Let's Switch to the "Fundedness Ratio" when doing retirement planning, by Scott Stolz, CFP, RICP (week 50)

 

In previous blogs I’ve written about the common industry practice of calculating a probability of success when doing retirement income planning.  I’m going to oversimplify this process a bit, but essentially, this process has the following steps:

1)      Calculate your annual income needs in retirement based on your life expectancy or an assumed age such as 90

2)      Determine how much income a retiree will get each year from Social Security, pensions, and annuities.  Subtract this amount from the annual income needs in the first step to determine the annual income gap (if any).

3)      Add up all of the available retirement assets and run this amount through thousands of different market scenarios to determine if the assets are sufficient to support the total income gap.

4)      If all of the income needs can be met prior to the retirement asset values going to $0, that is considered a successful outcome.  Any scenario where you would run out of money before you die would be considered an unsuccessful scenario.  The percentage of successful scenarios to total scenarios run is called your “probability of success.”

Most advisors strive for at least an 80% probability of success.  And the reality is that at that level of success, you are more likely to die with more money than you started with than to die with nothing left.

I have several problems with this entire approach.  First, most advisors do a poor job of explaining this, therefore as Stephanie McCullough correctly stated in a recent Rethinking65 article, to many clients, “The opposite of “success” of course is “failure,” which clients translate as they’ll end up eating cat food or living under a bridge!”  (Monte Carlo Results in the 60s? It’s OK, Really, Financial Planning Articles for Financial Advisors & Wealth Managers).  To avoid this misperception, she has learned to explain to their clients that a lower probability of success means there “…is a chance of needing to make adjustments.”  The lower the probability, the greater the odds that an adjustment will be necessary.  I like that because it’s true.  No one is going to just watch a plan fall apart without taking steps to fix it.  It might be as simple as cancelling or delaying a planned trip or going out to eat less often.

My second problem with this approach is that no matter how you attempt to explain it, there will always be that lingering doubt – the “what if?.”  This often causes clients to spend less in retirement than they otherwise could.  This is why studies have shown that half of all retirees end up with more wealth at death than they had when they entered retirement.  And finally, I believe the definition of “success” under this method is too inclusive.  For example, a person that started retirement with $1 million and still had $1 million at death, would be considered equally successful as someone that started with $1 million and died with $1.  I doubt those two individuals would consider themselves equally successful.

I think the industry needs an entirely different approach.  I like the method used by Dana Anspach with is covered in her new book “Living Off Your Acorns – Your Guide to the Four Phases of Retirement” which should be required reading for everyone heading in retirement.  Dana uses what she calls a “fundedness ratio.”  For brevity, I’m again going to oversimplify this, but here are the necessary steps in this methodology.

1.      Follow the first two steps in the probability of success methodology above.  This gives the annual expenses above and beyond any guaranteed income from Social Security, pensions, and annuities.  Make sure you include any expected big expenses such as the purchase of a new car and some estimate for health care costs as you age.

2.      Using a reasonable rate of return such as 5%, calculate the net present value of these annual expenses.  Or put another way, determine how much you need in today’s dollars, growing at 5% to cover these annual expenses.  I used to need a financial calculator to do this calculation, but now you can just enter all of the numbers in your preferred AI platform and it will calculate it for you in seconds.

3.      Add up all of your available assets you can use to cover these expenses.

4.      Divide the total arrived in step 3 by the net present value calculated in step 2.  This number is your “fundedness ratio.”  For example, if you have $1.5 million in available retirement assets and the net present value of your future annual expenses is $1.25 million, then your “fundedness ratio” is 120%. As long as it’s 100% or greater, you know you have enough money to meet your needs. 

This ratio should be recalculated each year to account for returns greater or worse than your assumed 5% as well as any new information about your expenses.

I haven’t done the exact math, but I would guess that an 85% probability of success would likely be the equivalent of a 150% “fundedness ratio”.  But I ask you, which do you think is clearer and reassuring to retirees – “you have an 85% probability of success” or you have 50% more in assets than you need to cover all of your expected expenses in retirement?