## There’s a simple concept that is extremely useful. Just compare how much you’ve got with how much you need! Here’s how to apply that concept to see how far you’ve come.

This is the first of five planned posts on the subject. I’m hoping to have the actual calculator available on the website in a couple of weeks.

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For some reason mathematical calculations involving retirement have appealed to me for a long time. I mentioned in Post #10 that I developed a simple tool that I called the STAR analysis (for Saving To Afford Retirement). It estimated for Canadians roughly what level percentage of pay needed to be saved in order to continue one’s lifestyle from age 65. It took into account Canadian income taxes and the amounts of saving and current consumption that would stop some time before retirement (such as mortgage payments, retirement contributions and children’s education). I had no idea at the time that the same technique would prove to be useful decades later; all I knew was that I was hopeless at turning it into a source of income for me!

Someone who reported to me when I joined Russell Investments some years later, and who became a good friend, in time rose to a very senior position. He remembered STAR from our conversations, and called me shortly after my 60^{th }birthday. He suggested that, if I ever thought about my own retirement and came up with some ideas, please let him know anything that wasn’t intensely personal, because he was sure there’d be ideas that Russell could use. I wasn’t thinking at all about retirement, but his suggestion launched a train of thought, and over the next couple of years I asked myself a number of questions and wrote a series of notes to myself, some of which have led to posts on this website. (And yes, some ideas were incorporated into Russell thinking, I’m proud to say.)

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One fundamental question was simple. When can we *afford *to retire? When our personal funded ratio exceeds 100%. That’s a concept that comes straight out of the defined benefit world. It’s the one thing every trustee of a defined benefit plan learns very early. They may know nothing about pensions or investing when they’re appointed. But in no time they know the funded ratio (the ratio of assets to liabilities): it’s 86%, or whatever. They may even remember the next decimal place, even though these calculations are only very approximate. And they know that a funded ratio over 100% is rare and means you have more money than you need, and under 100% means you’re under stress and have to add extra money to the pot.

Well, exactly the same thing applies to an individual or a couple. You have a lifestyle. Express it in terms of an annual budget. Subtract whatever you’ll get from your country’s Pillar 1 pension (and any Pillar 2 defined benefit you may have accrued). The balance is the amount that you need to generate each year from your pension pot. Calculate how large a lump sum you need in order to generate that annual amount for a period equal to your future life expectancy.

Think of that lump sum as the value of your *desired *or *target *liability from your pension pot. How does that compare with your pension pot? Or, in the case of my wife and myself when we first did the calculation, we used only our liquid assets: we didn’t include our home because at this stage we didn’t want to contemplate selling it or getting a reverse mortgage. We wanted to keep that as a safety margin against continuing bad economic circumstances or higher personal taxes, or to leave to our children. So the ratio of our liquid assets to our desired liabilities was the relevant ratio. Yes, we had become a two-person pension plan!

(In fact, from that time onward every idea I’ve had about retirement finance for individuals comes from the transformation of established pension fund notions to an individual or couple. It really is that simple.)

When I’ve explained the notion, some people say they prefer to call these amounts resources and claims, rather than assets and liabilities. That’s good. But no matter – whatever terminology works for you. I’ll use them interchangeably. The basic idea is to see how much of *what you need *is covered by *what you have*. That’s your funded ratio.

Actually, in practice I re-define the funded ratio slightly. Here I’ve explained it as a comparison of your pension pot’s resources and claims. In practice I add back the Pillar 1 and Pillar 2 amounts to both resources and claims, so that what we’re measuring is the extent to which your desired lifestyle is funded. That’s a bit more intuitive than the ratio of pension pot resources and claims.

And now it’s obvious that a funded ratio higher than 100% is good, and a funded ratio lower than 100% requires you to think about taking action. And I think of the action as turning a dial.

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There are four dials you can turn: save more; retire later; lower your ambition as regards desired lifestyle; or take more investment risk in the hope that the risk will be rewarded and will bridge the gap to 100%. Of course, after retirement only the last two dials are available.

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You may remember from Post #9 (http://donezra.com/9-im-rich/) the definition of “rich” as implying that your personal funded ratio exceeds 100%. Well, the explanation in this stage is where that notion came from.

You’ll have guessed that you can use two numbers for the assets. One is your total assets, including illiquid assets such as your home. The other is your liquid assets, meaning the assets you can convert to cash easily. I find it useful to calculate our funded ratio in both ways. One tells me if our lifestyle is supportable by our liquid assets, which would be a good outcome; the other tells me if we need to liquidate our home at some stage, in which case Post #35, ( http://donezra.com/35-is-your-home-part-of-your-portfolio-for-life-after-work/ ) becomes relevant.

I’ve also found it useful to calculate the target liability in two ways. One way is to estimate how much it would cost to buy an annuity that would lock in the required annual income for the rest of our lives. That’s essentially the way in which actuaries calculate the funded ratio for defined benefits. But since I’m taking investment risk, I also want to know whether, if the risk creates the investment reward I’m hoping for, our funded ratio would rise past 100%. So that gives me two estimates of the amount I’m targeting: a safety-oriented estimate of how much I can lock in (from the annuity calculation) and a hoped-for best estimate (the number that results from taking advance credit for the investment reward).

