## Funded Ratio Offers a Glimmer of Hope in 2022

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Topic Author
Horton
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### Funded Ratio Offers a Glimmer of Hope in 2022

BobK has been a long proponent of using the funded ratio for retirement planning. 2022 has been a tough year for bonds and stocks alike. The Vanguard LifeStrategy Conservative Growth Fund (VSCGX) is down about 17% YTD as of today. On the surface, it seems like this would be a significant blow to a 65-year old retiree, but let's see what the funded ratio says.

First, let's use BobK's funded ratio definition:
bobcat2 wrote: Sun May 28, 2017 9:52 am FR = portfolio/PV(liabilities)
The value of the portfolio is straight forward. The value of the liabilities is debatable, particularly the discount rate used to determine the liabilities. For the sake of illustration, I'm going to use the Daily Treasury Par Real Yield Curve Rates to determine the liability because they represent the risk-free real interest rates.

Now for the scenario. Let's assume we have a retiree who is 65 years old on Dec. 31, 2021 who needs \$40K / year in real income until age 95. The present value of these cash flows is the liability. The real yield curve rates on Dec. 31, 2021 were:

Code: Select all

``````Date 			5 YR	7 YR 	10 YR 	20 YR 	30 YR
12/31/2021 		-1.61	-1.31 	-1.04 	-0.63 	-0.44
``````
This would make the liability roughly \$1.4M. (Note: there's some variation in the amount depending on the calculation method used, but for the sake of illustration it should not matter much.)

Let's assume the funded ratio on Dec. 31, 2021 was 100%, so the retiree had \$1.4M in the Vanguard LifeStrategy Conservative Growth Fund.

So, at Dec. 31, 2021:

Code: Select all

``````Assets		\$1.4M
Liabilities	\$1.4M
Funded Ratio	100%
``````
Now, let's jump ahead to yesterday (Nov. 18, 2022). Real yield rates are significantly higher:

Code: Select all

``````Date 			5 YR	7 YR 	10 YR 	20 YR 	30 YR
11/18/2021 		1.71	1.63 	1.57 	1.59 	1.63
``````
As a result, our liability is much lower - approximately \$0.9M.

As noted above, the Vanguard LifeStrategy Conservative Growth Fund has lost about 17% YTD, so we have \$1.1M in assets.

However, the retiree's funded ratio is now approximately 120% - 20% higher than the beginning of year!

Code: Select all

``````Assets		\$1.1M
Liabilities	\$0.9M
Funded Ratio	120%
``````
In conclusion, it's important to recognize that interest rate changes impact not only the value of our portfolios but also the present value of our future spending.

=============

Edit: Watty noticed a gap in the calculations below. When determining the liability at Nov. 18, 2022 we need to adjust for inflation that has occurred during 2022. Here are the updated results after this adjustment:

Code: Select all

``````Assets		\$1.1M
Liabilities	\$1.0M
Funded Ratio	110%
``````
The retiree's funded ratio is now approximately 110% - 10% higher than the beginning of year!
Last edited by Horton on Mon Nov 21, 2022 12:54 pm, edited 2 times in total.
White Coat Investor
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Interesting concept. Low interest rates are definitely not awesome for savers/investors and this really illustrates that.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
Robin1234
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Sat Nov 19, 2022 3:20 pm
Now for the scenario. Let's assume we have a retiree who is 65 years old on Dec. 31, 2021 who needs \$40K / year in real income until age 95. The present value of these cash flows is the liability. The real yield curve rates on Dec. 31, 2021 were:

Code: Select all

``````Date 			5 YR	7 YR 	10 YR 	20 YR 	30 YR
12/31/2021 		-1.61	-1.31 	-1.04 	-0.63 	-0.44
``````
This would make the liability roughly \$1.4M. (Note: there's some variation in the amount depending on the calculation method used, but for the sake of illustration it should not matter much.)
Found this very interesting. Can someone point me to, or explain - how to use the above information, to arrive at \$1.4M?
So far the way I have been thinking about this using the 4% rule, \$1M would yield 40K, \$1.4 will yield \$56K approximately.
I wonder if the above is a more exact/precise way to look at it?

https://www.investopedia.com/terms/y/yieldcurve.asp
https://home.treasury.gov/resource-cent ... nth=202211
Topic Author
Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Robin1234 wrote: Sat Nov 19, 2022 10:41 pm Found this very interesting. Can someone point me to, or explain - how to use the above information, to arrive at \$1.4M?
So far the way I have been thinking about this using the 4% rule, \$1M would yield 40K, \$1.4 will yield \$56K approximately.
I wonder if the above is a more exact/precise way to look at it?

https://www.investopedia.com/terms/y/yieldcurve.asp
https://home.treasury.gov/resource-cent ... nth=202211
This spreadsheet will calculate the present value of a specified stream of cash flows and interest rates:

https://www.flexibleretirementplanner.c ... uilder.xls

Update the cells as follows:

- D7: \$40,000
- D8: 30
- I8:M8: Daily Treasury Par Real Yield Curve Rates [I used the 5 yr rate for the 1 yr input.]

It uses a slightly different methodology than my calculations, but I just input the amounts and its within \$20K.

Hope that helps!
Robin1234
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Also during the day I wondered about it. It seems to me, this is analogous to a loan, paid off in \$40,000 equal installments over 30 years. Not exactly, but good enough for an estimation exercise.

