– Jeremy SiegelThat TIAA-CREF example reinforces the need for goal- or liability-driven investing. …Regarding the example, it is important to decide whether the pot is a savings account or a retirement account. It is hard to have two different goals because they conflict. One calls for having principal stability, which is a Treasury bill. The other calls for standard-of-living and income stability, which is a long-term bond. You cannot have both.
If you get clients to focus on rates of return and asset mixes, it is likely to be the wrong approach. You should get people to determine their goals instead of asking them how much they want to put in real estate.
Everyone in this room knows what people want for retirement. It is an income. Social security gives an income. DB plans give an income. In DC plans, for some reason, we do not show people the funded ratio. We are showing them the wrong thing, and then we are saying they are making the wrong decisions. We are telling people that risk is the value of their fund, when risk is really how much income they can sustain for retirement.
– Robert MertonThe funded ratio is a better indication of success than the account balance. In contrast to generic asset allocation strategies, use a dynamic approach with customization according to age, income, gender, and the funded ratio. The focus should be on improving the funded ratio while managing income volatility.
EDIT: Here are links to the 2nd & 3rd posts on the funded ratio.
Part 2 - Using the Funded Ratio to determine your asset allocation
Link - viewtopic.php?f=10&t=220261&p=3392084&h ... k#p3392084
Part 3 - The Funded Ratio over the Life-Cycle
Link - viewtopic.php?f=10&t=220489&newpost=3396421
The funded ratio (FR) is a metric that can be used to monitor your retirement investment plan. The FR tells you how much of your retirement income goal you can purchase today. It is simply the ratio of your assets to your liabilities, where the assets are the size of your portfolio and the liabilities are the present value (PV) of your targeted retirement income stream. A relatively easy and straightforward way to estimate the PV of the liabilities in the denominator is to price a deferred real life annuity that has payouts that match your targeted retirement income and begins payments in your expected retirement year. For example, you want to withdrawal $30,000/year ($2,500/month) from your portfolio. Before retirement price a deferred real life annuity that pays out $2,500/month beginning on your expected retirement date. In retirement price an immediate real life annuity for the same $2,500/month payout.*
One additional step needs to be taken before retirement. Deferred real life annuities do not adjust for inflation before the payouts begin. That means you need to estimate inflation between now and the retirement date and adjust the real income target by that amount. For example, if you are ten years from retirement and you estimate cumulative inflation over the next ten years to be 20%, you need to raise the income target in the annuity price by 20%. I would use the break-even inflation rate calculated from the Treasury-TIPS spread for the inflation estimate. The difference between the yield on a nominal Treasury and the real yield on a TIPS bond is the break-even inflation rate. For the above example, you would use the break-even rate between 10 year nominals and TIPS. The yields on nominal Treasuries and TIPS can be found here.
Link - http://www.zvibodie.com/marketindicatorsview
You would like the funded ratio to be 1.00 or more at retirement. Ideally it would be between 1.10 and 1.25. Values above 1.10 suggest your portfolio should contain few risky assets as you can meet your income goal without taking on much risk. Values above 1.25 suggest there is a mismatch between your assets and your income goal. Before retirement you want to track the funded ratio over time and hopefully it is consistently rising towards 1.00. If the funded ratio is not approaching 1.00, the investor needs to save more, retire later, or consider income from home equity or income in late retirement from a longevity annuity. The other alternatives are to lower the income goal, or take more equity risk and live with the consequences of being even worse off if the risk materializes.
Note, however, that a funded ratio between 0.92 and 0.99 at retirement would hardly be earth-shattering. We are only looking at the income that would be derived from the portfolio. For most people over 35% of retirement income will come from Social Security and/or pensions. So a funded ratio of 0.93 for the portfolio would translate to a funded ratio of about 0.96 overall when including pensionized income. That would be 4% below the overall aspirational income goal, but likely well above the investor's minimally acceptable floor income goal.
FR = portfolio/PV(liabilities) = portfolio/price of deferred real life annuity
FR = portfolio/price of immediate real life annuity
But, as the above quotes suggest, the funded ratio can not only be used to monitor your progress, but also to drive the entire retirement investment process, including amount of future savings for retirement, age of retirement, and the asset allocation of the portfolio. As such the funded ratio is a core feature of many liability driven investment (LDI) retirement strategies. (LDI strategies are goal based investment strategies that seek to maximize the probability of reaching a financial goal. Often an LDI strategy is implemented by focusing on duration matching assets to future liabilities.)
The following are factors and techniques used in developing an LDI retirement investment strategy.
