Usually, when you run a comparison report of two different profiles – call them A and B – if your lifetime discretionary spending is higher in profile A than in profile B, your annual discretionary spending will, as you would expect, also be higher in A than in B. Or vice versa: if the lifetime spending is lower, the annual spending is also lower.
But a puzzling thing can happen if the Inflation Rate and/or the Nominal Safe Rate of Return for Regular Assets differs between the profiles. The lifetime discretionary spending (and other values) may go up, while the annual numbers go down! Or vice versa.
Why does this happen?
The Inflation Rate and the Nominal Safe Rate of Return for Regular Assets together form the “real interest rate,” or the interest rate above inflation, of the profile. The real interest rate is used to calculate the lifetime present values shown on the Lifetime Balance Sheet. (Learn more about the Lifetime Balance Sheet and Present Values.)
When the real interest rate differs between profiles, you can see these types of puzzling differences between the lifetime and annual numbers.
To see what's at play in such a case, suppose you have $1 million that earns 2% real interest each year. Then, you and your heirs can spend $20,000 each year through the end of time (2% of $1 million equals $20,000). Now suppose you have only $750,000, but you can earn 10% real interest each year. Now you and your heirs can spend $75,000 each year.
Hence, a lower amount of lifetime spending -- $750,000 -- can be associated with higher annual spending if the lower amount can earn a higher real (above inflation) return! In other words, you need to invest less today to spend the same amount in the future if you can earn a higher return on your investment.
To tie this discussion back to your lifetime discretionary spending: Your lifetime discretionary spending represents the assets you have available in the present to spend throughout your life, and your annual spending can rise even if, due to a higher real interest rate, these assets decline.
High Real Interest Rate Example
Consider the lifetime balance sheet results in the screenshot below. The Base Plan uses our default inflation and return rates, whereas the “High Returns” profile has a safe rate of return 2% higher and thus a higher real interest rate.
As you can see, even though nothing is different between the underlying profiles except the return rate, most resource and spending amounts in the results are different. This is exactly what one should expect. In the High Returns profile, most amounts are smaller. For example, the lifetime present value of labor earnings drops from just over $6 million to $5.1 million. Why? The household's real earnings in each future year haven't changed. But their value in the present has.
Think about earning $50,000 in today’s dollars ten years from now. That $50,000 in ten years is not worth $50,000 today in present value because you can invest less than $50,000 now and arrive at $50,000 in ten years. If the real interest rate is higher (for example, due to a high rate of return as we have in the High Returns profile), the present value of $50,000 received 10 years from now is smaller than if the interest rate is lower (as in the Base Profile). You don't need to put aside as much today to reach $50,000 in ten years if what you put aside can grow at a faster rate.
Because the household's present value of resources drops in the High Returns profile, the present value of its discretionary spending does as well. But in this example, for the reason provided above, the household can actually spend more per year!
High Inflation Example
Let’s take a look at the opposite of the example above. In this example, the Base Plan uses our default inflation and return rates, whereas the “High Inflation” profile has an inflation rate 2% higher and thus a lower real interest rate. In fact, the real interest rate is not just low, but negative.
Again, most numbers are different across the two profiles. For example, there is a big increase in the present value of labor earnings. Why? The stream of annual earnings is no different between the two cases, but the lower the real return, the more your future labor earnings are worth today in present value. Intuitively, you need a larger amount to invest to reproduce a given level of labor earnings in the future if the real return is low, let alone negative.
The discussion above helps to explain the puzzling results you see when comparing annual and lifetime dollar amounts between profiles with different real interest rates. But it can still be challenging to interpret the results and to identify the impact of different inflation and return rates on your plan.
One way to approach this is to show the lifetime present values as percentages using the button in the report. As shown in the High Returns example below, you can now see some interesting relationships between the numbers.
For example, while the lifetime dollar value for Labor Earnings went down in the High Returns plan, as a percentage of total lifetime resources, it actually went up. On the other hand, as a percentage of total lifetime resources, Social Security Benefits decreased by 6.5%. Basically, from the standpoint of present value, your future Social Security benefits are a less important resource if future returns are higher. In the High Inflation plan, the result is exactly the opposite: Social Security becomes a much bigger piece of your lifetime resource pie.
So, even when what appears low in the lifetime balance sheet is high in the annual numbers, the percentages can guide you to an understanding of the relative value of each item in the balance sheet as a percentage of the total. This can help provide a sense of the economic advantage or disadvantage across the two balance sheets.
Note that your real interest rate can rise or fall because you set your safe rate of return at a higher or lower level while keeping your inflation rate fixed. Or it can rise or fall because you keep your safe rate of return fixed and lower or raise your inflation rate.
You might think that the results will be the same if the real interest rates of the two plans are the same. But the results can be different depending on the source of the change in the rate.
Why? Neither the tax system, the Social Security benefits system, nor Medicare Part B premiums are fully indexed to inflation. Hence, inflation has an independent impact on your lifetime budgeting and your sustainable annual living standard.