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- 2009-12-31 00:35
The Real World Meaning of Being Borrowing Constrained
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I am still learning to use ESP more effectively. I have recently been analyzing a number of different ways to transition into retirement. (I am 6-18 months away.)
One question was raised by two scenarios I modeled. I need some help understanding how to interpret what ESP is telling me.
Scenario 1:
Take a job buyout and retire earlier than expected. This results in a recommended consumption of 2.44% higher than waiting the 18 months and retiring without the buyout.
Scenario 2:
When I do retire, roll a portion of my pension into an IRA. This results in a recommended consumption of 1.4% higher than simply taking the default pension.
Scenario 3:
Do both. Take the buyout and roll over a portion of the pension into an IRA. This results in a recommended consumption of 9.4% higher than the base of just retiring without the buyout and taking the default pension.
At first I was surprised by this result. I would have expected scenario 3 to be roughly the increase of Scenario 1 multiplied by the results of Scenario 2. I then realized that I may be borrowing constrained and reran both scenarios allowing for a maximum indebtedness of $50,000. The result for Scenario 1 was unchanged. However, the result of Scenario 2 went up to 6.94%. Now it makes more sense that doing both shows an increase of 9.4%
So, I conclude that I am borrowing constrained in the Scenario 2 where I roll over part of my pension to an IRA.
This brings me to my question. What is the real world meaning of this borrowing constraint? Does it mean I should simply borrow up to the $20,000 the reports show is needed in the three years before I start taking Social Security? (This feels somehow "wrong".) Does it mean that I should look at some of my Special Expenditures and choose to finance them for a length of time that ends around SS Benefits commencement? Does it mean something else?
What actions might I look into taking to be able to take advantage of the higher standard of living if I allow an indebtedness as shown in the reports?
Best Regards,
John
From: Dick Munroe
Well as you can see, the real world effect of being borrowing constrained is that you can't smooth your living standard at all or you can't smooth it at as high a level as you could otherwise.
You should feel that this is "wrong" [a relative term]. ESPlanner is a simulation of the future and is predictive to the extent that statements like "prior performance guarantee future returns" and any other assumptions you or we have made regarding the parameters of the simulation are true. The closer to reality the simulation is, the closer your actions can mirror ESPlanner's recommendations. You're in better shape with ESPlanner than other planning tools (and most planners) since we have tried to put all our parameters under your control but it's still a simulation.
As a rule of thumb however (and I don't think this is a dumb one), if you can live your life without going into debt, do so. I think ESPlanner's recommendations are best treated as floors and ceilings below which or above which your personal economy cannot be sustained, e.g., spend more than consumption, save less than recommended, etc.
If you can live spending less than the recommended consumption, do so. If you can save more, do so. If you can live without borrowing, do so. These are all conservative financial positions and cannot hurt you but they must be viewed through the glass of whatever quality of life factors are meaningful to you. Don't spend less or save more if it means eating dog food or otherwise compromising your life in unacceptable ways.
Best,
Dick Munroe