This post is a follow-up to our post of February 13, 2025, How to Improve Decumulation Planning. Subsequent to that post, we received our copy of Retirement Planning Guidebook, by the preeminent retirement researcher, Dr. Wade Pfau.
In his book, Dr Pfau outlines his key steps for quantifying spendings goals and measuring financial health in retirement:
- “Build a retirement balance sheet by collating household finances and determining all assets and liabilities, including the present value for income and expenses that happen in the future
- Choose a planning age and conservative discount rate to apply to the funded ratio [ or status] calculations, and then calculate the funded ratio.
- If the plan is underfunded, take initial steps to determine a course of action to improve comfort that one has a reasonably funded plan.”
Each year, Dr. Pfau recommends updating your funded ratio analysis and considering any planning adjustments based on the funded ratio update. According to Dr. Pfau,
“I hold the view that the funded ratio method is good enough for most situations. Once you have made the effort to estimate your budget, your Social Security strategy, your collection of assets and liabilities, and a way to estimate taxes, then a simple spreadsheet to calculate the relevant present values to create a funded ratio tells you what you need. There is not much need to also worry about Monte Carlo simulations and the probability of plan success.”
We, of course, agree with Dr. Pfau as his recommended approach is essentially the same as the 3M process we advocate:
Actuarial Approach--Three Key Planning Steps
- Measure your Funded Status (assets/liabilities) at the beginning of each year
- Monitor your Funded Status from year to year, and
- Manage your spending, assets and risks in retirement as necessary
Back in 2018-19, when I was reviewing the Society of Actuaries Viability of the Spend Safely in Retirement Strategy authored by Dr. Pfau, Steve Vernon and Joe Tomlinson, I argued that the Actuarial Approach was superior to the IRS Required Minimum Distribution withdraw strategy touted by the authors. The authors humored me by including the following section in their publication:
“7.1 Actuarial methods A more sophisticated and complex method for retirees to develop a retirement income strategy is to use an actuarial method. Such a method would solve for regular withdrawals from savings by equating the present value of future retirement income from all sources, including Social Security and pensions, to the present value of future living expenses from all sources. Such a method would require making a number of actuarial assumptions, including expected longevity of the retiree (and spouse/partner), the time value of money, expected return on assets, expected inflation on living expenses, expected benefits from other sources, such as Social Security and earned income, etc. Actuarial methods could use either deterministic forecasts that develop one set of results, or stochastic forecasts that develop a range of possible results with associated probabilities of occurrence (calculated in accordance with the assumptions for capital market returns and inflation). An actuarial method could use an asset smoothing method that would enable the retiree to remain significantly invested in equities, while reducing the volatility in the pattern of annual withdrawals. An actuarial method would periodically adjust the withdrawal amounts to reflect gains and losses that have occurred since the previous valuation. An actuarial method could be a more sophisticated way to address uneven living expenditures and temporary income amounts, as addressed in Sections 6.1 and 6.2. The tradeoff between the SSiRS and an actuarial method is simplicity/ease of use vs. more sophisticated treatment of the retiree’s goals and circumstances. Use of an actuarial method will either require retirees who are willing and able to prepare the calculations on their own, or work with financial advisers who are familiar with actuarial methods. Retirees with significant amounts of retirement savings and/or complex planning objectives and circumstances might appreciate the additional robustness of an actuarial method. For more details on one application of an actuarial method and a calculator to help implement such a method, see the website http://howmuchcaniaffordtospendinretirement.blogspot.com. “
Apparently, Dr. Pfau has become an actuarial approach convert, now recognizing that the more sophisticated treatment of a retiree’s goals and circumstances inherent in the Actuarial Approach outweighs the simplicity of the RMD withdrawals anticipated in the Spend Safely in Retirement Strategy.
According to Dr. Pfau, only a simple spreadsheet is required to convert future household asset and expense flows into present values for the household balance sheet. As suggested above, for those households and financial advisors who are looking for “a calculator to help implement such a method”, you might want to try the spreadsheets in our website. Unlike Dr. Pfau’s more simplified approach, our Actuarial Financial Planner (AFP) calculators:
- Use two discount rates: One for the Floor Portfolio assets and spending liabilities and one for the Upside Portfolio assets and spending liabilities
- Let the user match assets and liabilities by risk
- Let the user assess risks by changing assumptions
- Let the user distinguish between recurring and non-recurring expenses
- Provide default assumptions but let the user change them
- Provide separate longevity planning assumptions for members of the household and a decrease in recurring expenses assumption upon the first death within a couple (married couples)
- Provide the opportunity to have different rates of future increases (or decreases) for future expenses or income flows
Summary
For those households and financial planners who are dissatisfied with their current assessment of financial health process and want to know how much they (or their clients) can afford to spend in retirement, we strongly encourage you to select a different metric: the household Funded Status.
The beauty of the Funded Status metric is that if all assumptions are realized from one year to the next (including the assumption that spending will equal the spending budget for that year), the Funded Status is expected to remain unchanged. If the Funded Status increases (or decreases) from year to year, experience losses (or gains) have occurred. Monitoring these losses or gains over time will be valuable in determining when adjustments in spending or assets may be required.