Sort of like - I deposit \$1.4M with a friend, and the friend promises to pay me, \$40K a year, for 30 years. Which is what I need in my retirement.

Thus in excel if I use PMT(rate, nper, pv)
and plug in:
rate is the interest rate = 1.63%
nper is the number of periods = 30 years
pv is the present value = \$0.95M

I get \$40,290.04 which is \$40K approx.

Similarly if I plug in:
rate = -0.44%
nper = 30
pv = \$1.3M

again I get \$40,440.97 which is \$40K approx.

So in essence \$1.3M when 30 year interest rate is -0.44%, is approximately equal in value to \$0.95M when 30 year interest rate is 1.63% [Edit: Corrected the rates in this sentence]

Unlike the spreadsheet my method is tedious because you need to keep experimenting with different values for pv until you get a close enough match. But it is helpful in understanding the principle behind this idea.
Last edited by Robin1234 on Mon Nov 21, 2022 4:07 am, edited 1 time in total.
Topic Author
Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Robin1234 wrote: Sun Nov 20, 2022 5:03 pm Unlike the spreadsheet my method is tedious because you need to keep experimenting with different values for pv until you get a close enough match. But it is helpful in understanding the principle behind this idea.
Your method is a good approximation actually. To make it more simple and efficient you could use a specific point on the real yield curve (e.g., 20 years) rather than backing into a rate.
Topic Author
Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

The funded ratio actually offers more than a "glimmer" of hope. Our example retiree's funded ratio would be the same or better with just about any investment holdings at the beginning of the year.

Code: Select all

``````Investment		Funded Ratio
VG Wellesley		120%
VG Target Ret Inc	115%
VG Total Bond (BND)	115%
VG Wellington		115%
VG Balanced Index	110%
VG Total Stock (VTI)	110%
Duration matched TIPS	100%
NASDAQ (QQQ)		95%
``````
Last edited by Horton on Mon Nov 21, 2022 2:36 pm, edited 1 time in total.
bobcat2
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Mon Nov 21, 2022 9:01 am The funded ratio actually offers more than a "glimmer" of hope.
Yes, I was thinking that all along.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
Watty
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Sat Nov 19, 2022 3:20 pm Let's assume we have a retiree who is 65 years old on Dec. 31, 2021 who needs \$40K / year in real income until age 95.
.....
Now, let's jump ahead to yesterday (Nov. 18, 2022).
In your calculations did you adjust your starting value of \$40K in income from 12/2021 for the inflation that has happened in the last 11 months?

https://data.bls.gov/cgi-bin/cpicalc.pl ... ar2=202210

It looks like it has been about 6.9% so the starting amount would be about \$42,760 for the calculation you did starting today.

When looking at the interest rate real yield curve that you are using you also need to keep in mind that it is implied that all the investments are in retirement accounts where taxes are not a factor.

The problem with this is that if you have investments that are in taxable accounts then you will also be taxed on any increase in value due to inflation. It would be highly variable and very difficult to calculate but instead of using the "real yield" for the discount it would be more accurate to use the "after tax real yield" for any investments outside of retirement accounts.

One of the insidious things about inflation is that with most investments outside of retirement accounts you are also taxed on any price increase due to inflation which makes it much harder to keep up with inflation. For example if you have an I Bond with a low or zero fixed rate you might hold it for 30 years then cash if and pay significant taxes on the inflation adjust so that you would lose purchasing power after taxes.
Topic Author
Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Watty wrote: Mon Nov 21, 2022 10:30 am In your calculations did you adjust your starting value of \$40K in income from 12/2021 for the inflation that has happened in the last 11 months?
Good catch!

I've made an update to reflect this. It changes the magnitude, but not the conclusion.
Watty wrote: Mon Nov 21, 2022 10:30 am When looking at the interest rate real yield curve that you are using you also need to keep in mind that it is implied that all the investments are in retirement accounts where taxes are not a factor.
Taxes are unique to each individual. For the sake of this example, we'll just assume that the retiree has taxes factored into the annual income he wants. Again, it may change the magnitude (ever so slightly), but not the conclusion.
Topic Author
Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Early in my career I was in a meeting with an executive at my megacorp and he said something folksy with a tinge of truth that's always stuck with me - "Horton, sometimes bad news is good news and good news is bad news."

Above, I showed how 2022 is a case where bad news is actually good news. Now, I'll show the opposite - when good news was bad news.

Let's think back to 2020. It was a crazy year in so many respects, but by the end of the year stock and bond returns were both very favorable for the year. The Vanguard Total Stock index went up over 20%. The Vanguard Long-Term Treasury fund went up almost 18%. The Vanguard LifeStrategy Conservative Growth Fund went up almost 12%. But, what happened to our liabilities?

The real yield curve rates on Jan. 2, 2020 were:

Code: Select all

``````Date 			5 YR	7 YR 	10 YR 	20 YR 	30 YR
12/31/2021 		-0.05	0.01 	0.08 	0.32 	0.50
``````
The real yield curve rates on Dec. 21, 2020 were:

Code: Select all

``````Date 			5 YR	7 YR 	10 YR 	20 YR 	30 YR
11/18/2021 		-1.59	-1.31 	-1.06 	-0.61 	-0.37
``````
In response to the significant drop in real interest rates, this retiree's* funded ratio decreased from 100% at the beginning of 2020 to about 95% at the end of 2020, despite significant favorable asset returns during 2020!

