We encourage you to remember the following 3Ms when determining how much you can afford to spend in retirement:
- Measure your Funded Status periodically (we recommend at least annually at the beginning of each calendar year)
- Monitor your Funded Status from year to year, and
- Make changes when your Funded Status falls outside a reasonable corridor (guardrails)
Some of our readers question why the second M is important. We will answer in this post.
Background
Your Funded Status is determined by dividing the present value of your investments/sources of income (your Assets) by the present value of your future expected expenses (your Liabilities), or
Funded Status = A / L
The assumptions used to determine your A and L include assumed investment returns, assumed longevity, assumed inflation, assumed future rates of increases in expenses, etc.
If you spend your current year spending budget determined using the Actuarial Financial Planner (AFP) and all the assumptions used in the calculations are unchanged and exactly realized in the future, your Funded Status will remain unchanged from year to year. As discussed in our post of August 16, 2024, it is highly unlikely that the future will happen exactly as assumed. Increases (or decreases) in your assets relative to your spending liabilities can occur from:
- Actual experience more (or less) favorable than assumed
- Changes in assumptions, or
- Spending more (or less) than budgeted
The items above that increase your assets relative to your liabilities are called “actuarial gains” while the items that increase your liabilities relative to your assets are called “actuarial losses.” Actuarial gains will increase your Funded Status while actuarial losses will decrease your Funded Status.
Why monitoring your Funded Status from year to year is important
Periods of consistent actuarial gains or losses where your Funded Status is fairly consistently increasing, or decreasing, is an indication that your assumptions about the future are either too conservative (or too optimistic) an/or that you are under- (or over) spending your spending budget.
A perfect example of the importance of such a pattern outside of Household retirement financing is Social Security financing. When the system was last significantly amended (reformed) in 1983, the system’s long-range funded status was 100%. Since that time, the system’s funded status has fairly consistently deteriorated until it is slightly less than 80% today, with the expectation of even greater future deterioration. This is a clear indication that the assumptions used to determine the system’s Funded Status are too optimistic.
In addition to indicating that assumptions may be too optimistic or too conservative, the trend of a system’s funded status may also signal when it is time to make changes in the system’s financing. For Social Security, for example, this signal has been sounding loudly since the 1990s, but Congress has failed to act. Unlike Congress, individual households can ill afford to wait decades to make changes to their financial plans to bring them back into balance.
