The Funded Ratio: An Actuarial Approach to Retirement Spending

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In a recent Financial Professional Outlook, Russell Investments surveyed 234 financial advisors across 145 investment firms nationwide. According to their results, 60% of advisors said that more than half of their clients are near or in retirement. The three primary challenges identified by these advisors were:

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

A large majority of advisors (79%) said a typical client in or near retirement has under $1 million of investable assets, and 41% placed it at under $500,000. In developing a retirement spending plan nearly half (47%) of advisors said they either based it on the client’s pre-retirement spending or on simple rule of thumb, like the 4% rule (First year’s spending equal to 4% of assets and increasing annually with inflation). Interestingly, 16% estimated possible spending 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, 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 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 US population, so a retiree who is in very good health may want to consider using a more optimistic table which will result in a lower funded ratio.

The numbers are certainly looking good for the singletons, but what if we have a married couple and the assets must last until both are dead? In that case, 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 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%


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 has 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.