For those in the accumulation stage or those just entering retirement, the key is that our retirement liabilities have a very long duration. Significant changes in interest rates lead to significant changes in our retirement liabilities that may offset the impact of assets gains/losses.

* Look back at the OP for details on this retiree's situation. I've used the same facts for this example, only changing the years from 2022 to 2020.
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Sat Nov 19, 2022 3:20 pm BobK has been a long proponent of using the funded ratio for retirement planning. 2022 has been a tough year for bonds and stocks alike.
I agree that funded ratio is a useful metric. After all, what really matters is can you meet your future liabilities.
Horton wrote: Sat Nov 19, 2022 3:20 pm In conclusion, it's important to recognize that interest rate changes impact not only the value of our portfolios but also the present value of our future spending.
Interest rates have changed a lot this year! Who knows what will happen over the next 30 years. Or even over the next month.

You use real interest rates on Government bonds as the discount rate for your calculations. Not unreasonable. You have to use something. I do my planning once a year, on the second day of the year. Every year I puzzle over what I should use for the discount rate. Last year I assumed 1.3% discount rate (that happens to be what worked for the 4% "rule", it also reflects about what I expect in real terms from my investment portfolio - which is basically just a guess, and has been a bad guess so farm this year). So far I plan to use the same discount rate next year.

Your "glimmer of hope" comes from the rapid increase of real rates so far this year. And your use of that for your "discount rate" in PV calculations. That might be appropriate if all your investments were earning the current real yield in bonds purchased today.

I just did a quick look at my spreadsheet (based on ABW). Currently I project we will be able to spend more nominal dollars next year, but fewer real dollars. We'll be fine as long as the stock market does not drop 25% in the next month!
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Sat Nov 19, 2022 3:20 pm BobK has been a long proponent of using the funded ratio for retirement planning. 2022 has been a tough year for bonds and stocks alike. The Vanguard LifeStrategy Conservative Growth Fund (VSCGX) is down about 17% YTD as of today. On the surface, it seems like this would be a significant blow to a 65-year old retiree, but let's see what the funded ratio says.

First, let's use BobK's funded ratio definition:
bobcat2 wrote: Sun May 28, 2017 9:52 am FR = portfolio/PV(liabilities)
The value of the portfolio is straight forward. The value of the liabilities is debatable, particularly the discount rate used to determine the liabilities. For the sake of illustration, I'm going to use the Daily Treasury Par Real Yield Curve Rates to determine the liability because they represent the risk-free real interest rates.

In conclusion, it's important to recognize that interest rate changes impact not only the value of our portfolios but also the present value of our future spending.

=============

Edit: Watty noticed a gap in the calculations below. When determining the liability at Nov. 18, 2022 we need to adjust for inflation that has occurred during 2022. Here are the updated results after this adjustment:

Code: Select all

``````Assets		\$1.1M
Liabilities	\$1.0M
Funded Ratio	110%
``````
The retiree's funded ratio is now approximately 110% - 10% higher than the beginning of year!
dknightd wrote: Tue Nov 22, 2022 8:50 am
Horton wrote: Sat Nov 19, 2022 3:20 pm BobK has been a long proponent of using the funded ratio for retirement planning. 2022 has been a tough year for bonds and stocks alike.
I agree that funded ratio is a useful metric. After all, what really matters is can you meet your future liabilities.
Horton wrote: Sat Nov 19, 2022 3:20 pm In conclusion, it's important to recognize that interest rate changes impact not only the value of our portfolios but also the present value of our future spending.
Interest rates have changed a lot this year! Who knows what will happen over the next 30 years. Or even over the next month.

Your "glimmer of hope" comes from the rapid increase of real rates so far this year. And your use of that for your "discount rate" in PV calculations. That might be appropriate if all your investments were earning the current real yield in bonds purchased today.
Ok, this does interest me and (I believe that) I understand it all.

However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
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Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

dknightd wrote: Tue Nov 22, 2022 8:50 am You use real interest rates on Government bonds as the discount rate for your calculations. Not unreasonable. You have to use something. I do my planning once a year, on the second day of the year. Every year I puzzle over what I should use for the discount rate. Last year I assumed 1.3% discount rate (that happens to be what worked for the 4% "rule", it also reflects about what I expect in real terms from my investment portfolio - which is basically just a guess, and has been a bad guess so farm this year). So far I plan to use the same discount rate next year.

Your "glimmer of hope" comes from the rapid increase of real rates so far this year. And your use of that for your "discount rate" in PV calculations. That might be appropriate if all your investments were earning the current real yield in bonds purchased today.

I just did a quick look at my spreadsheet (based on ABW). Currently I project we will be able to spend more nominal dollars next year, but fewer real dollars. We'll be fine as long as the stock market does not drop 25% in the next month!
Thanks for sharing your results. I expected ABW might yield similar results. There are a variety of ways to set the discount rate for my analysis or the expected return assumption for ABW. No matter what source you use, it's important to use a source that updates based on current market conditions. For instance, I just looked at JP Morgan's capital market assumptions for 2022 and 2023 and here are a few highlights:

Code: Select all

``````Asset class		2022	2023
US Int Treasuries	2.10%	3.60%
TIPS			2.10%	4.30%
US Large Cap		4.10%	7.90%
``````
sean.mcgrath wrote: Tue Nov 22, 2022 9:01 am However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
While asset values are lower than the beginning of the year, expected returns for stocks and bonds are now higher.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Tue Nov 22, 2022 9:06 am
sean.mcgrath wrote: Tue Nov 22, 2022 9:01 am However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
While asset values are lower than the beginning of the year, expected returns for stocks and bonds are now higher.
Thanks, Horton. Yes, I meant to type "higher real returns."

