Why Advisors Should Distinguish Base And Discretionary Expenses – ValueWalk Premium
Discretionary Expenses

Why Advisors Should Distinguish Base And Discretionary Expenses

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Modern retirement theory assumes that all assets on an individual’s retirement sheet1 (financial capital, social contract, human capital) should be used for their definitional highest and best purpose. To determine the highest and best purpose of retirement sheet assets, goals are prioritized and assets and liabilities are matched.

Discretionary Expenses

Discretionary Expenses

The difference between base (mandatory or essential) and discretionary (voluntary or non- essential) expenses in retirement is fundamental and consequential. Properly making this distinction may be the most important decision in order to use assets efficiently and effectively in retirement income planning. Some advisors fail to highlight the difference between expense categories and claim that clients do not see food, shelter or insurance differently than country club dues or vacation cruises. Hence the expense categories are combined and called lifestyle expenses.

This is a distortion of affluence. Lifestyle expense is an unfortunate term and promotes the idyllic sense that to live the lifestyle one wishes these expenses should take on the same priority funding importance as basic expenses. Expense distinction is the most critical issue to optimize the use of retirement assets and to cover base (essential) expenses. Our “3S” model2 posits that net cash flow (base income) should cover Base expenses with sources of income that are simultaneously secure, stable and sustainable.

Advisors should always look for ways to add value to clients, especially if operating under a fiduciary standard. An overlooked area for value-add in retirement planning is in expense categorization. Many advisors question whether we should distinguish between types of expenses for planning purposes. The typical salvo is that clients don’t want to distinguish between food and country club dues, so why should we force them into expense categorization?

But if we fail to advise on this distinction, we miss a significant opportunity to properly frame client decision-making. If the distinction adds value and improves outcomes, should not advisors, as a best practice, parse these expenses in planning? We make distinctions between different kinds of stocks (small, large, value, growth) or bonds (corporate, sovereign, or high yield), so why the pushback on acknowledging expense types? The short answer is that if we push this conversation into a logical framework, we can improve client outcomes and add value.

The most important input to a retirement plan is monthly base expenses. All other retirement calculations measure or test the sustainability of this single number. Retiree outcomes can be enhanced by focusing on what the retiree can control, beginning with their base expenses. Intentional retirement budgeting improves sustainability through generating the highest net-cash flow from available assets while preserving other assets for funding unknowable future needs.

Retirement-income planning should start with the cash flow required to cover budgeted essential expenses. Rather than beginning with income replacement, start with necessary expenses, then build stable, secure, sustainable income (3S income) through liability matching. Income replacement ratios (i.e., the percentage of pre-retirement income that is needed in retirement) are too simplistic and no substitute for detailed budgeting. The goal of generating retirement income is to attain the highest net cash flow, i.e., the after-tax cash after basic expenses have been funded.

Read the full article here by Jason K. Branning and M. Ray Grubbs, Advisor Perspectives


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