What does “fully funded” mean? It means you have enough money to provide the retirement you want to have for the length of time you need it to last.
I talked about this topic in an earlier post though in a more general way. This article points to some of the specific techniques you can use to know the answer to the above question.
It doesn’t give the mathematical detail on how to do it, but simply the direction.
I said mathematical because at its core this is a calculation. As with all calculations forecasting the future, the results are based on your up-front estimates. But calculations can give the impression of an exactness that just isn’t there. The best you can do is make estimates as to the needed inputs and be aware that reality is always different than what can be forecasted. No one can tell the future.
The news is full of reports that most people do not have the finances for an extended retirement. Here is how to know if you do in a probabilistic sense.
The Percent Withdrawal Rate Method
Many financial planners suggest withdrawing a certain percent of your total net worth each year to fund your lifestyle and adjusting that amount based on inflation. This is probably the most common method you will hear about. It is easy to understand. This method was developed by a financial planner decades ago.
The most common withdrawal rate discussed is 4% of your total portfolio. That number was accepted for a while without dispute. But more recently some planners are suggesting it is either too high or too low.
Whether the 4% rate is too high or low depends on the assumptions you use. For example, interest rates and market valuations affect what’s called the “sustainable withdrawal rate.” Also affecting the withdrawal rate is your portfolio asset allocation. Typically, portfolios needing to last longer should have a higher allocation to equities.
For example, the recent ultra-low interest rate period meant that the withdrawal rate should be lower.
Note the 4% method assumes you need your portfolio to last about 30 years or so. Longer than 30 years probably means a lower withdrawal rate.
Annual Expense Multiples
Another simplistic way to determine “fundedness” is to consider your annual living expenses and apply a multiple of that amount to know how much you should have in savings and resources.
The research varies on this, but usually, it suggests you will need between 10 to 20 times your annual spending in financial resources.
From a mathematical perspective, this is really just an inverse of the sustainable withdrawal rate discussed above. The 20x figure is really just saying you can withdraw 4-5% and so on.
Net Present Value (NPV) of Assets and Liabilities
Academicians think this is the most accurate method. It is also probably the hardest to understand and hardest to calculate unless you are trained in finance.
The Net Present Value (NPV) of all your income sources is calculated. This is everything – pensions, interest, dividends, Social Security, hard asset liquidation. Do the same thing for liabilities. All of your expenses including housing, healthcare, vacations – everything. Then compare the two.
The NPV of assets should be higher than liabilities. If the NPV of your assets is greater than the NPV of your liabilities you are in good shape.
Very briefly, an NPV is the present value of a stream of cash flows discounted from the future back to the present at some rate called a “discount rate.” Frankly, this is somewhat complicated. Figuring out a good discount rate is probably the hardest part.
If you are interested, I suggest you look up how to do this on the internet for more detail. But better yet, hire a professional.
Monte Carlo Simulators
This is my personal favorite method. Except for reliance on probabilities, it has nothing to do with a casino (but does remind me of when I was kicked out of the real Monte Carlo Casino in Monaco when I was in college but that is a different story altogether).
A Monte Carlo simulation is a mathematical model that simulates the various possible returns of a portfolio based on its allocation to stocks, bonds, and cash (usually just those three asset classes are considered). The possible portfolio returns are calculated based on the historical performance of those asset classes and probabilities of returns are calculated. This is a range of returns – expressed as probabilities -rather than one definite figure.
The model then compares those returns with your estimated expenses to calculate the likelihood of your money lasting for different time periods. The result is a percent likelihood of your portfolio “surviving” the length of your estimated retirement.
Planners often say a 90% or better portfolio survivability rate is good. I prefer higher than that. Who wants to be 95 years old and in good health (it can happen!) and seeing your money running out.
The major investment firms usually offer some version of a Monte Carlo simulator on their website for use by consumers (most of us). There are commercially available simulators you can buy also. I will not recommend any specific one but suggest you try a couple and compare the results.
These calculators can be something of a “black box” calculation and you don’t know the rigor and validity of the programming-math behind them. So use several. The results should be similar.
Most importantly, work with someone who is familiar with the concepts in this article. My colleagues and I strongly recommend this.
Pay Attention to The Research but Know Its Limits
To be as objective as possible, I like to base my discussions and opinions on verifiable research. While research is sometimes contradictory and often just plain wrong, it is the best we have. But know it can be wrong.
Based on the research – it isn’t unanimous – the evidence indicates that retiring can make you healthier and more happy. A good example of this is a paper published by the National Bureau of Economic Research in 2015. It said there was strong evidence that retirement provides these effects.
So while we all love our work, retirement is a goal that most of us should eventually aspire to.
Finally, I extremely and strongly suggest that you do not do this alone, but rather work with a financial planner that is familiar with these concepts.
