PWL Capital January 21, 2015 Living in Retirement The question everyone thinking about retirement should ask: what’s my funded status? Most people are more worried about running out of money than death. In reality, very few people wake up one day and realize they have no money. Instead, they find that they’re having to make successive downward adjustments to their expenditure. Whether you end up in this position depends on how long you live, how much you spend in retirement, and how much you have saved when you retire. Suppose that there was a single number that provided a useful guide to people before and during retirement about whether they will run out of money and their sustainable level of expenditure. This number would have the interpretation that if it was above one then they would have sufficient retirement funds. A number less than one would require some adjustments. This is the idea, familiar in the pension industry, behind calculating an individual’s funded status . First, we outline how the funded status is calculated and then discuss its use and interpretation. A person’s funded status is the ratio of two numbers: today’s value of all their assets, and today’s value of all their liabilities. In this instance, assets include everything someone intends to use to fund retirement. This would include today’s value of current savings, future savings, and employer and government pensions. Liabilities include today’s value of all the future expenditures in retirement. To include the uncertainty of how long people live, we use the same approach that actuaries use when pricing annuities. An annuity is the promise of income for as long as the purchaser of the annuity lives. Annuities aren’t very popular, in part because they are an irreversible purchase. Our stance is not to require a retiree to buy an annuity, but to always ensure that they have enough funds to do so. We can adjust this calculation for men, women, or couples using statistics about the probability of a person being alive in future years. By way of illustration consider Joe, who is 65 and has $600,000 in investments and on the point of retirement. Joe’s government and company pensions are worth an additional $400,000 at today’s value, meaning he has total assets of $1,000,000. He plans to consume $40,000 each year in retirement. Using PWL’s calculator this represents a total liability of $893,830 and so Joe’s funded status is 1.12 ($1,000,000 divided by $893,830). We would expect Joe to have sufficient funds for his retirement because his funded status is greater than 1.0. Today he has the option of buying an annuity that would guarantee a lifetime income $40,000 and still have some investment capital left over. Joe’s situation is illustrated below. Readers may observe that the funded status calculation does not require an estimate of future market returns. This is because we are not predicting his future funded status, only the current value. Future market returns may increase or reduce Joe’s investments so we would continue to monitor his funded status and use it as an early warning indicator of possible changes. If in future his funded status rose to, say, 1.4, then he could consider increasing his retirement expenditure or taking more risk with his investments. If it fell below 1.0 then reducing expenditure would be a prudent option. Monitoring funded status is a useful addition to empowering investors and reducing anxiety about the future by anticipating problems and opportunities while options are still available. What’s your funded status? 1 “Reclaiming the Future”, a 2010 survey by Allianz Life Insurance Company of North America 2 The discussion that follows owes much to publications by Russell Investments, a global asset manager for individuals and institutions. In particular, see this article. Share: Facebook Twitter LinkedIn Email