Financial advisors don’t need extensive market forecasting or portfolio modeling to responsibly develop solid retirement plans for their clients, according to Wade Pfau, author, CFA and founder of Retirement Researcher, a firm that promotes effective retirement income planning.
Instead, he said, just two numbers will do the trick: the inflation rate and the nominal yield found in Treasury Inflation-Protected Securities (TIPS).
“To us, it doesn’t matter what the stock market is doing,” Pfau said of his Tysons, Va., firm’s approach to retirement planning. “We start with a ladder of TIPS.”
For example, the 10-year TIPS yielded a nominal interest rate on the Treasury of 3.8% as of last week, and the TIPS breakeven inflation rate was 2.25%. Subtracting one from the other, the result is 1.55%.
That’s the rate of return his system works with, he said during the most recent four-day Retirement Challenge, a quarterly online event lasting two hours each day during which consumers first establish their retirement income style awareness profile (RISA)—a kind of retirement income planning personality test developed by Pfau—and then calculate their funded ratio.
Put the two together, and concrete suggestions can be generated as to what kinds of investment approaches and products would make sense for that particular consumer to cover any gaps between projected assets and projected needs, as shown through the funded ratio (assets divided by spending needs).
“We’re seeing if the plan can work without taking risk,” said Pfau, who will be speaking on retirement income at Financial Advisor's virtual Inside Retirement conference on June 14. “Then if you’re overfunded, you can take on more risk with the excess.”
Pfau said the funded ratio provides a simple way of expressing whether a potential retiree is underfunded, overfunded or right on track. Unlike Monte Carlo simulators that generate a probability of success, the funded ratio uses a fixed rate of return assumption as a discount rate that converts the value of future cash flows into today’s dollars.
Chosen conservatively, he said, the funded ratio lets the advisor and client see if the needs and goals in retirement can be achieved without taking on the market risk of a diversified portfolio. If so, that would also correspond to a high probability of success.
To have a secure retirement, essential expenses must be covered by reliable income sources, such as Social Security, a pension, an annuity, a bond ladder, or even continued employment or a reverse mortgage, Pfau said.
Discretionary expenses and legacy wishes, meanwhile, can be covered with a diversified portfolio, where the asset allocation uses stocks, bonds, alternatives and tax-managed investing to provide more upside. And finally, emergency contingencies should be covered with reserves of cash or equivalents, or insurance, he said.
“In a Monte Carlo simulation, to say a portfolio has a high success probability, they have to assume a low rate of return,” he said. “This isn’t more conservative than Monte Carlo, it’s just a different way of expressing probability.”
It’s also a way to generate leads for the advisory side of Pfau’s business, McLean Asset Management. While the Challenge takes time to hold, it’s what he calls a “one to many” type of offering, he said, adding that some 400 potential clients attended this week’s Challenge.
“Through the Challenge, advisors can see how we use the RISA as a prospecting tool,” he said, adding that the RISA profile is currently licensed by nearly 200 other advisory firms. “We added in the funded ratio to give the participants valuable information about where they stand in relation to their retirement goals. While many attend just for the information, some sign up for our Academy, which offers more support, and some will raise their hands to meet with an advisor.”
Currently there are no plans to license the funded ratio interface alongside the RISA, as many advisors already have their own software, he said. “They don’t need another program.”