If you do this, you can them compare both the target liabilities with both the asset values, coming up with four funded ratios, in this order:

- If liquid assets exceed the safety-oriented target liability, this is your best outcome, because it means that you’re in a position to lock in all of your future lifestyle for all of your future life, without the need to create liquidity from your illiquid assets.
- If liquid assets exceed the best estimate target liability, this says that it’s reasonable to expect (but not certain) that you’ll live your desired lifestyle, without the need to create liquidity from your illiquid assets.
- If your total pension pot exceeds the safety-oriented target liability, it means that if you’re willing to convert your illiquid assets to liquid form, you’ll then be in a position to lock in all of your future lifestyle for all of your future life.
- If your total pension pot exceeds the best estimate hoped-for target liability, this says that it’s reasonable (but not certain) that you’ll live your desired lifestyle, but to do so you’ll have to convert your illiquid assets to liquid form.

And if none of the funded ratios reaches 100%? You really should think seriously about turning at least one of those dials.

This possibility leads me to make one more suggestion. It’s for you to make a rough division of your budget between essentials (“must have”) and discretionary spending (“nice to have”). Don’t worry about what others consider essential. Personalize it. It’s the answer to the question: “If I had to turn down the spending dial, what are the things I simply can’t imagine giving up?” Those are *your *essentials. We’ve already seen, in Post #28 (http://donezra.com/28-what-does-spending-money-do-for-you/ ) that your evaluation is the only one that counts. Beyond your essentials, everything else is, in a sense, discretionary. We’ll see in a future post (where we consider what I call “wealth zones”) how to find out how securely you have financed your essential spending and how securely you have financed your discretionary spending. For this post, introducing you to the notion of those two categories is enough.

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Let me add some thoughts on what that set of four ratios should do for you.

My purpose is to give you an *initial *impression of where you stand today.

It is *not *to suggest any precision in the numbers. The ratios are valid to the extent that the assumptions made in calculating them actually work out. Nobody can predict the future – that’s why the ratios are offered as orders of magnitude, initial estimates, rather than predictions. Beware of attaching too much significance to them.

Are they then worthwhile at all? Good heavens, yes! Think of what you were aware of before calculating them, perhaps even before being aware of the concept. Would you have known whether one of those four ratios was closer to 50%, to 100% or to 150%? Most people I’ve asked have said: no, they have no idea at all. Would it make a difference if they had an idea? Well, yes, of course it would. Their financial attitude to retirement would be vastly different if they thought their ratio was 150%, but it actually turned out to be 50% – or vice versa.

Similarly, would you have guessed, before making the calculation, how much of your desired future lifestyle is likely to be covered by Pillars 1 and 2, how much by your past accumulation, how much by your future savings, and how much by the hoped-for reward from investment risk-taking? Of course not. Those insights come from making the calculations.

Watch how the ratios evolve over time. That will actually be your best learning tool – seeing the progress of the numbers over time; whether there are trends; whether or not the numbers are volatile. Those learnings will greatly influence your attitude towards the financial aspects of retirement.

Others have potentially better tools to offer you, taking into account things like taxation, contributions that are an increasing percentage of pay, whether your proposed retirement is gradual or total, converting a level Pillar 2 pension into an inflation-equivalent one, integrating cash flows that start at different times, even the annual probability of survival of you and your partner. I encourage you to try them out. My purpose is simply to start you on this path, not to pretend that my personal funded ratio concept and the forthcoming calculator are all you’ll ever need.

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One final thought. For many it’ll be scary to attempt these calculations. Fair enough — nothing forces you to do them. If you remember Post # 11 ( http://donezra.com/11-is-retirement-complicated-or-is-it-scary/ ), I said this:

Most people find – eventually – that the best way to deal with fear is to face it. Once you face the fear, it stops growing. Typically you find it’s manageable. And then it’s a relief to stop running away from it. And new vistas open up as you proceed.

There’s an old saying: a journey of a thousand miles begins with a single step.

Calculating your personal funded ratio could be that first step.

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**Takeaway**

*Your personal funded ratio measures how much money you already have, and are likely to have after your future savings, relative to the amount you’ll need to support your post-retirement ambitions. Over 100% is good, under 100% suggests that you ought to think about doing something about it. *

### 13 Comments

I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.

Thank you Don. Time to do the pre-pre-retirement calculation to get a baseline and then re-evaluate in three years to see how I am progressing.

Question: Pension plans have a set benefit payment at retirement. What if you have only IRAs and PSP? Which have subjective withdrawal amounts. Do you use Social Security as a set payment benefit amount first and then fill in the difference with withdrawals from other sources?

Cheryl

Thanks for being so quick! Yes, you’re spot on. First identify the income that comes in regular amounts for life; then top up with regular drawdown amounts that ought to be sustainable for a length of time that should be appropriate for you. That’s the approach in the calculator – as you’ll see when it’s available on the website. I’ll also show an example of people filling in their numbers. Hope you like it! (At least as a ballpark estimate.)

