“One of the most complex economic calculations that most workers will ever undertake is deciding how much to save for retirement.” – Alan Greenspan

We like to think that what we have is our own: we earned it, we saved it, we invested it; we’ll spend it. But there comes a point in many people’s lives when conspicuous consumption comes to an end, and the altruistic impulse begins to take over: we begin thinking of others instead of ourselves.

We used to ask questions like:  “Will I have enough to get by on without earned income?” and “Will my tax brackets really go down in retirement?” When we arrive at the point when we have more than we need, we begin to ask questions like: “How do I want to be remembered?” and “What do I really believe in?” This is extremely fertile ground for very likely the most important calculation that anyone contemplating retirement can undertake: the core and excess capital calculation.

For any given person, core capital is the portion of that person’s financial assets needed to take care of living expenses from retirement to the end of life. Excess capital is any portion of her financial assets over this amount. Core is the “I need this” money; excess capital is the “I don’t need this” money. It can be quite startling to realize how few people know these numbers, and there’s a reason: economic calculations involving future values are notoriously tricky. Nonetheless, let’s do a brief calculation and see what we can discover.

Let’s use a very simple situation in which we have a husband and wife, both 65, and both anticipating receiving in five years an annual pension that will take care of all their expenses for the rest of their lives. So, in this case, these two only need to fund their expenses for the next five years – we’ll say they need $150,000 annually before taxes. How could we calculate the core capital they need to be able to pay themselves during this period? We start by looking at the variables we need. They are:

  • The number of years we’re considering in the calculation:  5
  • The amount of the pretax annual living expense:  $150,000
  • The annual adjustment for inflation:  we’ll say it’s 3%

There are two other important variables we need to consider to be able to perform this calculation. They are:

  • The probability that either the husband or the wife will be alive from one year to the next during that five year period
  • The assumed rate of return on the investments

Let’s explain why this information is needed…

Because there is a chance that one or both spouses may die during this period, their expected spending need is less than the full $150,000 annually should they both need to live.  A joint probability of survival for the couple is needed for each year. (This joint probability can be calculated from published tables of actuarial data for men and women; one such table is available from the Social Security Administration at http://www.ssa.gov/OACT/STATS/table4c6.html)

This annual joint probability percentage must be then multiplied by the inflation adjusted spending need to come up with the year-by-year expected spending.

 

Year (1)

Base spending need (2)

Joint probability of survival (H & W) (3)

Expected spending need (2 x3) (4)

 

 

 

 

65

$150,000

99.98%

$149,970

66

$154,500

99.98%

$154,469

67

$159,135

99.97%

$159,087

68

$163,909

99.97%

$163,860

69

$168,826

99.96%

$168,758

The next step is to discount these future cash flows back to the present to get a lump sum value. We might use the yield on a five-year Treasury note (1.72%) as a reasonable discount rate to come up with the present value of the expected spending need. The following table shows the result of discounting each year’s spending need to come up with an expected present value.

Year (1)

Expected spending need

Present value of expected spending need

 

 

 

65

$149,970

$149,970

66

$154,469

$151,857

67

$159,087

$153,752

68

$163,860

$155,688

69

$168,758

$157,630

 

 

 

Total core capital

 

$768,897

Total core capital for the five year period for this couple is equal to the sum of each year’s present value spending need.

So: what of this? Well, we know now that if this couple has $900,000, then their excess capital is merely their existing financial capital, less their core capital: it’s $900,000 - $768,897 = $131,103. This is the amount they can use for charitable causes, to give away to family, to improve their style of living, or to spend on whatever they wish. 

It gets easier to perform core capital calculations over longer times, mainly because the rates of return tend to be higher. When this happens, the present values of far-distant cash flows tend to shrink sizably, and the core capital can be a realistic number for a client to attain. Sometimes, of course, this doesn’t happen. 

The applications of the core/excess capital exercise are quite broad: it can be very liberating for you to know, with reasonable certitude, how much of your portfolio assets are “need to have” assets and how much are “nice to have” assets. Among other things, excess capital can be used for: 

  • Gifts to family members, outright or in trust
  • The purchase of life insurance policies that can dramatically increase the future wealth of families or charities through bequests
  • Luxury purchases
  • Creating additional income streams
  • The funding of charitable vehicles that can provide income and tax deductions, like charitable remainder trusts
  • Family foundations
  • Investments of passion, like vineyards, real estate, art, etc.

There are other elements of core capital that we can’t cover here. Because of this, it’s never a bad idea to have a CFP® professional help you with this calculation – your retirement security may well be riding on it. Einstein said “things should be as simple as possible, but no simpler.” The concept of core and excess capital echoes this sentiment, and should provide an excellent starting point for any deep retirement planning discussion.