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Don't Be Confused When Using a Funded Ratio

Christine Benz

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Tracking progress toward retirement savings can be complicated. It can be tough to know if you're on track. Joining me discuss that topic is financial planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Thanks for having me, Christine.

Benz: Michael, let's talk about how one could track progress toward retirement savings and having enough. One method that is out there that has maybe been gaining a little popularity recently is this idea of a funded ratio. Let's talk about what that is and how people are using that to gauge retirement readiness.

Kitces: The idea of a funded ratio actually comes largely from the world of pension plans. Pension plans have this obligation. We have all these people that are making ongoing contributions because are still working, a whole bunch of folks who are getting pension payments out, a lot of people who are going to be getting pension payments in the future, they are contributing right now but we know the money is going to be due later. And so, pension plans have to figure out, when you mix all that together do we have enough money?

They use this thing that's called the funded ratio. And the idea of it is to calculate all the asset flows that we've got, all the liabilities that we know we are going to have in the future, and let's if the assets we have fund all the different liabilities at the different time points in the future. The math is a little bit complex, but it's a very manageable calculation. You just have to make some assumptions about how the money is going to grow between now and when all the obligations are due. The pension plan can get some sense of, are we funded for all of the retirement goals that we need to pay for later for all these pensioners.

A lot of people have now been taking this and crossing it over to the individual space. Because the idea of it is kind of similar. I'm working and saving toward retirement. At some point in the future, I'm going to have to spend in retirement. We call those retirement spending liabilities. It's not a debt liability, but it is an obligation that you're planning to spend this later. We can do a similar calculation. Here is what we need in the future to cover our retirement spending goals; here is what we have today; we can make some assumption about growth rates between today and the future, and figure out how funded are we. Are we actually on track to accumulate the dollars that we need for our ultimate retirement goal? And we can convert that into, well it's actually a relatively simple number at the end of the day. I'm 25% of the way there, I'm 50% of the way there, I'm 75% of the way there. When I get to 100% of the way there, I say so long to my boss because we are done.

Benz: The thing that you wrote about on your "Nerd's Eye View" blog is this idea of funded ratios, how they can sometimes confuse, mislead, demoralize. Let's talk about how, especially early on in a retirement saver's progress, a lot of what he or she is seeing in terms of how big the account has grown is contributions. And so, if your own contributions aren't all that great that you can be demoralized from the standpoint of that funded ratio.

Kitces: The challenge for funded ratios with individuals, it works a little bit differently than pension plans just in practice. When most pension plans do this, the reality is, they already have a large asset base, they are already paying out a lot of dollars even while new dollars are coming in for some of the future pensioners. And so, frankly, the plans try to stay at 100% or pretty close to 100%. And the number doesn't tend to wobble a lot. Unfortunately, some pension plans are a little underfunded these days and the number is lower. But it's a pretty steady ongoing number.

When we do this with individuals, it doesn't flow so cleanly. Because the reality if we are saving for a very long-term retirement is, the primary thing that makes this work over long multidecade periods is not just our contributions, it's the growth and it's actually the growth and the growth on the growth and the growth on the growth and the growth--Einstein called compounding the eighth wonder of the world. And this has very real implications when we start looking at how a funded ratio plays out for an individual.

If you imagine someone that's in their mid-20s and their goal is, I want to retire with $1 million 40 years from now. They have done the math. They figured out that's what they need on top of Social Security and the rest. So, we can figure out how much do I need to save to get to $1 million in 40 years. It turns out that number is actually not that huge. It's about $300 a month, $300 a month in a balanced portfolio for 40 years gets you to $1 million.

Benz: What sort of return expectation?

Kitces: Balanced portfolios historically did about 8% returns. So, that's an 8% return assumption.

Benz: Lower today probably, right?

Kitces: Yeah, dial it down a little bit today. You need to go a little bit longer, or you need to dial it up a little bit more. But the problem that crops up when you do that kind of plan or that projection, if you actually just do the math about what would your progress be every year, on this 40-year plan, when you are 20 years into the 40-year plan, you will still only be at about $200,000 out of $1 million. You are actually less than 20% of the way there halfway through the time period. You don't even get to 25% until your 23rd year. You don't get halfway to your goal until the 31st year out of 40. And then in the last nine years compounding allows the portfolio to double again with reasonable market returns and you're done.

The good news is, you get there. The bad news is, and we see this so often with people, they are saying, I've got this dream that I want to save $1 million for retirement but I'm in my early 50s and I've only got $300,000 or $350,000, I feel like I'm so far. I'm, straight formula, I'm like 30% or 35% of the way there and I've been doing this for decades. I'm hoping to retire in 15 years. And we point out to them, well, actually, you're completely on track. If you're 30% to 35% to your goal with 15 years to go, compounding returns actually will take you there, the rest of the way, with surprisingly little ongoing contributions from that point on.

We get these misleading perspectives, I think, of when we look at a funded-ratio approach or just even in our heads start doing the math of here is where I want to be, here is how much I've got, like you kind of do the percentage. Because the nature of compounding means you're never halfway there when you're halfway through the time period. You're not halfway there until you're three quarters of the way through the time. But in the real world it kind of messes with our heads to say, I'm 50-something and I feel so far, but you're actually on track.

Benz: Right. One topic we've kind of danced around here is the idea of return assumptions. At some point, compounding is really going to kick in and be on your side. But these funded ratios are incredibly sensitive to what sort of return assumptions I'm embedding and of course, it depends on the asset allocation that I've chosen and so forth. Let's talk about that, like how can people approach that piece of it reasonably.