It makes sense; I do think it is another way of stating the CAPE argument. I'm not sure that it's actionable, though: it seems like it would morph into market timing.
vineviz
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

sean.mcgrath wrote: Tue Nov 22, 2022 9:19 am
Horton wrote: Tue Nov 22, 2022 9:06 am
sean.mcgrath wrote: Tue Nov 22, 2022 9:01 am However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
While asset values are lower than the beginning of the year, expected returns for stocks and bonds are now higher.
Thanks, Horton. Yes, I meant to type "higher real returns."

It makes sense; I do think it is another way of stating the CAPE argument. I'm not sure that it's actionable, though: it seems like it would morph into market timing.
Not necessarily.

The expected return for stocks can be expressed, in its simplest form, as the risk-free rate PLUS the expected equity risk premium.

The risk-free rate is approximately the yield on 10-year US Treasuries (or 10-year TIPS if you want to express this in terms of real returns).

The expected equity risk premium can be derived from CAPE10 (basically it takes the form of Shiller's excess CAPE yield), but if you don't believe the ERP is time-variant you could simply assume some sort of constant value (e.g. 4%).
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

Horton wrote: Tue Nov 22, 2022 9:06 am it's important to use a source that updates based on current market conditions.
I respectfully disagree. "current market conditions" are a quirk that may, or may not, continue, or repeat.
I think if you are planning to live for X more years, you have to guess what the discount rate will be over those X years. Good luck with that. I don't even know what X is.
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
sean.mcgrath
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 9:58 am
sean.mcgrath wrote: Tue Nov 22, 2022 9:19 am
Horton wrote: Tue Nov 22, 2022 9:06 am
sean.mcgrath wrote: Tue Nov 22, 2022 9:01 am However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
While asset values are lower than the beginning of the year, expected returns for stocks and bonds are now higher.
Thanks, Horton. Yes, I meant to type "higher real returns."

It makes sense; I do think it is another way of stating the CAPE argument. I'm not sure that it's actionable, though: it seems like it would morph into market timing.
Not necessarily.

The expected return for stocks can be expressed, in its simplest form, as the risk-free rate PLUS the expected equity risk premium.

The risk-free rate is approximately the yield on 10-year US Treasuries (or 10-year TIPS if you want to express this in terms of real returns).

The expected equity risk premium can be derived from CAPE10 (basically it takes the form of Shiller's excess CAPE yield), but if you don't believe the ERP is time-variant you could simply assume some sort of constant value (e.g. 4%).
Ah, true. Thanks.
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Horton
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

dknightd wrote: Tue Nov 22, 2022 10:03 am
Horton wrote: Tue Nov 22, 2022 9:06 am it's important to use a source that updates based on current market conditions.
I respectfully disagree. "current market conditions" are a quirk that may, or may not, continue, or repeat.
I think if you are planning to live for X more years, you have to guess what the discount rate will be over those X years. Good luck with that. I don't even know what X is.
It’s debatable for stocks, but are you suggesting that the expected return for bonds over the next X years is the same today as it was at the beginning of the year?
vineviz
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

dknightd wrote: Tue Nov 22, 2022 10:03 am
Horton wrote: Tue Nov 22, 2022 9:06 am it's important to use a source that updates based on current market conditions.
I respectfully disagree. "current market conditions" are a quirk that may, or may not, continue, or repeat.
I think if you are planning to live for X more years, you have to guess what the discount rate will be over those X years. Good luck with that. I don't even know what X is.
I think this is based on a misunderstanding.

A key (i.e. important) feature of a measure like "funded ratio" is consistency of terms in the numerator and denominator.

You're using TODAY's market value and TODAY's discount rates to generate ratio. Mismatching the terms (e.g. current value and future discount rate, or future value and current discount rate) will inherently produce a less reliable result.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

I like to keep my funded ratio over 1
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 10:09 am
dknightd wrote: Tue Nov 22, 2022 10:03 am
Horton wrote: Tue Nov 22, 2022 9:06 am it's important to use a source that updates based on current market conditions.
I respectfully disagree. "current market conditions" are a quirk that may, or may not, continue, or repeat.
I think if you are planning to live for X more years, you have to guess what the discount rate will be over those X years. Good luck with that. I don't even know what X is.
I think this is based on a misunderstanding.

A key (i.e. important) feature of a measure like "funded ratio" is consistency of terms in the numerator and denominator.

You're using TODAY's market value and TODAY's discount rates to generate ratio. Mismatching the terms (e.g. current value and future discount rate, or future value and current discount rate) will inherently produce a less reliable result.
What am I misunderstanding?
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

I wish I could predict the numerator and denominator with any degree of certainly.
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
vineviz
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

dknightd wrote: Tue Nov 22, 2022 10:34 am I wish I could predict the numerator and denominator with any degree of certainly.
You don't need to predict anything.

Both the numerator and denominator are observable: they are values that exist today, not in the future.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
dknightd
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 10:41 am
dknightd wrote: Tue Nov 22, 2022 10:34 am I wish I could predict the numerator and denominator with any degree of certainly.
You don't need to predict anything.

Both the numerator and denominator are observable: they are values that exist today, not in the future.

