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.



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.

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