Kitces: Yeah, the return assumptions do matter, absolutely, because it's all about the compounding effects. Every time you dial the return down a little, it extends the time period a little. With 8% returns, your money doubles in about nine years. With 7% returns, it takes a little over 10 years. If I've got to do two more doublings in the last 15 years, but I dialed the returns down, now it's not going to take me 15 years, it's going to take me 17 or 18 years.

Bringing the returns down, that's to me the true trade-off when we talk about the implications of, do I want to take a little more risk and volatility or do I want to take a little less. We tend to talk about as things like 7% returns versus 8% returns. As I view it, it's two or three more years of working. That's what the trade-off comes out to be. Or in times like this where we're just stuck in slightly lower return environment, it's going to be a few years longer or you're going to have to earn a little bit more and save a little bit more. Unfortunately, those are just the cards that you were dealt when you're trying to close the gap to retirement in today's low return environment.

The return assumptions do matter. The way that we actually try to explain it to people is, say, look, higher or lower returns isn't really about the returns per se, it's about when you're going to get to retire. Lower returns means you got to save a little more or work a little bit longer. Higher returns means you get to save a little bit less or work a little bit fewer years, but higher returns means higher volatility and higher volatility means the risk that, when we actually get to that point a few years out, a badly timed bear market shows up right in advance. And so, we have this thing that I call retirement date risk, which is what's the risk that, I'm aiming for age 65 date doesn't turn out to be 65. If I've got a low volatility portfolio, it might be 65 plus or minus a year or two. If I've got a higher volatility portfolio, it might be 63 because I get there a little faster, but it's 63 plus or minus five years, because a big market runup and I can retire when I'm 58, but bad market crash a year before retirement, now I'm stuck three to five years more to make it up.

Just to start thinking about in those terms, I think, helps a little bit more. The volatility is not the volatility of your portfolio. It's really the volatility of your retirement date. The more certainty you want to the date, the less risk you take. But the more you've got to save and the further out it's going to be. If you want the certainty, you got to wait a little bit longer to get there. If you're willing to take a little bit more of the risk, there's a wider range, but you got a good chance of getting there sooner.

Benz: This funded ratio idea, I think, has intuitive appeal as you discussed. But it has drawbacks too as you've also discussed. How should people approach this? How should they think about gauging their own retirement readiness, whether they are trying to figure this out on their own or maybe they are working with an advisor and they are trying to backstop the advisor's recommendations. How would you say that people should approach this question?

Kitces: To me the starting point is, it's not enough to just look at what your balance is, hey, I'm at this much money and I kind of think I need this much in the future. You got to run some kind of projections, see if it's actually on track as the growth and the compounding comes. Our brains are not well-built to do exponential compounding math in our head.

Benz: Mine isn't, no.

Kitces: We know how to do straight line things. I know how to do multiplication. But exponential compounding doesn't work well in our brains. You got to have a computer help you out with that. Now, the good news is, there's lots of retirement calculators online. You can find plenty of them on Google. Advisors have a lot of retirement calculator tools as well. Some are a little bit more sophisticated and considering tax issues, some are a little bit simpler. But it gets you to an understanding of not just, what do I have today and how does it compare to this number I'm shooting for, but am I on track, am I on track with the growth that can come in the future?

One of the nice things that exists in almost any retirement calculator tools that are out there is that first thing is you can plug in your projections to see how you are doing to your goal given the dollars that you've got today. The next is, what happens if the returns are a little lower, because we are in a little bit of a lower return environment for bonds, with low yields and for stocks with high valuations. What does this really do to my portfolio? I'm going to have to probably work another year or two.

Benz: And people should arguably be making those adjustments downward in terms of return assumptions rather than looking over the past decade and saying, this is going to continue forever.

Kitces: We actually see this go both ways. We've dialed down our return assumptions for retirement projections that we do. Historically, balanced portfolios see about 8%. We now project them at about 7%. The caveat from the flip side is, I have seen a lot of people that want to do things, bond yields are so low, like I just want to assume that bonds are only going to do a couple of percent for the rest of my retirement. And when we look at the history of markets and we look at the history of bond yields, we have had low bond yields before. We also had high yields sometimes. The numbers move around.

In fact, one of the most fascinating things that you see when you look at bond yields is, they never stay anywhere for very long. They go low, then they go really high, then they go really low, they go really high in cycles. And because of that we actually caution people, yes, we do think it makes sense to dial return projections back a little bit, but don't overdo it. I understand yields are low right now, but they don't stay here forever. And valuations are a little bit high right now, but they don't stay high forever.

There is a difference between recognizing, all right, returns on bonds are probably going to be low for the next five to 10 years because I can look at the five- to 10-year yields and it is what it is. But do I really know what 10-year bonds are going to yield in the late 2020s after the current ones mature as I look out for the subsequent decade and then the decade after that? We really don't have that much information about it, and I think people have to be careful not to push the return assumptions down too much by taking just the recent past and kind of overextrapolating in the future. And we see people go both ways. We have seen a lot of really pessimistic people on bonds because the returns have been so low for the past of years, but that doesn't mean it's going to happen for the next 30. And markets have been up off the market bottom 300% from the bottom nine years ago. That doesn't mean you always get 300% every nine years. You really have to be careful on both ends about taking a long-term perspective for about returns. But we do think it's reasonable to say we're in a lower-return environment, but not necessarily a super low one when you're looking over 30-year time periods.

Benz: Michael, such an important topic. Thank you so much for being here to discuss it with us.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for