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.