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The “AgeBander” Approach Presents a More Accurate Portrayal

[By Somnath Basu, PhD, MBA]

A convergence of mega-trends will forever change the face of retirement planning and raise its importance in the pantheon of physician retirement planning and most all employee benefits. Chief among them: longer life expectancy, advances in medicine, healthier lifestyles and mounting concern about years of abysmally low savings rates.

What it all Means in Practical Terms

What this means in practical terms for future retired physicians and most all retirees is the need for employers, service providers and financial advisers [FAs] to plot a more accurate and thoughtful course to planning for retirement that acknowledges the necessity of pursuing an “age-banded” approach. The idea behind this new approach is that individuals undergo various changes in lifestyles during retirement that last for finite or “age-banded”, periods.

Example:

For example, doctors like most people spend more time and money on leisurely activities early on in retirement, while health care needs dominate the latter years. Further, the costs associated with these lifestyles also change at differential inflation rates than from the basic inflation rate. While the basic inflation rate is about 3%, the U.S. Census Bureau noted that annual recreation costs increased at 7.14% though most of the 1990s. Health care costs also increased by much higher rates than the basic rate. Since the traditional model bundles all costs (including leisure, health care, basic living, etc) and extrapolates at the basic rate, it tends to underestimate retirement expenses. The traditional model’s “static” approach to retirement can have dangerous implications since it may lead to under-funded retirement plans, especially those earmarked for the critical years.

A Flawed Model?

In a research paper published by the Association for Financial Counseling and Planning Education, I detailed the reasons why an age-banded approach is superior to the traditional view of retirement planning. This new model provides for a more accurate portrayal of retirement expenses and an algorithm to calculate the income-replacement ratio, as well as smaller resource requirements and greater flexibility in managing risk. It also allows easier incorporation of long-term care insurance (LTCI) and significantly reduces funding needs. Indeed, the funding needs of a husband and wife who are both age 60 and presumably five years away from retirement are reduced by more than 16% and contributions for a 35-year-old single woman are reduced by 42% compared with previous approaches.

Traditional Retirement Planning Weaknesses

There are five inherent weaknesses to the traditional approach to retirement planning. They include the assumption that all living expenses will increase at the overall rate of inflation as measured by the Consumer Price Index (CPI), bundling all expenses together and not allowing them to change based on the life-cycle, estimating those expenses as a fixed percentage (replacement ratio) of pre-retirement costs, investing in low-return assets and failing to consider contingencies such as LTCI benefits, which can have a significant impact on the amount of funding required for retirement.

Financial Advisory Estimates

When financial planners estimate how much income a client needs in retirement, the calculation hinges on their income just prior to retirement. The pre-retirement income is adjusted downward by 10% to 35%. This adjustment reflects the income necessary to maintain one’s standard of living and incorporates reductions in taxes and other work-related expenses that cease upon retirement. Unfortunately, there’s no objective way to estimate the replacement ratio. Aggressive financial planners typically use large ratios and conservative planners use smaller ones.

30-year Retirement Window

Under the age-banded model, an individual typically lives about 30 years in retirement (e.g., age 65 to 95) and experiences a lifestyle change every 10 years at 65, 75 and 85. Of course, both the retirement period and the width of the age bands are arbitrary but can be subjectively changed to fit each retiree as closely as possible. In addition, a number of steps are taken to produce a clearer picture of retirement costs by categorizing them based on taxes, living expenses, health care and leisure, as well as calculating anticipated expenses using the appropriate rate of inflation for each category, which is adjusted to reflect post-retirement lifestyle changes.

Those expenses are extrapolated through 30 years of retirement and the present value of post-retirement expenses are calculated at an amount deemed sufficient to finance the three following decade (each age band). Instead of discounting these values to the year of retirement (the traditional model), the age banding considers them to be three retirement portfolios that require funding.

Since the portfolio required to fund the expenses during the years 86 to 95 is 20 years behind the first band (66 to 75), investors can seek marginally higher rates of return to reflect the longer terms. Contributions toward these amounts can now be calculated.

Example:

For example, the couple mentioned earlier is able to seek higher rates of return for longer-term investment portfolios which more than mitigate the effects of escalating health care costs. In the case  of the 35-year-old single woman, since the funds required for these three portfolios are 30, 40 and 50 years away she should be willing to take on more risk since she has ample time to manage the portfolio risk.

The expenses for the age-banded method become considerably higher at the latter stages of retirement as compared to the traditional model. This is desirable since the over-funding is associated with an age at which one cannot afford to be out of funds. The higher estimate of the age band comes from higher inflation rates for health care and the incorporation of lifestyle changes that imply accelerated costs such as increased leisure spending upon retirement and higher health care costs in the latter years.

Thus, these higher costs are not only more realistic but they incorporate the dynamics of a retired life, unlike the traditional model. Incredible as it might seem, the ability to assume a marginally higher risk leads to an actual decrease in the funding requirements versus the traditional plan.

Assessment

One caveat that doctors need to know, and that financial planners will need to keep in mind, is that their clients may be reticent to buy equities when markets are underperforming. Clear explanations are required regarding why it may still be beneficial for the long run and that the risk will be managed on an ongoing basis. But, the results will be well worth the effort for the multiple stakeholders involved in assuring that tomorrow’s retirees are able to live more comfortable after their working years. It’s a small price to pay for the peace of mind associated with knowing retirement expenses will be portrayed more accurately and plan participants will be afforded greater flexibility in managing their risk.

Table [Comparison of growth in retirement expenses]

Link: Age-Banded Retirement Planning FINAL[1]

Editor’s Note: Somnath Basu PhD is program director of the California Institute of Finance in the School of Business at California Lutheran University where he’s also a professor of finance. He can be reached at (805) 493 3980 or basu@callutheran.edu. See the agebander at work at www.agebander.com

Conclusion

And so, your thoughts and comments on this ME-P are appreciated. Financial advisors please chime in on the debate? Is Basu correct; why or why not? Review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, be sure to subscribe to the ME-P. It is fast, free and secure.

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Filed under: Financial Planning, Investing, Research & Development, Retirement and Benefits | Tagged: Association for Financial Counseling and Planning Education, California Institute of Finance, CFP, CPI, financial advisors, LTCI, retirement planning, School of Business at California Lutheran University, Somnath Basu, www.certifiedmedicalplanner.com | 7 Comments »