Hi Don,

Another great post – I really look forward to your posts. I really value a high level (almost non-technical) point of view to counter-balance all those good folks in the blogosphere who are heavily into the minutiae. I value their contribution as well – it is just that we all run the risk of not seeing the forest for the trees if that is the only angle we consume.

Here in Australia, there is another little quirk to consider when calculating your retirement income when relying on compulsory and privately held, non-taxed superannuation (the Australian scheme similar in very broad terms to 401k).

The Government quite correctly does not want superannuants to build up a unnecessarily large nest egg for your heirs under this essentially partly subsidised scheme. Withdrawal rates are mandated by legislation , and rise with age.

For 55 – 64 year olds, the minimum withdrawal rate is 4%, and increasing in each 5 year age bracket up until you are 95 or over, whereby 14% is the required minimum withdrawal rate.

This maybe unnecessarily burdensome for some until you realise that just because you are forced to withdraw a set amount, that does not mean you need to spend it; you can reinvest it in an admittedly taxable environment.

Looking forward to your calculator – it seems a heroic undertaking, given all the complexity and possible variations and permutations.

All the best

Thanks, I appreciate the compliment!

I’m trying to write for the average participant in a DC environment, and to stick, as far as possible, to principles that apply everywhere and for all time rather than for a particular location and a particular market or taxation environment. Your final paragraph captures my goal for the calculator: to provide a first estimate, a starting point, from which readers can create their own points of departure (like the wise perspective you suggest). That means I’ll simplify, and let experienced readers or their financial professionals convert it to an action plan.

Count me in Don! Can’t wait to try the actual calculator!

Best, Ralph

Delighted!

I love the “personal asset liability” approach and have created my own balance sheet.

But I am not sure how to treat a non-COLA SPIA on the balance sheet. Specifically, how to calculate the PV of the payout on the annuity.

For example, suppose I expect the real rate of return on my investments to equal 0 (nominal return = inflation). I would discount my expected liabilities for “essentials” and “lifestyle” using a 0 discount rate. On the asset side I would do the same for my SS income. However, because the SPIA PAYOUT does not increase with inflation, my intuition tells me the annuity payout stream should be discounted at the expected rate of inflation. Does this make sense?

thanks

Yes indeed. Discounting inflation-adjusted streams at a zero real return implies that a nominal stream of payments is discounted at the rate of assumed inflation.

Thank you Don!

Again, love the Funded Ratio approach.

My biggest concern is estimating the PV of the liability (i.e., future stream of required income).

Your calculator uses “how much it would cost to buy an annuity that would lock in the required annual income for the rest of our lives.” But since it is no longer possible to purchase real (inflation adjusted) annuities, do you simply use the nominal annuity amount?

In addition to using a nominal annuity, I can think of three other ways to estimate the liability:

1. Discount the desired income stream by the duration-matched TIPS yield (which I have seen suggested elsewhere).

2. Use the cost of an annuity that is COLA-adjusted for some guess of future inflation, say 3%.

3. Use the expected return on a TIPS ladder constructed to mimic the desired income stream (which may have been suggested by Wade Pfau).

Any thoughts/suggestions on the best way to estimate the liability? I get very different Funded Ratios with each of the above four methods.

Thank you — excellent points! If you go ahead to Blog Post #48 you’ll see how I made the calculator estimate the amount needed. For the “locked-in” amount I used an annual discount rate of 0% real, and then added 20% to the PV as an estimate of the insurance company’s loadings. That’s a rough-and-ready approach, intended to give a ball-park estimate; an accurate approach for all time is impossible, partly because (as you point out) these contracts may not be available, and partly because, even if they were, their price would change over time. Your Method #3 is conceptually the most accurate approach (and I can well imagine Wade saying it, as his stuff is always excellent); your Method #1 is a quicker approximation to the more accurate #3. Your #2 is yet another reasonable approximation. As you say, all those results will be different. That’s not a flaw: it simply reflects the fact that, if you can’t actually buy an inflation-adjusted annuity, there’s uncertainty about the number you need — a fact of life. Remember, too, that the calculator is intended simply to give a set of ball-park numbers to people who have no idea at all where they’re situated: that’s all, and it’s far better than not knowing whether you’re closest to 50%, 100% or 150% funded. Hope that helps.

Thank you Don! This is very helpful. Totally understand that the FR is an approximation. I like the idea of using multiple estimates, each of which has its unique strengths and weaknesses.

Just to reiterate, I find this FR approach incredibly useful. I am probably a few short years from retirement and this has given me a whole new set of insights into planning for retirement. (This attraction may be because I am an accounting professor, so the benefits of creating a balance sheet seem very intuitive!)

BTY, i found out about the FR approach from Wade Pfau’s new book, and from his reference to Noonan and Smith’s excellent book, which in turn gives you the credit for introducing this approach for individual investors. Thank you for your contribution!

Thanks, you’ve made my day! Tim Noonan is a long-standing friend, Matt Smith is both my friend and my co-author, and I know Wade well. It’s a small world!