Fundedness: Do You Need a Goals-Based or an Investment-Based Plan?

FUNDEDNESS: SHOULD YOU USE AN INVESTMENT-BASED OR A GOALS-BASED PLAN?

Sometimes we talk too much about theory and lose touch with the everyday reality of what lifecycle financial planning is about. It’s a fair question for someone to ask, “What is a financial plan, and why do I need one? I think I know what stocks and bonds are and that I probably should be invested in some combination of them, but how do I figure out how to split it up? ”

If you go to a financial advisor, most will provide you with an investment allocation of stocks and bonds that they determine to be suitable for you, usually based on your “risk tolerance.” That’s an investment plan, not a financial plan. They provide an investment plan and sell you some investment products because that’s the business they are in—they earn their money from managing and selling investment services and products, not from planning.

Goals-Based Planning is Different
A lifecycle financial plan is different. A lifecycle or goals-based planner isn’t trying to set you up with an investment plan and some investment products. The planner is looking for the smoothest path through life that will get you—successfully—to your goals. A lifecycle planner does not rely on “risk tolerance,” market forecasts and timing, investment horizons, or rules of thumb for planning—these methods are too unreliable. Instead, the planner will use your financial resources, the simple math of cash flow, and the time value of money to construct your path into the future.

A goals-based plan starts with your priorities and goals, not your investment portfolio. The planner evaluates your household earning potential (human capital), savings (financial capital), and your other resources (social capital). Then the planner looks at your current and expected future income and expenses, and your household risk exposures, which are much broader than the market risk an investment plan considers with its mix of stocks and bonds, but which can significantly impact your ability reach your goals.

It all comes together in a personal household balance sheet and a projected lifetime cash flow. The result is a lifetime or retirement policy statement, depending on your age, summarized as a lifetime (or retirement) policy allocation for upside/floor/longevity/reserves. This allocation isn’t an investment plan. It comes straight from your balance sheet, not from an army of stock analysts. It’s a goals-based plan to manage the risks that threaten your lifestyle and could stop you from reaching your goals.

Here’s How This Works in Real Life
Let’s look at an example. Let’s say you and your spouse are 60 years old, in the pre-retirement red zone, and your household income is $195,000. You plan to retire at age 66 (Social Security full retirement age). You have $700,000 in after-tax, tax-deferred and tax-free retirement savings. You owe about $90,000 on your house, which is worth about $500,000. You watch your expenses closely and save about $25,000 a year, so your annual expenses, including taxes, are about $170,000.

As you enter retirement, in this example, your expenses are expected to drop to about $117,000 a year, including taxes and after inflation. The drop includes about $30,000 saved from no payroll and lower income taxes, $25,000 you’ll no longer be saving in an after-tax account, some cost cutting on items such as clothes and auto expenses, but with some add-back from inflation over the next six years.

By building up your after-tax savings in these last few years before retirement, you’ll be lowering the taxes you will need to pay on your withdrawals, at least until age 70 when taxable Required Minimum Distributions start forcing you to draw down your tax-deferred accounts. This is important because in retirement, taxes are an expense like any other expense that you have to pay from savings—there’s no magic “after-tax” paycheck in retirement.

Your estimated household Social Security benefit will be about $65,000 at age 70, with both of you claiming at full retirement age, but with no deferred credits, which is an option for increasing the household annual benefit (claiming strategy, which can have a significant impact on your plan, is a topic for another time). So net of Social Security, you will need about $52,000 a year from savings to cover your expenses.

There are a few other things we look at as we get deeper into the plan such as household risk exposures (another topic for another time), but this is enough to get a sense of your “fundedness” and a first look at your household balance sheet.

Fundedness Sets the Planning Stage
Fundedness is the ratio of your savings to your uncovered annual expenses at retirement (this is the amount of your expenses not covered by guaranteed income such as Social Security and pensions). In this case, even with the expected growth of your $750,000 savings to about $1,224,000 over the next six years from additional savings and appreciation, your fundedness ratio is 4.3% ($52,250/$1,223,600), which is in the middle of the constrained range.

Here’s how this looks in R-MAP Planner, which automatically calculates fundedness from your financial input:

Even with savings at retirement over $1,200,000, constrained fundedness indicates that you should use a goals-based and not an investment-based method for building a secure retirement plan. The investment-based method the typical financial advisor provides works best for high-net worth households who are over-funded with fundedness less than 3.5%. The over-funded have enough cushion in their portfolio that they can endure losses in the market without those losses impacting their lifestyle. Those who are constrained do not.

Once you begin making withdrawals for retirement income, you are no longer in Buy-And-Hold, Kansas. When you sell equities at a loss in a downturn for income in retirement, you are permanently impairing your capital, locking in your losses. This is called sequence-of-returns risk, which is a fancy name for eating your capital for lunch, and then having trouble paying for dinner.

Fundedness, not “risk tolerance,” tells us whether you should be embracing investment-based or goals-based planning.

With a fundedness ratio above 3.5%, you need to be wary of market risk. So how much risk is too much? This is where your household balance sheet comes in, and what distinguishes a goals-based lifecycle financial plan from investment-based or product-based plans.

In this case, your household balance sheet at retirement (automatically calculated from R-MAP, below) shows a cushion of about $535,000 (your cushion is the difference between the present value of all of your assets and liabilities).

R-MAP subtracts the present value of SS and pensions from the present value of all of your future retirement expenses (liabilities), to determine your income floor—$688,000. The floor is the amount of your capital that is needed to pay your uncovered expenses throughout retirement.

From your $1,223,600 in savings (financial capital), we’ve also set aside 8% for reserves (about $100,000), for shocks that can’t be insured, hedged, or avoided.

The rest of your savings, minus the reserves—$437,000—is upside (1,223,600 – 688,000 floor – 97,800 reserves = 437,000 upside).

R-MAP summarizes this as your policy allocation of 35%/57%/0%/8% for upside/floor/longevity/reserves.

Now We Know How Much Risk is Too Much
Now we have an answer for the question, how do I figure out how much to split between stocks and bonds? How much risk is too much for me?

Your income floor of $688,000 needs to be safely invested in risk-free or guaranteed income like government bonds, CDs and income annuities, to protect your lifestyle throughout retirement. Reserves are held in cash.

The upside allocation is the only part of your savings that you can safely expose to market risk without jeopardizing your retirement goals. In this case, that’s 35% or $437,000. If you are constrained, you can’t afford to take any more risk than that, no matter how enticing the investment-based plan sounds, without playing dice with the rest of your life.

When it comes to your future, bet on your balance sheet. That’s the goals-based difference.

—Michael Lonier, RMA℠

Visit www.rmap-planner.com to check out my goals-based planning software!

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Michael Lonier, RMA℠ is a Ramsey-based lifetime financial planner and retirement income specialist. Email him for more information at mlonier@lonierfinancial.com  On the web atwww.LonierFinancial.com