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I find the “liability matching” concept as outlined in Dr. Wad Pfau’s “Funded Ratio” helpful based on our household-specific inputs I provide. This analysis, while based on different inputs than those of Monte Carlo simulation, has given me another way to project whether we expect to have adequate financial resources for the remainder of mine and my spouse’s life.
I have used Mike Piper’s simplified funded ratio example spreadsheet to “run the numbers” using the following inputs for each year of our expected life spans:
| 1) Select a conservative, real (after-inflation) discount rate, such as the yield on 10-year TIPS. | |||||||
| 2) Enter current portfolio value. | |||||||
| 3) Enter income and expense values in “real” terms as well (i.e. today’s dollars). | |||||||
| 4) The income column should not include income from the portfolio (i.e., dividends/interest). It should only include work income, Social Security, pension, etc. | |||||||
| 5) The expense column should include all discretionary and non-discretionary expenses, including taxes. | |||||||
| 6) Be sure to extend the calculation to a year that is beyond your life expectancy. What have been the strengths and weakness of any of your experiences using the “funded ratio” projection? How does it compare to the Monte Carlo simulation in regards to getting to the same destination- better certainty about a successfully financed life span(s)? Does one do a better job at forecasting success at a more personalized level?
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Funded ratio is what we used to evaluate the health of a pension plan. Total assets relative to total projected liability. Federal law requires minimum 80% to avoid penalties.
I used both tools.
I use funded ratio to understand if I am on track and if I need to adjust spending or derisk my overall portfolio. It’s more like a balance sheet analysis.
i use Monte Carlo to predict whether I will run out of money under a variety of return and inflation expectations.
Does a funded ratio of 100% correspond to a Monte Carlo success rate of 50%?
Randy, interesting question. Are you thinking that the funded ratio uses mean values of the input variables? My stats are a bit rusty – I’d have to think about this.
Wasn’t thinking about that, Rick, just that I’d want a funded ratio higher than 100%.
Bill, Thanks for the post and references. I hadn’t thought about this concept in a while, and had never played with the spreadsheet.
Rick, I would especially be grateful to know what your perspective is on this concept as it applies to personal finance given the experiences you have shared that have been valuable to me. My understanding that this concept is what is used in the pension and insurance industries.
Bill, I appreciate your kind words. I have a tremendous respect for Mike Piper and Wade Pfau. I have no doubt they have forgotten more about finances and retirement planning than I could ever hope to know.
Our pension puts out a yearly funding notice that provides 2 versions of their funded ratio, based on different rate assumptions. In a recent year the funded ratio varied from 85% to 105%. This highlights the need to think about the chosen discount rate, and how conservative you want to be. I’ve always liked to see a positive year-over-year growth in the asset column, it makes me feel better.
Monte Carlo is a useful tool, but it requires the user to be comfortable with some notions of probability and statistics. Whatever method one uses, I like to understand what the assumptions are and how conservative they are, and to see a margin of safety in the result.
Rick, In re: “I like to understand what the assumptions are and how conservative they are, and to see a margin of safety in the result.” I have found that toggling the discount rate down even lower than the current 10-year TIPS yield has helped me feel even better about my “projected balance sheet”… especially when I have set my mortal demise at the avg. 84yr life span, and my 6.5-yr younger spouse spouse moving to SS survivor benefits, living to 100, and spending 100K/yr (today’s $) in long term care for her last 20 yrs.
Sounds like you have a sound grasp on the analysis.