Webinar Preview: Innovations in Retirement Income Planning Hot

My webinar on January 17 will focus on explaining developments related to these techniques as it relates to my role as Chief Financial Planning Scientist at inStream Solutions.

Funded Ratio

Funded ratio analysis allows advisors and clients to see a snapshot at a given point in time about whether the assets on the household balance sheet (including human and social capital, as well as financial capital) are sufficient to cover the client’s lifetime liabilities. This approach brings institutional pension fund management to the household level, and it has been popularized by the Retirement Income Industry Association. Based on the trajectory of cash flows related to a lifetime of income and expenses, discounted at an appropriate rate, advisors can immediately determine their client’s funded ratio. This provides instant knowledge about whether the lifetime financial plan, as determined from a specific point in time, is overfunded, underfunded, or looks to be on track.

Though today’s funded ratio is calculated without use of Monte Carlo simulations, the funded ratio can also be projected forward with Monte Carlo simulations in order to see a 10-year look ahead. This provides a distribution of funded ratios for the client. Clients who are currently overfunded, but who are using more aggressive investment portfolios, will experience a greater dispersion in outcomes and a higher probability of seeing their funded status move from over- to underfunded. This aspect of the funded ratio analysis can alert advisors and clients to the possibility that in overfunded states, it may be appropriate to lock-in gains and reduce the likelihood of witnessing that unfortunate transformation to an underfunded status through portfolio losses.

Distribution Management

Distribution management can be used to answer two basic questions for clients: (1) For those who’ve planned a budget, what is the sustainability for the plan? and (2)For those without a budget, what is the most that can be spent on a sustainable basis?

As well, distribution management must move beyond simply assuming clients will spend a constant inflation-adjusted amount from their portfolios. Early research by William Bengen, Jonathan Guyton, and others illustrated that for those who are willing to build flexibility into their plans to reduce spending if the markets perform poorly, it is possible to begin retirement with a higher withdrawal rate.

I will describe various rules which advisors can use to frame retirement income strategies with their clients. These involve determining when inflation adjustments for spending are appropriate, how to set bounds on what percentage of remaining assets still imply a sustainable strategy, and the impact of incorporating constraints on spending fluctuations through the use of hard dollar ceilings and floors on spending.

Safe Savings Rates

Related to the distribution management strategy, clients in the pre-retirement phase may wish to determine what savings rate should be used in order to have a high chance to meet one’s retirement spending goal. This matter can be addressed through an investigation of the “safe savings rate” for a client, related to research published in the Journal of Financial Planning in 2011.

This approach is more sophisticated than traditional methods of assuming an asset return and a savings rate needed to target a wealth accumulation level that allows the retirement spending goal to be met using a “safe withdrawal rate.”

The reality is that when holding a portfolio of volatile financial assets, it is very difficult to know whether one is on track to meeting a wealth accumulation target, because the returns experienced in the final years before retirement have a disproportionate impact on the final wealth accumulation. This is the case whenever households contribute new savings throughout their careers. The point is lost in static analyses which assume a fixed rate of return compounded to investments over time.

Safe savings rates removes the need to worry about achieving a wealth accumulation target that will correspond to a safe withdrawal rate, because it considers the planning problem as an integrated whole for both pre- and post-retirement. Conceptually, safe savings rates works as an inverse of the maximum distribution module in post-retirement, helping clients to know whether they are on track to meet their goals.

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the new Ph.D. program in financial services and retirement planning at the American College in Bryn Mawr, PA. He is also the lead financial planning scientist for inStream Solutions. He actively blogs about retirement research. See his Google+ profile for more information.