My future expenses are unknown.
My portfolio value will change today.
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

I'm not sure how to predict my future Funded Ratio.

Divide one unknown, by another unknown. Then multiply by X
Retired 2019. So far, so good. I want to wake up every morning. But I want to die in my sleep. Just another conundrum. I think the solution might be afternoon naps ;)
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 10:09 am
dknightd wrote: Tue Nov 22, 2022 10:03 am
Horton wrote: Tue Nov 22, 2022 9:06 am it's important to use a source that updates based on current market conditions.
I respectfully disagree. "current market conditions" are a quirk that may, or may not, continue, or repeat.
I think if you are planning to live for X more years, you have to guess what the discount rate will be over those X years. Good luck with that. I don't even know what X is.
I think this is based on a misunderstanding.

A key (i.e. important) feature of a measure like "funded ratio" is consistency of terms in the numerator and denominator.

You're using TODAY's market value and TODAY's discount rates to generate ratio. Mismatching the terms (e.g. current value and future discount rate, or future value and current discount rate) will inherently produce a less reliable result.
You mean like CAPE, which has current price and mostly past earnings?
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

sean.mcgrath wrote: Tue Nov 22, 2022 9:19 am
Horton wrote: Tue Nov 22, 2022 9:06 am
sean.mcgrath wrote: Tue Nov 22, 2022 9:01 am However, related to dknight's post: I understand how this would be true if on those two dates I retired and put all of my money into appropriate-duration treasuries. How does this affect me if (as is the case) I am 90% equities? Is it sort of like a CAPE argument, that I can expect higher real interest rates in the coming years?
While asset values are lower than the beginning of the year, expected returns for stocks and bonds are now higher.
Thanks, Horton. Yes, I meant to type "higher real returns."

It makes sense; I do think it is another way of stating the CAPE argument. I'm not sure that it's actionable, though: it seems like it would morph into market timing.
So, we should all be cheering for a huge market crash that drastically lowers CAPE? We will have way less money, but hey our expected returns will be better, so we can celebrate and spend way more money!!!

I do recall all the people gleefully posting about ramping up their spending in 2009 when CAPE got quite low, right?

Ahh, if only I could pay my bills with "expected" returns
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 11:50 am You mean like CAPE, which has current price and mostly past earnings?
I'd use whatever you think is the most accurate discount rate estimate you can find.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

dknightd wrote: Tue Nov 22, 2022 10:51 am My future expenses are unknown.
My portfolio value will change today.
The fact that your future expenses are "unknown" is irrelevant. They can be estimated, and that's the value you use.

If that estimate changes in the future, you'll update it based on that new information.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

The expected returns from stocks has nothing to do with the funded ratio. The only way stock holdings enter the calcuation is thru their PV, which is obviously known.

BobK
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

bobcat2 wrote: Tue Nov 22, 2022 12:19 pm The expected returns from stocks has nothing to do with the funded ratio. The only way stock holdings enter the calcuation is thru their PV, which is obviously known.

BobK
Agreed. I built an elaborate funded ratio spreadsheet after seeing your funded ratio posts a few years back. Expected returns don't enter anywhere in the analysis.

I have inputs for a few large lumpy expenses, non-COLA pension, SS, and investments, as well as desired ending balance for legacy. I can also manually simulate a non-recoverable market crash by simply reducing my equity valuation. One thing that I was never sure about was the discount rate and inflation rate. I used 1% discount rate on all the separate PV calculations including SS, and I used 5% discount rate (1% discount rate plus 4% inflation) for my non-COLA pension. One thing I noticed is the discount rate has a fairly large influence on the funded ratio vs other variables.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

diy60 wrote: Tue Nov 22, 2022 12:46 pm
bobcat2 wrote: Tue Nov 22, 2022 12:19 pm The expected returns from stocks has nothing to do with the funded ratio. The only way stock holdings enter the calcuation is thru their PV, which is obviously known.

BobK
Agreed. I built an elaborate funded ratio spreadsheet after seeing your funded ratio posts a few years back. Expected returns don't enter anywhere in the analysis.

I have inputs for a few large lumpy expenses, non-COLA pension, SS, and investments, as well as desired ending balance for legacy. I can also manually simulate a non-recoverable market crash by simply reducing my equity valuation. One thing that I was never sure about was the discount rate and inflation rate. I used 1% discount rate on all the separate PV calculations including SS, and I used 5% discount rate (1% discount rate plus 4% inflation) for my non-COLA pension. One thing I noticed is the discount rate has a fairly large influence on the funded ratio vs other variables.
Isn't the discount rate you use essentially your expected return?
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 1:14 pm Isn't the discount rate you use essentially your expected return?
Could be, but to be transparent I don't fullly understand the discount rate in layman terms. I became intrigued with the challenge of putting together a somewhat flexible funded ratio spreadsheet and to look at the overall range of values for the ratio. In my particular situation the funded ratio never dropped below 1.00, so I never revisited the results. As noted by BobK above, and in my post, I adjust the value of my current equities to simulate poor returns or a market crash that doesn't recover in my remaining years. Hope this helps explain my approach.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 1:14 pmIsn't the discount rate you use essentially your expected return?
No. If your liabilities are the income stream you intend to have and not something wildly different in either direction you need to use a discount rate that is in financial economics speak "risk-free". Since the liabilities are in real terms the closest thing we have to risk-free are TIPS. If CPI inflation adjusted life annuities were still available, their cost would the PV of the liability in the denominator.

