Support Grows for Using “Funded Status” Rather Than “Probability of Success” as the Key Metric for Measuring Financial Health in Retirement

This post is a follow-up to our post of February 13, 2025, How to Improve Decumulation Planning. Subsequent to that post, we received our copy of Retirement Planning Guidebook, by the preeminent retirement researcher, Dr. Wade Pfau.In his book, Dr Pfau outlines his key steps for quantifying spendings goals and measuring financial health in retirement:“Build
a retirement balance sheet by collating household finances and
determining all assets and liabilities, including the present value for
income and expenses that happen in the futureChoose a planning
age and conservative discount rate to apply to the funded ratio [ or
status] calculations, and then calculate the funded ratio.If
the plan is underfunded, take initial steps to determine a course of
action to improve comfort that one has a reasonably funded plan.”Each
year, Dr. Pfau recommends updating your funded ratio analysis and
considering any planning adjustments based on the funded ratio update.
According to Dr. Pfau,“I hold the view that the funded ratio
method is good enough for most situations. Once you have made the effort
to estimate your budget, your Social Security strategy, your collection
of assets and liabilities, and a way to estimate taxes, then a simple
spreadsheet to calculate the relevant present values to create a funded
ratio tells you what you need. There is not much need to also worry
about Monte Carlo simulations and the probability of plan success.”We, of course, agree with Dr. Pfau as his recommended approach is essentially the same as the 3M process we advocate:Actuarial Approach–Three Key Planning StepsMeasure your Funded Status (assets/liabilities) at the beginning of each yearMonitor your Funded Status from year to year, andManage your spending, assets and risks in retirement as necessary Back in 2018-19, when I was reviewing the Society of Actuaries Viability of the Spend Safely in Retirement Strategy
authored by Dr. Pfau, Steve Vernon and Joe Tomlinson, I argued that the
Actuarial Approach was superior to the IRS Required Minimum
Distribution withdraw strategy touted by the authors. The authors
humored me by including the following section in their publication:“7.1
Actuarial methods A more sophisticated and complex method for retirees
to develop a retirement income strategy is to use an actuarial method.
Such a method would solve for regular withdrawals from savings by
equating the present value of future retirement income from all sources,
including Social Security and pensions, to the present value of future
living expenses from all sources. Such a method would require making a
number of actuarial assumptions, including expected longevity of the
retiree (and spouse/partner), the time value of money, expected return
on assets, expected inflation on living expenses, expected benefits from
other sources, such as Social Security and earned income, etc.
Actuarial methods could use either deterministic forecasts that develop
one set of results, or stochastic forecasts that develop a range of
possible results with associated probabilities of occurrence (calculated
in accordance with the assumptions for capital market returns and
inflation). An actuarial method could use an asset smoothing method that
would enable the retiree to remain significantly invested in equities,
while reducing the volatility in the pattern of annual withdrawals. An
actuarial method would periodically adjust the withdrawal amounts to
reflect gains and losses that have occurred since the previous
valuation. An actuarial method could be a more sophisticated way to
address uneven living expenditures and temporary income amounts, as
addressed in Sections 6.1 and 6.2. The tradeoff between the SSiRS and an
actuarial method is simplicity/ease of use vs. more sophisticated
treatment of the retiree’s goals and circumstances. Use of an actuarial
method will either require retirees who are willing and able to prepare
the calculations on their own, or work with financial advisers who are
familiar with actuarial methods. Retirees with significant amounts of
retirement savings and/or complex planning objectives and circumstances
might appreciate the additional robustness of an actuarial method. For
more details on one application of an actuarial method and a calculator
to help implement such a method, see the website
http://howmuchcaniaffordtospendinretirement.blogspot.com. “Apparently,
Dr. Pfau has become an actuarial approach convert, now recognizing that
the more sophisticated treatment of a retiree’s goals and circumstances
inherent in the Actuarial Approach outweighs the simplicity of the RMD
withdrawals anticipated in the Spend Safely in Retirement Strategy. According
to Dr. Pfau, only a simple spreadsheet is required to convert future
household asset and expense flows into present values for the household
balance sheet. As suggested above, for those households and financial
advisors who are looking for “a calculator to help implement such a
method”, you might want to try the spreadsheets in our website. Unlike
Dr. Pfau’s more simplified approach, our Actuarial Financial Planner
(AFP) calculators:Use two discount rates: One for the Floor
Portfolio assets and spending liabilities and one for the Upside
Portfolio assets and spending liabilitiesLet the user match assets and liabilities by riskLet the user assess risks by changing assumptionsLet the user distinguish between recurring and non-recurring expensesProvide default assumptions but let the user change themProvide
separate longevity planning assumptions for members of the household
and a decrease in recurring expenses assumption upon the first death
within a couple (married couples)Provide the opportunity to have different rates of future increases (or decreases) for future expenses or income flowsSummaryFor
those households and financial planners who are dissatisfied with their
current assessment of financial health process and want to know how
much they (or their clients) can afford to spend in retirement, we
strongly encourage you to select a different metric: the household
Funded Status.The beauty of the Funded Status metric 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. Monitoring these losses or gains over time will be
valuable in determining when adjustments in spending or assets may be
required.