When clients ask their advisors whether they have enough wealth to retire, they’re essentially asking whether they have enough money to support spending for the remainder of their lives. The uncertainty associated with spending patterns, portfolio returns and longevity, in general, makes the answer complex and risky.
We believe the personal funded ratio (PFR), a technique adapted from the world of defined benefit pension plans, can serve as a valuable addition to the financial advisor’s tool kit and provide a useful gauge for clients to understand how they can pursue their lifestyles both before and during retirement.
What is the personal funded ratio? How can it help clients gain a deeper understanding of where they stand? What insights does it offer to help us measure the sustainability of a financial plan? And what important information does it reveal that other commonly used approaches don’t?
The PFR: Looking at sustainability across the spectrum of life choices
Let’s start with the big picture. Simply put, increasing longevity is one of many challenging variables in financial planning. The old model in which people retire at age 65 is often no longer applicable. We are living longer lives, and our individual retirement expectations and lifestyles vary widely. This is particularly true for the upper-income Americans bringing business to RIAs.
At the same time, asset returns over the next 10 years or so are expected to be lower than their historical averages because yields are low and equity valuations are rich, particularly in the U.S.
Monte Carlo simulation, which is based on an assumption of future returns, is a useful approach for examining the sustainability of retirement plans. But its conclusions depend on modeling assumptions that are difficult even for experts to estimate. The expected returns will vary in volatile periods, and we cannot determine whether the return pattern will match the pattern of desired spending.
For these reasons, another approach is necessary. Enter the personal funded ratio: the present value of a client’s future income plus current investment assets (resources), divided by the present value of expected essential and lifestyle spending (claims).
Personal funded ratios are similar to pension-plan funded ratios, but there are differences. In pension plans, the large number of participants allows actuaries to diversify each individual’s mortality risk. This can’t be done for one retiree. So in discounting future cash flows, in and out, we use actuarial net present values, something an insurance company would use in valuing an immediate life annuity.
This approach provides a link to market-valued cash flow streams that depend on mortality and interest rates.
We prefer using the terms “resources” and “claims” instead of assets and liabilities. Clients’ “resources” include both their current investment assets and future expected cash flows, such as Social Security. Social Security is not an “asset,” but it has real value that can be brought to a current capital value when we discount cash flows.
The individual’s “claims” include spending for essentials such as living costs, which may be actual liabilities. But claims also include desired spending—for example, spending to support family members for whom there is no legal support requirement. Clients might also want to spend on charitable giving, family legacies, etc.
We prefer the terms “resources” and “claims” because they enable us to embrace more of what is material to clients’ financial lives, including what matters most to them.
The personal funded ratio allows us to assess a client’s financial readiness for a new lifestyle without counting on unreliable market returns. In the past, the typical “goal” was retirement. Today, the client’s goal might be something else; perhaps he or she wants to change careers or pursue a passion (or both!)
The personal funded ratio takes into account both longevity risk and market-based metrics. It integrates what commercial annuity providers, in a competitive market, believe are the appropriate mortality and interest assumptions. And it produces a ratio that quickly and directly reveals what the current claims on clients’ resources are.
Exhibit 1 shows how a client’s resources and claims can be viewed graphically, and includes important levers that can be pulled to improve a client’s personal funded ratio. The rate of future savings or timing of Social Security claims will affect future cash flows. Spending—divided between what’s essential and what’s simply set aside for a person’s lifestyle—will impact claims. This allows advisors and clients to quickly see how their decisions affect the funding of the plan.
If the value of their resources for, say, a husband and wife is larger than the cost of their spending stream over their joint lifetimes, then the answer to “Can we retire?” is yes. That means fully funded clients with a personal funded ratio in excess of 1.0 could do something besides invest. Perhaps they could buy an annuity from an insurance company to cover their spending—though we’d be pretty uncomfortable if they had no remaining cushion for contingencies.
