In our first article in this three-part series, we introduced the personal funded ratio as an enhancement to the financial planning process. The personal funded ratio (PFR) is a robust measure that allows an advisor to quickly determine whether a client is on track to meet her goals, while also providing insights about the appropriate investment solutions for her. Its clarity and relative simplicity enable clients to easily grasp the sustainability of their retirement spending plans—which makes it a great communication tool as well.
In this article, we’ll provide more detail on why it is important to measure the funding level of a client’s financial plan, how to measure it, and how it correlates with Monte Carlo simulation results.
Injecting More Accuracy Into Retirement Planning
The most important characteristic of the personal funded ratio is that it takes account of both clients’ assets (resources) and liabilities (claims). Consider a retiring client who has $1 million saved and wants to spend $50,000 per year. Is this a sustainable plan? There are several conventional approaches to answering this question. Typically, planners will examine the chance of a client’s running out of money by a specific age—one that’s associated with a conservative estimate of life spans. A simple rule of thumb like the 4.5% rule or a more complex Monte Carlo simulation could be used.
Both of these approaches provide valuable perspective, but consider this: The 4.5% withdrawal rule is based on a history that differs substantially from the future we face; the results from Monte Carlo rely on assessments of future returns that are very uncertain; and the life spans of clients are unknown. Neither method assesses the cost of the desired spending in today’s market, whereas the PFR does. It also draws on valuations for immediate life annuities, which provide a market price for lifetime spending in the current market.
Computing the PFR: An example
Consider a hypothetical client named Lucy, a new retiree, age 66, looking to spend $50,000 a year in constant dollars from her accumulated assets. How do we accurately assess the cost of her future spending in today’s dollars?
Using the formula of actuarial net present value, we can value generic spending obligations that occur over Lucy’s lifetime. Importantly, actuarial net present value is consistent with how insurance companies price immediate life annuities: The value computed is consistent with market prices for lifetime income streams. Thus, future spending is discounted by a combination of risk-free rates and mortality assumptions as published by the Society of Actuaries.
In addition to valuing future spending, the planner who uses the personal funded ratio to assess Lucy’s retirement readiness will also need to value her resources to support spending. Assets that are currently held in her bank accounts, brokerage accounts, IRAs or 401(k) plans are easily valued and combined—although taxes, a liability, must be considered. Lucy’s future cash flows from Social Security can be valued using actuarial net present value, similar to essential and desired spending. Future cash flows that are more uncertain can be discounted by interest rate curves varying from Treasurys to “BBB” bonds of appropriate duration. If Lucy chooses to work part time in retirement, we can value her wages and include those as an asset.
Individuals still saving for retirement would also need to value future contributions. Employees typically receive regular salary payments throughout their working lives that tend to increase with inflation; this payment pattern is similar to an inflation-protected bond. Given this, we can value a client’s future percentage-of-salary contributions in the same way we would value an inflation-protected bond.
We can now calculate the funded ratio of Lucy’s plan by dividing the value of her resources by the value of her claims:
(Future Contributions + Investment Assets) / (Essential + Desired Spending Goals)
Since Lucy will have no further contributions, the value of her future contributions is zero. If the resulting ratio is positive, Lucy’s personal funded ratio is positive, and she is fully funded.
What It Means To Be Fully Funded
What does it mean for clients to be fully funded? In retirement, being fully funded means that a client can afford to buy her spending stream at current market prices from an insurance company. Insurance companies price annuities according to current interest rates and their tie to fixed-income investments that will support the obligation to meet the spending stream. Annuity prices factor in potential returns from the marketplace. We are not suggesting that clients purchase annuities to fund their spending.
However, we feel that it is important to preserve their option to do so, which means plans should be managed to a benchmark of at least 100% funding. This target also has the effect of grounding an investment plan in the client’s current starting investment conditions.
For clients still in their pre-retirement years, being fully funded means they can invest their wealth and future contributions in risk-free assets to meet their retirement goals. But achieving a fully funded status early in life is rare. Most clients don’t save enough to afford themselves a risk-free investment strategy over their entire accumulation life cycle. Usually, a client will have to accept equity risk to eventually become fully funded (unless she has saved an exceptional amount). However, by the time retirement is reached, the spending plan should be fully funded.
The PFR And Retirement Plan Success
To draw a closer connection between the personal funded ratio and the typical Monte Carlo simulation approach, we’ve plotted the probability of success from a simulation against the initial funded ratio of a fairly generic plan as Exhibit 1. (Both Exhibits 1 and 2 and the supporting scenarios can be found in Sam Pittman’s article: “Use Your Client’s Funded Ratio to Simplify and Improve Retirement Planning Decisions,” from the Fall 2015 issue of The Journal of Retirement.) The portfolio used is one allocated to 40% equity and 60% fixed income, and the spending amount is constant in real terms, withdrawn annually at the end of each year.
We could simulate other portfolios too; the point here is to provide a sense of how the funded ratio relates to a suitable retirement portfolio. In this example, it is assumed that all wealth is invested and all spending comes from this wealth.
We note two interesting patterns. The first is that the probability of success and the PFR are positively related. Individuals who have more money to fund their spending stream are at lower risk of running out of money.
The probability of a 100% funded plan running out of money is in the range of 17% to 30%, depending on the person’s age. Investors who desire higher certainty should engage in spending plans that have a higher funded ratio. For example, investors early in retirement (age 66) can achieve a probability of success of approximately 90% by adopting a spending plan that has a funded ratio greater than 115% (see Point A). The second pattern revealed in Exhibit 1 is that the younger you are, the greater your probability of success for a given funded ratio. This occurs because there is more uncertainty in the relative life span for an older individual.