- Income goals, both aspirational and floor
- Portion of human capital assigned to retirement income, i.e. future contributions to retirement portfolio
- Funded Ratio [assets/(PV)liabilities]
- Price of real life annuity
- Duration matching of income goals (liabilities) to real bond funds or real bonds
- Rebalance equity with contributions
- Monte Carlo analysis
- Writing covered calls and/or buying protective puts on the equity portion of portfolio
Developing the portfolio
Keep the number of assets in the portfolio low, typically three or four assets. While you could add additional equity asset class funds or ETFs to gain additional exposure to sub-equity asset classes with slightly higher historical returns, the additional risk and complexity adds little to solving the problem of reaching your retirement income goal.
Use two equity funds, a broad based US stock index fund, and an international stock index fund. Decide on the ratio of US to international exposure you want (say 70/30), and keep that equity ratio constant, regardless of the proportion of equity in the portfolio. Instead of these two equity funds you could instead use only the US fund or simply a global index fund.
For bond exposure in the early years use a nominal LT US or global bond fund. Once you are within about twenty years of your retirement date, replace the nominal bond fund with a LT TIPS fund and later add a ST TIPS fund. You could replace the TIPS bond funds with a TIPS bond ladder. Assuming the duration of the ladder and the funds is the same; then in that case these two methods of providing safe income are equivalent.
During the early years the portfolio is heavily weighted toward stocks, typically 85% to 95% equity. Not because stocks are safe in the long-run (they are not), but because so much of your wealth when you are a young investor consists of relatively safe human capital. In this case the relevant human capital consists of future contributions to your retirement plans by both you and your employer. The present value of these future contributions to your DC plan, IRA, and other personal savings for most investors under 35 dwarfs the retirement portfolio balance. Beyond age 35 the proportion of the portfolio dedicated to stocks begins to decline, as the ratio of portfolio wealth to human capital rises.
Twenty years from retirement you replace the nominal bond fund with a LT TIPS bond fund. When you are about fifteen years from retirement you add the ST TIPS fund, and match the average duration of the two TIPS funds to the duration of the retirement income goal, the liability. (In this case, you are literally matching the duration of the TIPS to the duration of a life annuity that begins payouts at retirement.) The more duration matched TIPS assets you have in the portfolio, the more safe income the portfolio can generate. If nearing retirement the funded ratio was 1.00, then in that case an all TIPS portfolio could be counted on with probability of about 98% of providing the funded ratio level of safe retirement income. This could be done by either purchasing an immediate real life annuity for the aspirational level of income at retirement, or using withdrawals for that amount of income from the TIPS assets until life expectancy, and purchasing a longevity annuity for that amount to begin payouts at life expectancy. In other words, the LDI strategy has done its work of hitting the income goal with high probability.
Following this strategy it is unlikely that you would have more than about 25% of your portfolio dedicated to equities, once you are near or in retirement. Even if you don’t want all your aspirational level of retirement income to be safe, the level of safe TIPS assets should at least cover your targeted floor level of income as you near retirement. This would be the case if you are willing to fall somewhat short of the aspirational income goal in return for having a good shot at surpassing it.
When planning for retirement what’s important is meeting your income goals. This means that the investor should be focused on income for retirement, not growth in the account balance. Likewise, the risk is income shortfall, not portfolio volatility. Therefore, the account balance and its standard deviation are the wrong metrics for determining retirement planning success. What matters is the funded ratio, both in terms of hitting the income goal and measuring its potential shortfall.
Link to previous funded ratio thread - viewtopic.php?f=2&t=205824
In the above thread I began by using a present value calculation based on LT interest rates to determine the present value of the income stream. I now believe using deferred life annuity pricing to be at least as accurate and replaces the TVM calculations with simply getting an annuity price online.
Links to articles about Funded Ratio -
Retirement Security In a Single Number – Eleanor Laise, Kiplinger
http://www.kiplinger.com/article/retire ... umber.html
3600 Retirement Planning – Morgan Stanley
https://www.morganstanleyfa.com/public/ ... 6134f8.pdf
Tips to Manage Spending in Retirement – Paul Sullivan, New York Times
https://www.nytimes.com/2014/04/12/your ... .html?_r=1
Funded Ratio: What is it and what’s yours? – Russell Investments
https://russellinvestments.com/-/media/ ... -ratio.pdf
Funded ratio should replace account balances as the priority - Robert Merton, Benefits Canada’s Defined Contribution Plan Summit in Vancouver
http://www.benefitscanada.com/wp-conten ... Update.pdf
In a later post I give an example of how to use the funded ratio to derive over time a dynamic asset allocation that maximizes the probability of reaching your retirement income goal.
* Edit - I've been asked down thread to add to this original post where you can price real (inflation-adjusted) life annuities on the internet. Here's where I go to price real life annuities.
The website is immediateannuities.com and you need to use their 'advanced' calculator to get a real (inflation-adjusted) life annuity quote. The link I provide takes you to the 'advanced' calculator page. But even when using the 'advanced' calculator you have to click the "Show More Annuity Options" box on the 2nd page to select the real life annuity option.
Link: https://www.immediateannuities.com/annu ... rs/?sce=hc