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The Bottom Line is Your Living Standard

All personal financial planning questions, from Can I retire early? to When should I take Social Security? to What can happen if I invest in risky assets? boil down to the impact on your living standard.

ESPlanner is the only financial planning program that directly calculates your living standard and helps you achieve the highest living standard that your current and future economic resources can support.

Take the example of Jack and Jill Sprat, a middle-aged couple.

Basic Profile:
Jack is 51, Jill is 49
Their children have already graduated from college.
Housing: 25 years remain on their $350,000 mortgage. They pay $2,000 per year in property tax, $1,500 per year in homeowners insurance, and make a $2,255 monthly mortgage payment. Their last payment is due in 2033.

Retirement Dates: Jack 65, Jill 63 (year 2023)

Income Jack: 130K in today’s dollars, steady through age 65
Income Jill: 100K in today’s dollars, steady through age 63

401(k) Contributions Jack: 3K / Employer 3K
401(k) Contributions Jill: 3K / Employer 3K

401(k) Retirement Balance Jack: 500K
401(k) Retirement Balance Jill: 500K

Inflation is set at 3%.
Nominal return on retirement assets: 6%
Nominal return on regular assets: 5%
Tax Tables: Michigan

The Downside of Zero Saving
Consider first what happens to Jack and Jill if they save nothing for retirement beyond making contributions to their 401(k) plans. As the diagram below shows, this leads to a 38 percent drop in their living standard at retirement. (To implement this scenario in ESPlanner, we lowered the value of the standard of living index after Jack reaches age 65 until the program recommends zero current saving.)

Consumption Smoothing, Econsomics-Base Planning
Next we let ESPlanner smooth Jack's and Jill's consumption (by restoring the standard of living index values to 100 after retirement). Pre-retirement, the couple's living standard is now about 24 percent lower than were they to save nothing apart from making retirement contributions; after retirement it is 11% to 17% higher (depending on the age at which we take the reading) than it is with zero saving.

Use that 401(k)!
Having smoothed Jack and Jill's living standard, let's roll up our sleeves and look for ways to raise it. First, instead of using regular saving to smooth consumption, let’s have Jack and Jill add another $9,000 each to their 401(k)s. This will raise their lifetime living standard by 3.41% above our baseline smooth case.

A 3.41 percent increase in the couple's living standard each year until they reach age 100 is quite significant given that achieving this increase entails essentially no risk. (Recall that we're assuming the couple invests conservatively.) The reason the couple can afford to spend more now as well as in all future years is that contributing more to the 401(k) reduces their lifetime tax payments.

Your FP will tell you this, but what he won't be able to say is how large the federal and sate tax changes will be in each future year and what these tax changes mean for your current and future living standard (your affordable discretionary spending per household member adjusted for economies in shared living).

But wait . . . should we have recommended contributing the extra $9,000 each to the Roth 401(k) accounts to which Jack and Jill have access?

It turns out that the advantage of the ROTH throughout most of their life is negligible ($122 per year) in terms of living standard. But this actually argues strongly for using the Roth because a) the Roth does as well as the 401(k) and b) tax rates may be raised substantially by the time the couple retires.

Taking Social Security at Age 70

We can generate a generally higher living standard relative to the baseline by just postponing the collection of Social Security retirement benefits by Jack and Jill until age 70. This strategy comes with a bit of a trade off. Pre-retirement, their living standard goes down by .97 percent ($966 per year). However, in their retirement years, they will see massive living standard increases as indicated below. (12.69 percent, 21.8 percent, and 29.58 percent depending on the age in question.)

These living standard increases reflect two things--the fact that waiting to collect Social Security leads to dramatically higher benefit payments thanks to Social Security's delayed retirement credit.

Second, by waiting to collect their retirement benefits, Jill can collect spousal benefits for free. (See our case study: When Should I Take Social Security?) But the fact that the living standard is no longer smooth means that waiting to collect leads the Sprats to become cash constrained; i.e., they can't achieve as high a living standard before age 70 as after unless they were to borrow, which we assume isn't feasible.

Let’s Alleviate the Sprat's Borrowing Constraint
by having the Sprats plan to withdraw all their retirement assets by age 95 instead of 100. This will make withdrawals larger in all years before age 95 and relieve the couple's borrowing constraint.

The impact on living standard is illustrated below. As you can see, this delivers a 5.03 percent higher pre-retirement living standard relative to the base case. During their retirement years, they will enjoy a 11.09 percent higher living standard compared to the base case.

The Sprats can refinance their mortgage and raise their living standard even further. The refinance involves paying tax-deductible points and (non-deductible) closing costs to lower the interest rate on their $350,000 mortgage from 6.0 percent down to 4.5 percent. This reduces their monthly mortgage payment from $2,255 to $1,896.

Refinancing raises the pre-retirement living standard by 2.7 percent above the base case value; in retirement, it's 17 percent higher than the basic case.

There are other ways to further raise the couple's living standard, but the main message is clear--your living standard is your bottom line and if you can't calculate it, you can't plan your financial future.