Exhibit 2 shows that before retirement for the same funded ratio, younger individuals have higher success rates. Someone who is one year from retirement and 70% funded must close a 30% funding gap in a single year. This would require a very large portfolio return. On the other hand, a younger person 30 years from retirement can close a 30% funding gap by investing a portion of her wealth in equity over multiple years. For example, to achieve a 70% chance of success, we can see that at the start of one’s career, the retirement plan should be nearly 65% funded (see Point A). And she should achieve a funded ratio of at least 100% (see Point B) by the time she reaches retirement.
Benefits Of Using The Funded Ratio In Planning
Now that we’ve explored how the personal funded ratio is calculated and how it can be related to the probability of success, it’s time to look at the benefits of adding this powerful technique to one’s planning tool kit.
We know that most people would like a written plan, but increasingly they want it to be interactive and collaborative and not a static document delivered by a planner.
We also know, of course, that no system can accurately predict the future, much less tie a particular individual’s path to broader expectations. But when we include those broader projections (capital markets, interest rates and commercial mortality rates) and include them with the personal funded ratio, we can offer the client greater confidence in projections more specific to them (such as the interaction of market volatility with their spending, at which point Monte Carlo simulations come into play). Multiple approaches give greater confidence when they intersect.
Top 5 Reasons To Use The PFR
1. It focuses discussions on the interplay of assets and liabilities, and more broadly on resources and claims, and it forces a discussion about cash flows rather than asset levels. In this thinking, inflation-adjusted lifetime annuities become more attractive, and if we do not like annuities, we can at least think of annuity equivalents. At the very least, we come up with spending rules that keep a client from depleting assets before they die.
The ratio also encourages communication with clients about the direct effect of interest rate changes on the ability of their portfolios to support desired spending. Such discussions might be particularly useful if one expected, say, a lower portfolio return environment and rising interest rates. The amount of wealth required to create an income stream is not static; it changes over time. Incorporating the cost of retirement spending into the retirement investment problem is an important step in moving the focus from wealth to income.
“Importantly, the amount of wealth required to create a spending stream changes over time,” Pittman writes in the Journal of Retirement. “Consider this: As of January 2015, $1 million translates to a lifetime income stream (an immediate life annuity) of just over $61,300 per year for a 65-year-old male. In January 2007, $1 million could have purchased a lifetime income stream of $ 80,900—nearly 30% more annual income.”
2. The PFR expressly includes consideration of mortality expectations. There are certainly problems with applying expectations developed from large populations to individuals, using actuarial net present values. But asking the correct questions often trumps the precision of the answer. A periodic review, perhaps annually, can clearly show the effects of both interest rate and mortality changes. Moreover, such reviews might reveal the benefits of adding less traditional assets to an investment portfolio, such as reverse mortgages, which can add home equity to investments, or an annuity, which can improve cash flows with credits for mortality and provide direct longevity protection.
3. The personal funded ratio reduces clients’ uncertainty about portfolio projections and makes them less likely to want to use future performance to bail out a failing plan. Because it uses market rates and commercial-equivalent math (actuarial net present value) rather than portfolio projections, it reduces the need for human forecasting. As Warren Buffett has said: “Forecasts usually tell us more of the forecaster than of the future.”
4. The ratio supports the expression of the client’s goals, not the advisor’s. Many (most?) software programs are geared toward getting people through retirement. But is retirement what most concerns the clients? Might they want to continue working, if possible? Or pursue other dreams, or create a legacy? The job of the advisor is to discover and enable, not prescribe.
To reach that determination, we have created a simple, graphical approach called “3 Dimensions of Financial Life: 3 Dimensions of Risk.” It was mentioned, but not shown, in our last article. Some think that clients cannot distinguish between essential and desired spending; we think they do it all the time. Writing goals down, discussing them, and looking at trade-offs can be very beneficial between spouses and between the client and advisor.
The personal funded ratio has several other advantages:
• The presentation allows the advisor to avoid—or at least move to the back—the many pages of detailed calculations dear to the advisor’s heart but generally foreign to the clients or spouses. We like to say that the personal funded ratio is more usable for people not overly enamored with numbers, elegant software or complexity. We usually call this group “clients.”
• The ratio helps advisors overcome the rigidity of traditional accounting statements, which yield the same information by including a balance sheet, income statement and cash flow statement. Sort of.
• Those multiple pages pushed to the rear, or eliminated, give the impression of great precision. Footnotes are not terribly effective at mitigating that inaccurate impression of accuracy.
• If the clients are well funded, it implies that they can make current transfers to family members or charities or to other activities, ones that help them preserve their legacy, for example.
5. The personal funded ratio gives the advisor a direct mechanism for discussing how secure the plan might really be. It can either be elastic, giving the retiree lots of opportunities and ways to succeed, or it can be inelastic, in which case they will have to live closer to the bone and with far less room for missteps.
There are three available levers to modify the personal funded ratio: Clients can save more (be able to work or save money), take equity market risk (in hopes of increasing the “current investment” number by the next review), or they can spend less. Outlining the trade-offs can be the advisor’s job: prioritization is the client’s.
The successful use of the ratio with clients needs to be combined with some form of decumulation, or distribution management. But that’s a subject for another day.
Russ Hill, CFP, AIFA, is chairman/CEO of Halbert Hargrove Global Advisors LLC and the co-founder of the Stanford Center on Longevity. Sam Pittman, PhD, is head of asset allocation, Private Client Services, for Russell Investments. They will discuss the Personal Funded Ratio in detail at Financial Advisor's Inside Retirement conference in Dallas on May 12.