In this post I explain how to use the Personal Funded Ratio calculator that’s on the website: the principles it’s based on, the questions it can answer, the information you need to provide, where and how I’ve imposed limitations on its flexibility – that sort of thing.
My purpose in this post is to show you how the Personal Funded Ratio (or PFR, from now on) calculator works, and how you can use it to answer a number of questions – or at least get initial orders of magnitude, always subject to the imprecision of making any sort of estimates about the future, as explained near the end of Post 46 ( http://donezra.com/46-your-personal-funded-ratio/ ). I assume explicitly, in fact, that before you use the calculator you have first read that stage.
Here’s the basis of how the calculator can be turned to multiple uses.
Three things are always intertwined. You put money into your pension pot, you invest it to make it grow, and there’s something available at the end. Common sense, right? What’s fundamental is how those three elements are connected. If you know what goes in and how much it’ll grow, that’ll tell you how much will be available. But also, if you know what goes in and how much you’d like to have available, that will tell you how much growth is necessary. Or, if you have some rate of growth in mind and know how much you’d like to have available at the end, that will tell you how much you have to put in. You see how the three things tie together?
The website calculator gives you all three options.
To me, the first one is the natural starting point. I asked friends which of the three unknowns they’d most like to start finding out about, and they all had essentially the same answer. “First I want to know whether I’ll have as much money as I need. That’s where I want to start. After that it might be interesting to see how the answers change if I change my savings rate or my future investment return, but start me off with my PFR.”
So that’s the first of your three choices: calculating your PFR. You can select two other options if you want to work backwards from a desired funded ratio to the savings or the investment return required to get there.
Some inputs are the same, no matter which aspect you’re looking at. For example, your personal details and your current position. So those inputs stay the same for all the output screens.
All the calculations are done on the website. There’s nothing to download. And the website saves nothing. So, if you want a record of any calculation, you need to print it. Once you erase it, the record is gone. So, right at the start, I give you a spot to name a particular calculation, to enable you to identify it (the “version name”) if you end up doing multiple calculations.
OK, let’s go with the instructions.
Oh, one more thing. In future posts I’ll go through an example of a couple actually going through the calculations. So you’ll be able to see how they comply with the instructions and fill in the required boxes. I hope that’ll help you with your own inputs.
First, the common inputs.
Your name, age, gender. If the calculations involve two of you, then add your partner’s name, age, gender.
How far in the future you’re planning to retire.
Together these tell you what your ages will be at your planned retirement date.
Now you have some work to do. Go to http://www.longevityillustrator.org (or whatever longevity tables you find most useful) and find two estimates. One is the 50% estimate of survival in years (for you alone, or for your partner and you, depending on your calculation). Enter that number in the “locked-in basis” for “Years of post-retirement income needed.” The other one is the 25% or the 10% survival in years, depending on your degree of caution. (I have a personal preference for the 25% number. I realize I haven’t explained why — in some future post, I will.) That number of years goes into the “best estimate basis.”
Next enter your current (combined, if that’s relevant) annual gross income.
Next enter the required gross (that is, pre-tax) annual income that’s your target. This target income will be assumed to increase every year with inflation, to preserve your purchasing power. The calculator tells you how it relates to your current gross annual income, as an interesting comparison.
Next we take into account what annual amount you’re likely to receive from your country’s Pillar 1 pension (such as US Social Security, or the UK state pension, or C/QPP and OAS in Canada). I can’t help you here. You need to find out about this yourself or from the national agency or an expert or friend – whatever.
You’ll also need to find out about any Pillar 2 pension you may have, that is, a defined or target benefit plan offered by your employer or union. (This is NOT a defined contribution plan for which you receive periodic statements about how much money you have accumulated.). Though in many countries this annual amount, once it starts, does not get increased with inflation, nevertheless enter the projected starting annual amount in the relevant box. (The absence of inflationary increases results in an inaccuracy in the calculator’s analysis, which is too complicated for me to make good. Sorry. More advanced calculators may be able to do adjust your fixed Pillar 2 pension to an equivalent inflation-adjusted basis.)
The calculator now tells you the balance of your target annual income required to be met by your personal assets, after the Pillar 1 and Pillar 2 pensions have been taken into account.
And finally, where do you stand today? Input your current liquid assets and your current illiquid assets.
All of those inputs are common to all three sets of calculations.
OK, now we come to the choices regarding the output screens.
The first choice is focused on calculating your personal funded ratio.
This requires two further sets of inputs.
