In Episode 211 of their Retire with Style podcast series, Dr. Wade Pfau and Alex Murguia discuss the importance of using present values in financial planning for retirement. They conclude their podcast by saying that present values are “the heart and soul of retirement financial planning calculations,” and “It only took us 200+ episodes to get to the heart of the matter.” We agree.
Our Actuarial Financial Planner (AFP) workbook is entirely consistent with the math discussed by Dr. Pfau and Mr. Murguia in their podcast. Yes, we call the present value of assets divided by the present value of spending liabilities the household’s “Funded Status” and they call theirs the “Funded Ratio”, and, so far, theirs only uses one discount rate to calculate present values, but the present value concepts are the same.
The AFP uses different discount rates to calculate risk-adjusted discounted cash flows. Expenses that are identified as 100% “Essential” and asset cash flows that are identified as 0% “Upside” (or non-risky) are discounted using the expected return assumption on Floor Portfolio assets. Expenses that are identified as 0% “Essential” and asset cash flows that are identified as 100% Upside are discounted using the expected return assumption on Upside Portfolio assets.
Expenses and future cash flows that are identified by the user as being partially Essential and partially Discretionary (for example, asset cash flows that are identified as 75% Upside and 25% Floor) are discounted using a discount rate developed by taking 75% of the expected return on Upside Portfolio assets and 25% of the expected return on Floor Portfolio assets.
In our opinion, the use of the risk-adjusted cash flows is far superior to simply assuming a risk-free investment return rate and associated discount rate on all assets and spending liabilities which Dr. Pfau’s model assumes to develop his Funded Ratio.
But, thanks to Dr. Pfau and Mr. Murguia for noting that the basic actuarial concept of present values is the heart and soul of retirement financial planning calculations.