We are not advocating that advisors buy annuities for their clients. Instead, we recommend the professionals measure the value of their clients’ spending needs using this convenient pricing of lifetime income and adopt spending policies that are more than 100% funded. The value of an immediate annuity conveys what the market pricing would be for mortality-hedged lifetime income by institutions. Thus, it embeds current estimates of mortality and current interest-rate assumptions upon which annuity providers are willing to provide guarantees.
Why should financial advisors do this? Consider, broadly, what clients want from advisors:
• Help in identifying their current financial position relative to their goals.
• A path to achieve or maintain those goals.
• A way to implement the agreed-upon plan.
• A mechanism for monitoring progress, with a way to make any necessary course corrections.
The personal funded ratio helps advisors in all four ways, by either confirming or supplementing their use of both Monte Carlo simulation or simplified withdrawal rules (such as the “4.5% rule.”)
The personal funded ratio is a useful step because it tests the affordability of a client’s spending plan, independent of the investment strategy (and thus capital market forecasts). That gives you an alternative way to measure a plan’s sustainability. Moreover, if the capital market assumptions on which the Monte Carlo simulation is based are consistent with the expectations derived from prevailing interest rates, the personal funded ratio and Monte Carlo simulation offer us consistent information.
Goals, Circumstances, Preferences
We’ve found that viewing the personal funded ratio through something we call the “Goals, Circumstances, Preferences Framework” helps clarify its role in the planning process for both clients and advisors.
• Goals are the fundamental problems involving money and time that clients are trying to solve.
The importance of goals must be defined by the client and gleaned by an advisor in the discovery process or over time. The advisor’s role is to help convert stated goals into accumulation and spending milestones. Most clients have difficulty conceptually converting asset levels into sustainable cash flows; that’s the advisor’s job.
Clients prefer simple, understandable metrics, which is why we have proliferating phrases such as “What’s your number?” and “the 4.5% Rule.” But such simple numbers can prompt people to both overspend and underspend the personal funded ratio. So it’s important to stress that clients also understand the notions of complexity and uncertainty and know contingencies must be planned for along the way, which is why plans are periodically updated to capture changes in their circumstances, market wealth, interest rates, etc.
• Under the heading of “circumstances” we might include clients’ investment account balances and their tax status, along with their stage of financial life, marriage status and ability to save or reduce spending as needed.
These are the primary inputs that allow us to assess the clients’ goals and ability to use the personal funded ratio. Current interest rates also play a role.
• Preferences are the things that clients desire in their investment solution rather than need. These may even be inconsistent with markets, circumstances or the achievement of their financial goals.
In the past, advisors have used market volatility as a proxy for risk and a client’s stated risk tolerance was the most critical thing to take into account. But clients also care about their portfolio drawdown potential, cash flow consistency and illiquidity. Advisors must always first meet goals. But the best approach is still to try to align the goals with preferences. That will lead to happier clients.
We find that clients typically better understand their personal funded ratio when it’s placed in the context of their phase of financial life. We use a simple 3 x 3 matrix to illustrate that position.
On the vertical axis illustrated below, there are three phases of financial life: accumulation, transition and distribution. On the horizontal axis are the three types of client spending.
The matrix allows clients to make trade-offs among the types of spending with greater or lesser significance. It also begins to inform the discussion of a more nuanced view of the personal funded ratio. Basically, it is much easier to visualize any necessary trade-offs in spending (or saving, for that matter) when ratios are calculated and compared with essential spending and lifestyle spending goals.
Almost no one’s financial life resides completely in one cell. The client’s general position informs which risks are appropriate and necessary, and which are merely preferences. Perhaps the most important distinction is between essential spending and lifestyle spending. Not surprisingly, spouses have a tendency to disagree, at least at the margin, about how “essential” that golf club membership might be.
In follow-up articles, we’ll discuss the advisor’s role in structuring a path for clients to achieve their goals, how they can implement it, monitor it and make course corrections. We''ll also discuss this subject at Financial Advisor's Inside Retirement conference in Dallas on May 12.
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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.