The first relates to how much more money you are planning to save. Enter the annual amount that will go into your pension pot in the relevant box. Your contribution and your partner’s contribution are both relevant here. So too are any contributions made by your employer, your union, the government – whoever. Add them all up, and the total goes in here. (Of course, this does NOT take account of anything going to Pillar 1 or Pillar 2, which are implicitly taken into account earlier.)
The second relates to your projected average annual investment returns. As you might guess, these are all returns after inflation (often called “real returns”). And (sorry, but this is necessary) there are four relevant inputs here.
Two relate to the locked-in basis. Actually, I give you no choice here. The calculator uses 0% annually for these returns. These are safety-oriented returns, designed to be relevant for safety-oriented investing, which is what underlies the attempt to lock in a cash flow. (See Stage F81 for a reminder of safety-oriented and growth-seeking goals. And you’ll have seen why I use 0% when, in Stage I21, I showed you historical results.)
The other two relate to the best estimate basis. There’s an annual real return to be estimated before retirement, and another one after retirement. Why the difference? Because most people tend to take less risk after they retire, in which case their reasonable expected reward should also be lower after retirement. (And of course, these inputs cannot be 0%, since here you are inserting the reward you expect for the risk you are willing to take.)
Done! Finally, you can look at the results! Hit “Calculate.”
Remember, all the results are shown in terms of today’s currency (dollars, euros, pounds, whatever), so that you’ll have an immediate idea of what you can purchase with the output.
The first set of results shows how much money your target income will require you to accumulate by retirement. The locked-in basis is an approximation of what it would cost to buy a lifetime income annuity at retirement, guaranteeing you the required income for life. (Information for the techies: I’ve assumed a 20% loading for the insurance company.) The best estimate basis is the projected amount your own pot will need to reach, to provide your target income for the number of years you input earlier.
OK, those are the targets. What are the projected amounts you’ll have available?
The amounts available are shown, item by item, from your current liquid assets, from your current illiquid assets, and from your future savings. And they are shown separately for the locked-in basis and for the best estimate basis.
In turn, those amounts lead to the components of your personal funded ratio. You can see the funded ratio if you attempt to lock everything in, and you can see the funded ratio that’s your best estimate if the reward comes from the investment risk you will be taking. And you can see how much of your funded ratio comes from Pillar 1, from Pillar 2, from your current liquid assets, from your current illiquid assets, and from your future savings.
Take some time to absorb those results. See whether they make you feel comfortable or anxious. See if they give you any insight into what you might like to change: your future annual savings, your best estimate annual investment return, or your target post-retirement income.
(You might want to name this set of calculations and print out these results, regardless.)
You can go back to the top of the screen and edit your inputs, if you’d like to test different inputs.
Often, instead of changing the planned savings or assumed investment returns, people often prefer to ask: what do those need to be, for me to get to 100% of my target? That’s when you need to go back to the initial page, and select a different calculator.
You can retain, or change, your inputs shown above the calculator choice.
To calculate the required annual savings, you have of course to input the investment returns.
And you have a choice of which ratio you would like to set at 100%: the locked-in or the best estimate ratio, excluding or including illiquid assets.
Hit “Calculate,” and there you are. Right at the end, you will see your required annual future savings.
Similarly, if you want to calculate the annual real returns required to reach your target, that’s the calculator you select.
And this time, of course, you have to specify your planned future annual savings, and identify which ratio you would like to set at 100%. Naturally, if you’re searching for an unknown rate of return, that implies it’s not a locked-in funded ratio that’s relevant; it can only be a best estimate ratio. Whether to exclude or include illiquid assets is always relevant.
You’ll notice, after you hit “Calculate” and look at the results, that you’ll see required returns both before and after retirement – and in particular you’ll notice that the return before retirement is three times as high as the return after retirement.
That’s deliberate on my part. It’s an arbitrary relationship, I admit, but I had to make a choice here to limit the complexity in the calculator, and I thought it would be useful to show what both returns need to be, if there’s to be the usual risk-reduction after retirement.
I hope that’s useful. Already I can imagine the more numerate among you finding ways to use the three calculator choices to answer even more complex questions. If that’s you, I’m delighted, because it means I’ve piqued your interest and you’re taking it further – yes, I’ve created a teachable moment!
One last thing. If you use someone else’s calculator and get a substantially different outcome, please let me know. I’ll try to see why the difference, and if this indicates that something in my calculator is worth changing.
You should now be ready to use the calculator to help you find out what point you’ve reached, as far as retirement finances are concerned.
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.