You don't get to raise the funded ratio by saying, "Oh, it's too low. I'll solve the problem by moving from a 60/40 portfolio to a 90/10 portfolio. There, denominator is lower and the problem is solved." That thinking has led to the demise of more than one pension fund.
The discount factor comes into play on the liabilities side – the PV of your targeted retirement income stream. A basic principle of finance is that if you want to hit a financial target with high probability, in this case your targeted retirement income stream goal, then the discount rate applied to those liabilities must be safe. This has nothing to do with the portfolio’s expected return. To repeat, there is no connection between the portfolio’s expected return and the discount rate applied to the liabilities.

For a safe discount rate the duration of the asset must match the duration of the liability. Furthermore, since in this case the targeted retirement income stream is real, the matched asset needs to also be real. For US investors that matching asset is a long-term TIPS bond.

See Monitoring Your Retirement Goal – the Funded Ratio

BobK
Last edited by bobcat2 on Tue Nov 22, 2022 1:50 pm, edited 1 time in total.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

diy60 wrote: Tue Nov 22, 2022 1:25 pm
marcopolo wrote: Tue Nov 22, 2022 1:14 pm Isn't the discount rate you use essentially your expected return?
Could be, but to be transparent I don't fullly understand the discount rate in layman terms. I became intrigued with the challenge of putting together a somewhat flexible funded ratio spreadsheet and to look at the overall range of values for the ratio. In my particular situation the funded ratio never dropped below 1.00, so I never revisited the results. As noted by BobK above, and in my post, I adjust the value of my current equities to simulate poor returns or a market crash that doesn't recover in my remaining years. Hope this helps explain my approach.
You seemed to make a pretty strong definitive statement that expected returns don't enter into it anywhere.
Now, you are saying there are inputs that you don't really understand?

The discount rate is essentially an estimated growth rate.
In the Funding Ratio formula, It is used to normalize future liabilities to current dollars.
But, it could just as easily be put in the numerator of the equation to inflate current portfolio to future dollars.

It is essentially your expected return. It definitely enters into computing the funding ratio either explicitly, or implicitly.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

bobcat2 wrote: Tue Nov 22, 2022 1:33 pm
marcopolo wrote: Tue Nov 22, 2022 1:14 pmIsn't the discount rate you use essentially your expected return?
No. If your liabilities are the income stream you intend to have and not something wildly different in either direction you need to use a discount rate that is in financial economics speak "risk-free". Since the liabilities are in real terms the closest thing we have to risk-free are TIPS. If CPI inflation adjusted life annuities were still available, their cost would the PV of the liability in the denominator.

You don't get to raise the funded ratio by saying, "Oh, it's too low. I'll solve the problem by moving from a 60/40 portfolio to a 90/10 portfolio. There, denominator is lower and the problem is solved." That thinking has led to the demise of more than one pension fund.

BobK
All that is saying is that to be conservative one should use the TIPs rate as their expected returns.
Sure, that is a reasonable position to take. But, that does not change the fact that you are still making use of expected returns.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 1:14 pm Isn't the discount rate you use essentially your expected return?
Yes, at least as this sort of analysis is normally done:

https://www.investopedia.com/terms/p/presentvalue.asp
Discount Rate for Finding Present Value
The discount rate is the investment rate of return that is applied to the present value calculation. In other words, the discount rate would be the forgone rate of return if an investor chose to accept an amount in the future versus the same amount today. The discount rate that is chosen for the present value calculation is highly subjective because it's the expected rate of return you'd receive if you had invested today's dollars for a period of time.
However, as the article goes on to explain:
In many cases, a risk-free rate of return is determined and used as the discount rate, which is often called the hurdle rate. The rate represents the rate of return that the investment or project would need to earn in order to be worth pursuing. A U.S. Treasury bond rate is often used as the risk-free rate because Treasuries are backed by the U.S. government. So, for example, if a two-year Treasury paid 2% interest or yield, the investment would need to at least earn more than 2% to justify the risk.
One has to be really careful when using that concept, however. Of course if you are just invested in something like a TIPS ladder, you can know you are going to get some particular real rate of return (at least if you are OK using CPI as your inflation measure). But if you are invested in something quite different, you may not know that at all.

This raises the question of why anyone would take the risk of investing in something besides a TIPS ladder. And the basic answer is because you want to do better than that. Like, either you want a chance at better returns over the next 30 years, or you want better returns so it might be able to stretch out longer than 30 years, or something like that.

But of course the risk is then you will do worse instead.

Anyway, if you only invested in a TIPS ladder, it would be quite easy to see whether it would or would not cover some defined set of future real cash flows. I guess you could express that as a PV ratio, but that is a rather roundabout way of expressing the answer. What you really want to know is what is going to happen in the future, and figuring out the present value of your actual expected cash flows versus your desired cash flows appears to be an unnecessary complication that actually loses potentially important information. Like, you actually want the cash when you need it--a set of investment returns could have the same present value as the set of cash flows you need, but be on a different schedule entirely. That would not be a particularly good investment plan despite this PV calculation telling you are fully funded.

And then if you invest in something else besides a TIPS ladder, you would have to figure out what else to use for a discount rate in light of that something else. One would hope you did that thinking it would be higher than the "hurdle rate" associated with a TIPS ladder, but exactly how much higher gets into complex issues. And you still would not necessarily have fixed the timing issue.

So I don't know, maybe people have found this sort of exercise useful to them, but I can't really see it doing much for me personally. Again, I do want to have some good reason to believe I am going to be able to cover the future cash flows I am trying to plan around covering. I don't really see how this reduction to present values is doing much for me as an additional step.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 1:39 pm All that is saying is that to be conservative one should use the TIPs rate as their expected returns.
Sure, that is a reasonable position to take. But, that does not change the fact that you are still making use of expected returns.
No it is not saying that. If you want to hit your income goal with high probability you need to use the risk-free rate to discount your liabilities.

The discount factor comes into play on the liabilities side – the PV of your targeted retirement income stream. A basic principle of finance is that if you want to hit a financial target with high probability, in this case your targeted retirement income stream goal, then the discount rate applied to those liabilities must be safe. This has nothing to do with the portfolio’s expected return. To repeat, there is no connection between the portfolio’s expected return and the discount rate applied to the liabilities.

For a safe discount rate the duration of the asset must match the duration of the liability. Furthermore, since in this case the targeted retirement income stream is real, the matched asset needs to also be real. For US investors that matching asset is a long-term TIPS bond.
First, when planning for retirement, set yourself up for clear decision-making. Separate the exercise of determining the cost of safely funding your income in retirement from the exercise of deciding how to invest your portfolio. When planning for retirement income, use as your base case a plan that does not rely on stock performance for success. Then, look at the range of possibilities implied as you increase risk from that base income projection. As you increase portfolio risk beyond the base case scenario, you are in essence indicating that you are able and willing to accept a reduced future standard of living if necessary in return for having a chance of obtaining a higher standard of living.

Or, perhaps you will decide to increase portfolio risk even though you are unable or unwilling to reduce your future standard of living if investments don’t work out as planned.If you take this route, and like a pension fund use current accounting guidelines rather than a fair-market valuation approach, you are in essence relying on the future-taxpayer/white-knight scenario as your ultimate financial safety net in retirement.
- Paula Hogan

BobK
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

bobcat2 wrote: Tue Nov 22, 2022 2:01 pm
marcopolo wrote: Tue Nov 22, 2022 1:39 pm All that is saying is that to be conservative one should use the TIPs rate as their expected returns.
Sure, that is a reasonable position to take. But, that does not change the fact that you are still making use of expected returns.
No it is not saying that. If you want to hit your income goal with high probability you need to use the risk-free rate to discount your liabilities.

The discount factor comes into play on the liabilities side – the PV of your targeted retirement income stream. A basic principle of finance is that if you want to hit a financial target with high probability, in this case your targeted retirement income stream goal, then the discount rate applied to those liabilities must be safe. This has nothing to do with the portfolio’s expected return. To repeat, there is no connection between the portfolio’s expected return and the discount rate applied to the liabilities.

For a safe discount rate the duration of the asset must match the duration of the liability. Furthermore, since in this case the targeted retirement income stream is real, the matched asset needs to also be real. For US investors that matching asset is a long-term TIPS bond.
First, when planning for retirement, set yourself up for clear decision-making. Separate the exercise of determining the cost of safely funding your income in retirement from the exercise of deciding how to invest your portfolio. When planning for retirement income, use as your base case a plan that does not rely on stock performance for success. Then, look at the range of possibilities implied as you increase risk from that base income projection. As you increase portfolio risk beyond the base case scenario, you are in essence indicating that you are able and willing to accept a reduced future standard of living if necessary in return for having a chance of obtaining a higher standard of living.

Or, perhaps you will decide to increase portfolio risk even though you are unable or unwilling to reduce your future standard of living if investments don’t work out as planned.If you take this route, and like a pension fund use current accounting guidelines rather than a fair-market valuation approach, you are in essence relying on the future-taxpayer/white-knight scenario as your ultimate financial safety net in retirement.
- Paula Hogan

BobK

They are mathematically identical.

You can discount future liabilities to today's value using a discount rate.

Or you can project your current portfolio into future value using the same exact growth rate.

Those two approaches will give you the same exact answer.

So, that just leaves the question of what value to use for the discount/growth rate.

You are saying the risk-free (TIPS) rate is the right answer. I am not disagreeing with you. All I am saying is that when you say that, you are saying that the risk-free rate IS your expected return for this modeling exercise.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

By the way, thinking about the math involved here, my tentative conclusion is that what it is really saying is that given what happened to TIPS prices, it is kinda surprising stocks didn't crash by a lot more.

Like, I have put zero really serious thought into this subject, but as I recall, long-term TIPS are down like 30% over the last year in terms of NAV right? But isn't the total US stock market only down like 18% or so?

So I guess you could interpret that as saying the expectations for future real stock earnings per share went up even more, meaning more than just enough to offset higher than expected inflation.

But that sounds . . . optimistic?

So maybe the equity risk premium decreased at the same time the risk-free rate was going up? That sounds coincidental, no?

But who knows . . . stock markets are strange.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

NiceUnparticularMan wrote: Tue Nov 22, 2022 2:12 pm By the way, thinking about the math involved here, my tentative conclusion is that what it is really saying is that given what happened to TIPS prices, it is kinda surprising stocks didn't crash by a lot more.

Like, I have put zero really serious thought into this subject, but as I recall, long-term TIPS are down like 30% over the last year in terms of NAV right? But isn't the total US stock market only down like 18% or so?

So I guess you could interpret that as saying the expectations for future real stock earnings per share went up even more, meaning more than just enough to offset higher than expected inflation.

But that sounds . . . optimistic?

So maybe the equity risk premium decreased at the same time the risk-free rate was going up? That sounds coincidental, no?

But who knows . . . stock markets are strange.
The effective duration for stocks is shorter than the duration of LTPZ. Most research suggest it has usually been more like 7-10 years.

I don’t like the concept of equity duration in general, but I guess it helps explain most of the disconnect you’re seeing here.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

If you want to hit your retirement income goal with high probability you need to discount the PV with a safe discount rate. If you don't care by how much you miss your targeted income goal you can use any discount rate you please. Say the rate of return on a 2:1 leveraged equity portfolio and a 12% discount rate.

BobK
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

bobcat2 wrote: Tue Nov 22, 2022 2:50 pm If you want to hit your retirement income goal with high probability you need to discount the PV with a safe discount rate. If you don't care by how much you miss your targeted income goal you can use any discount rate you please. Say the rate of return on a 2:1 leveraged equity portfolio and a 12% discount rate.

BobK
How is that any different than saying use a "safe" expected return rather than an overly optimistic one?
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

A basic tenet of finance is that you cannot reduce the PV of a liability by taking on more risk.

If the liability has to be met you need to use the 'risk-free' rate. If the liability doesn't have to be met, you can use any discount rate you please.

While you can't reduce the PV of a liability by taking on more risk, you can reduce the PV of a liability by taking out a contingent claim against the liability. In the case of retirement income the contingent claim is a life annuity with its mortality credit.

BobK
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 3:01 pm
bobcat2 wrote: Tue Nov 22, 2022 2:50 pm If you want to hit your retirement income goal with high probability you need to discount the PV with a safe discount rate. If you don't care by how much you miss your targeted income goal you can use any discount rate you please. Say the rate of return on a 2:1 leveraged equity portfolio and a 12% discount rate.

BobK
How is that any different than saying use a "safe" expected return rather than an overly optimistic one?
It's simply confusing the issue to refer to the discount rate as "expected return" in this context unless we specify that it is the expected return of the risk-free asset, not the expected return of the invested portfolio.

In this case, it's true that the discount rate is the (expected) return of the risk-free asset. By choosing to call it what it is (the discount rate) we can avoid the confusion that ensued earlier.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 3:52 pm
marcopolo wrote: Tue Nov 22, 2022 3:01 pm
bobcat2 wrote: Tue Nov 22, 2022 2:50 pm If you want to hit your retirement income goal with high probability you need to discount the PV with a safe discount rate. If you don't care by how much you miss your targeted income goal you can use any discount rate you please. Say the rate of return on a 2:1 leveraged equity portfolio and a 12% discount rate.

BobK
How is that any different than saying use a "safe" expected return rather than an overly optimistic one?
It's simply confusing the issue to refer to the discount rate as "expected return" in this context unless we specify that it is the expected return of the risk-free asset, not the expected return of the invested portfolio.

In this case, it's true that the discount rate is the (expected) return of the risk-free asset. By choosing to call it what it is (the discount rate) we can avoid the confusion that ensued earlier.
Discount rate serves the same purpose as expected return in any context.

If you want to say expected return needs to be specified as that of the risk-free asset, then you would need to impose the same condition on the discount rate. There is nothing about a discount rate that inherently implies that it is of a risk-free asset.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 4:01 pm Discount rate serves the same purpose as expected return in any context.

If you want to say expected return needs to be specified as that of the risk-free asset, then you would need to impose the same condition on the discount rate. There is nothing about a discount rate that inherently implies that it is of a risk-free asset.
In this context, the appropriate discount rate to use is the yield of the investor's risk-free asset. And it is less confusing to call it what it is, a discount rate, than to call it anything else.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

vineviz wrote: Tue Nov 22, 2022 4:21 pm
marcopolo wrote: Tue Nov 22, 2022 4:01 pm Discount rate serves the same purpose as expected return in any context.

If you want to say expected return needs to be specified as that of the risk-free asset, then you would need to impose the same condition on the discount rate. There is nothing about a discount rate that inherently implies that it is of a risk-free asset.
In this context, the appropriate discount rate to use is the yield of the investor's risk-free asset. And it is less confusing to call it what it is, a discount rate, than to call it anything else.
Nothing about funded ratio requires, or even implies, the use of a risk-free rate.
That may be a good conservative option to use. But, the definition of funded ratio is simply the ratio of liabilities to assets, at present value. The PV calculation can use whatever discount rate you choose.

To quote an astute observer from earlier in this thread:
vineviz wrote: Tue Nov 22, 2022 12:15 pm I'd use whatever you think is the most accurate discount rate estimate you can find.
Using the expected value of one's portfolio is not that uncommon.

The choice to use the risk-free rate is just another way of saying you want to be conservative and use the expected return of the the risk free assets rather than of the portfolio. That is fine. But, just because you chose to use a more conservative expected return value does not mean expected returns do not play any part in establishing the funded ratio. Which is the claim I was questioning, not the semantics used of calling it "discount rate" vs. "expected return".
Once in a while you get shown the light, in the strangest of places if you look at it right.
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### Re: Funded Ratio Offers a Glimmer of Hope in 2022

marcopolo wrote: Tue Nov 22, 2022 4:39 pm
Nothing about funded ratio requires, or even implies, the use of a risk-free rate.
Nonetheless it is the appropriate rate to use.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch