume a nominal (not inflation adjusted) return of 7% (on average and compounding) and 3% inflation.  In the first example, we adjust the return of 7% for the annual inflation rate of 3%, meaning that the actual real return is 4%.  You see how each year, the costs assumed stay the same at $60,000 “real” dollars.  That is, you’re not adjusting the $60,000 for inflation, but instead using $60,000 as your base purchasing power – or, put differently, your costs mirror what $60,000 would purchase you in Year 1.

In the second example, the return is not adjusted for inflation, so the nominal account value goes up 7% per year (on average, and compounding), but your costs reflect inflation, so they grow by 3% each year.  

Also note that in each example, the market value accounts for the fact that you’re spending the costs.  This means that the value of the account goes down by the amount you spend and up by the amount of the return.  For simplicity’s sake, I calculate the return on the amount after spend (i.e., assume you spend all the costs at once and then earn the rate of return on the reduced value), which reduces the return, but is more conservative.

As I explained above, my opinion is that scenario number 2 is a better way to look at how inflation affects how much money you need to budget.  

Scenario number 1 might be better if you haven’t calculated a budget because it shows you in the future how much purchasing power you could theoretically have in “real” (i.e., not impacted by inflation) dollars.  If you adjust the rate of return for inflation, then the amount of your gain essentially shows your purchasing power in today’s dollars. 

Take Year 9 in scenario number 1 – it shows your market value at $793,601 (after you’ve spent $60k, per year up to that point).  If you’re in Year 1 projecting forward, your understanding would be that in Year 9, you’ll have the ability to purchase what would cost $793,601 today.  That gives you an understanding of the worth of your portfolio at a given time.  However, it doesn’t tell you the actual market value dollar amount that would be in your account in Year 9.

Scenario number 2 tells you the actual, nominal amount of money your account would theoretically have in it at a point in the future.  So in Year 9, if you logged on to your brokerage account, in theory it would say that your account value is $993,663.  Of course, in Year 1, you can’t necessarily know what $993,663 will buy you (i.e., the “real” worth) because you can’t compare the nominal amount to what $993,663 would buy you today.

But, the reason I like scenario 2 is that in the future, you won’t be looking back to what you could have purchased in Year 1.  You’ll be looking at what you can purchase on a given day, and the only way you can know that is based on the market value on that day.  A given day’s market value is the purchasing power that you have on that future day.  However, to account for inflation, you’ve assumed that your costs have gone up in nominal dollars.  So it’s baked into the calculation that although your account shows a higher amount of nominal dollars (than with an inflation-adjusted return), your costs to maintain the same standard of living have gone up.

This is all a long way to say that you need to account for inflation in your budget.  And the way I would do it is to take your assumed budget at your starting year and add inflation to it in future years.  Your costs will increase over time, giving you an understanding of the amount of nominal market value you need in your portfolio to cover them.  Then you can see whether your assumed rate of return gives you enough to cover your inflation-adjusted expenses.

Conclusion

So what did we learn? 

One, budgeting is crucial when you’re projecting into the future because you need to ensure you have enough money to cover expenses when you’re planning to retire.  Two, your budget has to account for inflation, and while there are several ways to capture it in your projections, I favor the approach that adjusts your presumed costs .  As you see, however, before you can do this, you need to develop a budget to create an assumption of how much you’ll be spending in retirement.

The fact remains that you’ll never accurately be able to know what will happen in the future.  The best we can do is predict based on what we know.  But in the process of predicting, it’s important that we consider the right things and plan the correct way to maximize the odds that we can make retirement work.