The Value of Budgetary Flexibility

Here’s a question for you:

Which of the following has the greatest impact on your standard of living in retirement?
A. Employing a wise asset allocation.
B. Having a wise investment advisor.
C. Having a wise tax advisor.
D. Having flexibility in your budget.

If you said, “E. All of the above,” shame on you. You’re not being responsive to the question. I said greatest impact. Of course they’re all important, but you have to pick one.

My educated guess is that the answer is D. Flexibility in your budget. Someday I hope to do a study confirming the relative importance of those factors, but for now it remains an educated guess. Consider the following tale.

Rita Rigid and Zelda Zen are twin sisters. Both are about to retire with $2,000,000 of assets (in a traditional IRA). Both use the same financial advisor. Both want a standard of living that’s as luxurious as possible, consistent with prudence—neither wants to run out of money. The sisters are alike in every way, except for one key difference. While Rita Rigid wants to live on a budget that doesn’t fluctuate from year to year, except for increasing with inflation, Zelda Zen believes she can stand some ups and downs in her annual spending.

Here is the advice they get after consulting with their financial advisor. Rita is advised to plan on spending $70,000 per year, increased annually by inflation, plus necessary income taxes. That’s 3.5% of her starting assets. Zelda is advised to spend $110,000 plus necessary income taxes. Every year, Zelda's budget is to be 5.5% of her remaining assets, but no less than $60,000 and no more than $130,000 (with those brackets increased for inflation each year). Zelda is told to expect her future budget to be both unknown and erratic, to fluctuate significantly between the $60,000 and $130,000 brackets. But the central tendency of her expected annual budget will be about $96,000 (plus taxes).

Depending on which number you look at (Zelda’s $110,000 starting budget or her $96,000 expected budget), Zelda’s standard of living is either 57% or 37% greater than Rita’s. That entire difference arises from her willingness to be flexible in her annual spending. Of course Zelda might experience an unlucky investment environment in the future, and her spending will be less than Rita’s; but she has expressed a willingness to accept that. And it is precisely that willingness that enables her to prudently spend more than Rita.

These figures come from an article I wrote that will appear in a professional journal later this year (CCH Journal of Retirement Planning). They were not just pulled out of a hat, but were based on a rigorous study of how Rita’s and Zelda’s investments might be expected to behave in uncertain markets. Rita prudently deals with that uncertainty by reducing her spending to a conservative amount so that she has a low likelihood of running out of money. Her desire for budgetary certainty demands that conservatism. Zelda prudently deals with uncertainty by anticipating that her spending will fluctuate—within the limits she has set—as the unknowable future unfolds.

Either approach is legitimate. But it’s eye-opening to see that Zelda’s budgetary flexibility is worth a whopping 37%-57% of her standard of living. It’s positively Zen-like. The less you must spend, the more you can spend.