In several of our recent posts, we have been touting the Actuarial Approach and its use of the Funded Status metric to measure household financial health. This is another one of those posts.
One of my Bridge buddies recently mentioned the Peter Drucker quote, “You can’t manage what you can’t measure” which highlights the importance of incorporating quantifiable metrics in managing and improving business processes. Mr. Drucker’s quote is equally applicable to the process used by households (and financial advisors) to manage their finances in retirement.
The Actuarial Approach actually employs two Funded Status metrics—the first which compares the present value of household non-risky assets and investments with the present value of its essential expenses and the second which compares the present value of total household assets with the present value of total household spending liabilities. The first metric can be used to manage investment of household assets and investment-related risks, while the second can be used to broadly manage household assets, spending and risks from actual future experience differing from assumed future experience.
The beauty of the Funded Status metrics 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. Using this self-adjusting process and monitoring these losses or gains over time will be valuable in determining when adjustments in the household plan may be required.
Risks that actual future experience may differ from assumed future experience are easily quantifiable by changing default assumptions in the Actuarial Financial Planner (AFP) and noting the impact on the calculated Funded Status (i.e., stress-testing). Quantifying these risks will help households develop strategies to manage them.
Measuring and monitoring your Funded Status can also help you manage many financial decisions in or near retirement, including:
- Timing of retirement,
- Whether you should decrease or possibly increase your spending,
- Timing of Social Security benefit commencement,
- Whether to take benefits from a defined benefit pension plan in the form of a lump sum or a life annuity,
- Whether to purchase a life annuity product or Tips ladder, and
- Whether to go back to work or take a part-time job in retirement or look for other sources of income (such as renting a room or other space in your home).
Summary
If you want to properly manage your finances in retirement, you need to incorporate a reliable metric or two into your planning process. We believe the Funded Status measures that you can calculate using our Actuarial Financial Planners are just the ticket.
