It’s time to assemble the facts required for a funded ratio calculation. If you’ve never done it before, gathering the information is not always easy. Here’s how one couple did their best, even though it was far from perfect.
For a list of blog posts with recent responses, go to the end of this post.
Let’s follow Alain and Amélie (both now 40 years old) as they have a go at calculating their personal funded ratio. They both work, and together they earn $115,000 a year. They’re a long way from retirement (they think perhaps 25 years), and they’re pretty sure that they’re far short of 100%, particularly if they exclude their home, but just for fun they’re going to calculate all the ratios set out in Post 46 ( http://donezra.com/46-your-personal-funded-ratio/ ).
It has been tough just getting to the starting line.
They started with longevity estimates and found that, at their ages (65 and 65) at projected retirement, their 50% and 25% estimated “joint and last survivor” life expectancies are 27 years and 32 years respectively. In other words, of couples like them, half expect that at least one of the couple will still be around after 27 years, and a quarter of such couples will still have at least one partner around after 32 years. Those are the numbers they’re using for their calculations.
They haven’t a clue as to what their post-retirement income target should be. Living expenses, the mortgage payments and their retirement contributions eat up their net pay. No children, and none planned. They don’t keep track of their expenses and don’t have a budget. In despair, they decided to use 70% of their gross pay as an initial target, a number they got from a friend, as a sort of default option. That gets them to $80,500 a year. They round it to $80,000 for their selected target. (And they resolve, before recalibrating next year, to see how much money they actually spend, and get expert help to gross that up to a post-retirement income target.)
What will their Pillar 1 pensions give them? Again, not a clue. The same friend said it might be $30,000.
They have no Pillar 2 pensions, unfortunately.
That means their combined pension pot needs to provide the $50,000 a year remaining from their $80,000 initial target. (Further note to themselves: find out about their Pillar 1 entitlements.)
What are their current assets?
They have both assiduously contributed to their workplace defined contribution plans. With excellent equity returns, their combined tax-deferred assets are now an amazing $150,000. They have no after-tax savings worth including in the calculation, just a small amount for emergencies. They own a home but even though its value has climbed to an estimated $300,000, their mortgage is $250,000, so there’s only net equity of $50,000 there. No other significant debt.
Wait a minute! They’ve just realized that by retirement their home mortgage will have been paid off, and their net worth will reflect the full value of their home, not just their current equity. Good heavens, it’s the mortgage payments that eat so heavily into their current standard of living – and that’s a form of saving for retirement that wouldn’t otherwise be taken into account. So (quite correctly) they change their starting illiquid assets position to reflect the full value of their home. And so, while their liquid assets stay at $150,000, they change their illiquid assets to $300,000. Whew, that’s better!
They choose to calculate their personal funded ratios.
Between them and their employers, total contributions amounting to 8% of their combined current pay are going into their pension pots. That’s $9,200 a year.
They have one more set of inputs to insert.
At this point they feel exhausted, but they’re nearly there, so they don’t give up! They realize that once they have all the inputs, the calculator does all the remaining work for them.
For their best estimate annual real return before retirement, they guess that they’ll need to take a lot of risk to reach their target income level.
For the liquid assets and their future savings, given that they won’t touch them for 25 years, they’re going for growth. They won’t have 100% in growth throughout, but they’ll have 100% for a long time. Assuming 4% (real) a year for growth investments, they decide to use an average real return of 3.5% a year over the next 25 years.
The calculator uses the same number for their illiquid assets too (their home), for convenience. A more sophisticated calculator might use a different number.
Through the drawdown period after retirement, they expect to take much less risk. So they don’t want to use the same 3.5% number. They think it likely that, over the whole post-retirement period (which, remember, is being planned as 32 years), they’ll average perhaps a quarter of their assets in seeking growth. So they use 1% as their input here.
(By the way, you recognize, of course, that these numbers are not meant to have any significance at all, as far as your own decisions are concerned. They’re not benchmarks to compare yourself with. They’re purely what I attribute to Alain and Amélie for illustrative purposes.)
OK, finally they can hit “Calculate”! Let’s look at their results.
Their interpretation of the results
The first thing they notice, with relief, is that the final funded ratio number is 103%. Yes, it exceeds 100%! They’re excited!
Not so fast, though.
Of that 103%, 32% comes from their illiquid assets (their home). Without their home, the rest only adds up to 71%. That tells them that they’ll have to find a way to monetize their home – an uncomfortable feeling.
Of course, they were just guessing at their target 70% requirement. This makes them realize how very important it is to see how much they’re actually spending right now, so they won’t have to make a wild 70% guess again next year. The good news is that their mortgage payments take up a good chunk of their take-home pay, and so their spending isn’t really related to their gross income, it’s more a function of income minus mortgage payments. Their post-retirement need, to maintain their current spending, won’t have to be large enough to meet mortgage payments too.
And in fact, once the mortgage is paid off, they’ll be able to save much more of that cash flow towards retirement, improving their funded ratio. This calculator doesn’t take that into account.
The biggest chunk of their funded ratio comes from their Pillar 1 pension. Remember, that too was a piece of guesswork, made by their friend. Again, this is clearly a significant number, and therefore one to be researched before next year’s recalibration.
As for accumulated liquid assets and future savings, together they generate 18% on a locked-in basis and 33% on a best estimate basis. That tells them that the difference (33% – 18% = 15%) comes from hoped-for growth in their growth-seeking assets. That disappoints them, as they remembered the 10-30-60 stage ( http://donezra.com/18-the-10-30-60-rule-shows-the-huge-multiplier-effect-of-investing/ ).
(My explanation, which they weren’t aware of: there are two factors. One is that, when expressed in real terms, that is, in terms of today’s purchasing power, the investment multiplier effect isn’t as great as 10-30-60 suggests. The other is that they are now 40 years old, and have fewer years in the future than 10-30-60 involved. In fact, their past investment returns have been extremely high.)
Regardless, they really do need that growth to get to 100%. Another memo to themselves: talk to an expert (whether at work or outside their work environment) about what is required to make this a reasonable outcome – and also what are the risks involved, and what might happen if the risks result in some shrinkage rather than growth. (A horrible thought, but a necessary one.)
All in all, the only firm conclusion that they come to is that some form of lifestyle continuation is feasible after retirement. There’s a lot more to investigate before they feel knowledgeable about interpreting the results, let alone confident about their future.
No, they realize they can go further. That’s not the only firm conclusion. There’s another really important firm conclusion. It’s a psychological one. They realize that they’re no longer totally ignorant about where they stand. They’re no longer scared stiff. They’ve taken the big first step, just by doing this rough calculation. They’ve escaped from their previous world of unknown monsters, and moved to a new world of research and discussion. It’s as if they were totally lost, and now know where they are; and they own a compass, indicating directions. They have a framework for looking at the future, financially. They feel, for the first time, a little bit more in control. Talk about a teachable moment!
Well done, guys!
Even without precision, using the calculator represents a psychological step forward, indicating areas that need further investigation. Having a framework is a big first step.
Recent responses have been made to the following posts:
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.