The article discusses calculating a "funding ratio". It appears the definition is the net assets divided by liabilities. In terms of one's retirement I assume what they are doing is adding up the unfunded expenses (spending minus SS and pensions, etc.) during retirement and dividing that amount into the retirement portfolio. The article said one should have a ratio of 135%. Does anyone have a reference to this approach for retirement planning? Calculating the health of pension plans was all I could come up with.
I read the article, excerpt below, had some of the same questions as you, then did a little research on pension fund accounting (since the article referred to it) and spent some time on Investopdia.
My conclusion is that the "funded ratio" method is no better and, perhaps worse, than using FIRECalc, RIP or the like.
1. It purports to remove the "how much" factor, focus on the "how long" factor and, voila...it's simple enough for the retiree to understand.
Wrong. Both factors are important because either one can tank your retirement, and visibility of both is required IMO, to have a sound analysis of where one stands.
2. Then they assert that the retiree (or FA) do a NPV calculation to address the "how much" (returns) side of the equation.
Mostly wrong. This is essentially a deterministic approach that could give on a false sense of security because, there are key assumptions that must be made to calculate NPV. When pension funds do this, it's where they make the most 'judgments', including discount rate and rate of return, and also evidently where they play the most games and experience the most scrutiny/criticism.
3. Lastly, the proponent of the "funded ratio" method says, 'just to be safe, have 35% extra in case something happens.' And, oh yeah, "it is still an art, not a science..."
Well, yeah. That's why we use historical and Monte Carlo modeling tools to quantify, as best we can, the impact of those other factors.
"Funded Ratio" method anyone?
Not me. It strikes me as a "head in the sand" (at least half way in) approach, versus a "head in the spreadsheet" approach. I'll take the spreadsheet, thank you.
Excerpt
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A newer and more dynamic approach is to borrow the concept of funded ratios from the pension fund world. This number is a measurement of the assets in a pension fund versus the payments it will eventually have to make. The closer to 100 percent it is for a pension, the better.
Timothy Noonan, managing director of capital markets insights at Russell Investments, said using funded ratios with individuals would help take the focus off returns and account balances and put it on how long a person expects to live with the money he has. The funded ratio is calculated by doing a present-value calculation of the amount of money someone has saved or will receive — say, from Social Security or a pension — and comparing it with basic and desired expenses and life expectancy.
Since it gets represented as a percentage, it gives advisers and clients a way to check how they’re doing. “When you consider, what percentage of my portfolio is it safe to distribute, most people believe mistakenly that it must be related to the amount of my wealth,” Mr. Noonan said. “But in fact it’s related to the length of my life.”
In his book, “Someday Rich: Planning for Sustainable Tomorrows Today” (Wiley Finance, 2012), Mr. Noonan gives the example of a couple trying to calculate their annual spending, having saved $775,000 by their early 60s and counting on $38,000 a year from Social Security. They’re debating between needing $60,000 a year and $72,000 a year (including Social Security) for their expected life expectancies. With the former, they’re 152 percent funded; with the latter, that number drops to 98 percent.
In his own situation, Mr. Noonan, 50, said he was 95 percent funded if he retired today. In two years, with his earnings and savings continuing, that number rises to 114 percent. Two more years and it hits 125 percent. Ideally, he said, people should aim to get to 135 percent funded, which would insulate them from most shocks.
But it is still an art, not a science, since people don’t know how long they’re going to live. To compensate for living longer than expected, Mr. Noonan said people needed to continually assess their funded ratio. If it goes too low, and it looks as if they’re going to run out of money, the funded ratio would dip below 100 percent. At that point, people have a choice: reduce spending to get the ratio back up or buy an income annuity to cover basic expenses."
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