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The Funded Ratio: An Actuarial Approach to Retirement Spending

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In reviewing the types of investors IFA serves, we've noticed a definite trend. Namely, our advisors find that many of their clients are near- or in-retirement. In fact, we've identified three overarching challenges these people typically face:

  • Setting reasonable spending expectations
  • Maintaining sustainable plans
  • Determining a sustainable spending policy

In developing a retirement spending plan, advisors can base such a strategy on a client's pre-retirement spending pattern or on a simple rule of thumb like the 4% rule (i.e., the first year's spending equals 4% of assets with annual increases in keeping with inflation).

But it's also possible to consider someone's spending activites based on the ratio of assets-to-liabilities. In the pension world, the actuaries refer to this as the "funded ratio."

In calculating the funded ratio, the numerator is straightforward — it is simply the value of investments that will be used to fund retirement.

The denominator, however, is a bit tricky. The liability of retirement can be thought of as a stream of known payments that terminates at an unknown time, death. This is also known as a life annuity. The value of each payment should be adjusted downward by the probability of reaching each age, and each payment should be discounted by the rate of return expected to be earned on the underlying investments.*

Let's begin by supposing that we have a 65-year-old with $600,000 of retirement savings. The methodology used by many (if not the overwhelming majority of) advisors is to simply assume that the 65-year old conservatively lives to a reasonably old age such as 90. If we assume that our retiree needs $40,000 per year, which inflates at 3% and is discounted at 6%, we get a present value of $723,842 -- or a funded ratio of 83% -- which would be great for a government pension plan but not for an individual's retirement.

Now, we will bring mortality into the mix. Instead of assuming that our 65-year-old will live to 90, we will consider all possible ages at death. Using the Social Security Mortality Table for males (available to us at the time of this writing), we get a present value of $544,789 -- or a funded ratio of 110%. Using the same table for females, we get a present value of $607,273 -- or a funded ratio of 99%.

Recall that women live longer than men, and with this particular table, the median 65-year-old woman is expected to live three years longer than her male counterpart. As for whether Social Security mortality is appropriate, it is based on the entire U.S. population. So a retiree who is in very good health, at least for illustrative purposes as reviewed for this article, may want to consider using a more optimistic table which will result in a lower funded ratio.

The numbers are certainly looking good in this hypothetical case study for the singletons. But what if we have a married couple and the assets must last until both are dead? In such an illustration, we must consider the probability that at least one of them is alive in each year. We end up with a present value of $697,817 or a funded ratio of 86%. All four of these potential results are summarized in the table below.

Hypothetical Retirees at Age 65 with $600,000 of Savings

Assumed to Spend $40,000 per Year Inflated at 3% & Discounted at 6%

  PV(Retirement Spending) Funded Ratio
Single Male or Female Who Lives to Age 90 $723,842 83%
Single Male Based on Social Security Mortality $544,789 110%
Single Female Based on Social Security Mortality $607,273 99%
Married Couple Based on Social Security Mortality $697,817 86%

Source: http://www.ssa.gov/oact/STATS/table4c6.html

Please note that even if the funded ratio is above 100%, that does not guarantee that the assets will be adequate to meet the liability of retirement -- even if the assets achieve the assumed rate of return over the whole period. The reason for this can be summarized as the "sequence of returns" risk. Quite simply, a low (i.e. highly negative) returns period at the beginning of retirement can have far worse consequences than the same returns occurring at the end of retirement.

While the funded ratio does not tell you how much you can safely spend in retirement, we consider it a good rule-of-thumb for determining if future proposed spending lies within the realm of reason. If you would like to learn more about IFA's approach to the questions of saving for and spending in retirement, please give us a call at 888-643-3133.

*An argument can be made that unlike the investment return which includes a risk premium component, there is no risk (other than mortality) in the liability payment, and therefore the only discount that should be applied is the assumed rate of inflation. For the purpose of this example, we choose to follow the convention of discounting by the expected return on investments.

Hypothetical data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such past or future performance. Actual performance realized by an investor may be more or less than amounts illustrated and could change the outcome of the hypothetical illustration above. This article is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal.