In
Episode 211 of their Retire with Style podcast series, Dr. Wade Pfau and
Alex Murguia discuss the importance of using present values in
financial planning for retirement. They conclude their podcast by
saying that present values are “the heart and soul of retirement
financial planning calculations,” and “It only took us 200+ episodes to
get to the heart of the matter.” We agree. Our
Actuarial Financial Planner (AFP) workbook is entirely consistent with
the math discussed by Dr. Pfau and Mr. Murguia in their podcast. Yes,
we call the present value of assets divided by the present value of
spending liabilities the household’s “Funded Status” and they call
theirs the “Funded Ratio”, and, so far, theirs only uses one discount
rate to calculate present values, but the present value concepts are the
same.The AFP uses different discount rates to calculate risk-adjusted discounted cash flows.
Expenses that are identified as 100% “Essential” and asset cash flows
that are identified as 0% “Upside” (or non-risky) are discounted using
the expected return assumption on Floor Portfolio assets. Expenses that
are identified as 0% “Essential” and asset cash flows that are
identified as 100% Upside are discounted using the expected return
assumption on Upside Portfolio assets. Expenses and future cash
flows that are identified by the user as being partially Essential and
partially Discretionary (for example, asset cash flows that are
identified as 75% Upside and 25% Floor) are discounted using a discount
rate developed by taking 75% of the expected return on Upside Portfolio
assets and 25% of the expected return on Floor Portfolio assets.In
our opinion, the use of the risk-adjusted cash flows is far superior to
simply assuming a risk-free investment return rate and associated
discount rate on all assets and spending liabilities which Dr. Pfau’s
model assumes to develop his Funded Ratio.But, thanks to Dr. Pfau
and Mr. Murguia for noting that the basic actuarial concept of present
values is the heart and soul of retirement financial planning
calculations.
