Funded Ratio Offers a Glimmer of Hope in 2022

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NiceUnparticularMan
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by NiceUnparticularMan »

vineviz wrote: Tue Nov 22, 2022 2:42 pm
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.
Yes, that would seem consistent. I guess it still doesn't necessarily make sense to me as a personal investor, particularly in this context.

Meaning the OP's PV calculation for the future liabilities was spread over 30 years. Apparently, the NAV hit to the stocks in the balanced fund did not track the same distribution of future earnings flows. Not sure about the bonds, but at a guess a 30 year bond ladder with rising payments to keep up with inflation would also have had a duration significantly longer than the duration of the bonds in that balanced fund.

Which I guess is a variation on what some other people pointed out.
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by sean.mcgrath »

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
Ok, I understand all of this and thank you, BobK. My question remains: what is actionable for me with a 90% equities portfolio? (do realize that this is a theoretical question. I am at 50x assets to spend with an enormous amount of discretionary, and I have not even retired yet.). It does feel that if the funded ratio changes, my view of my assets should change, but I suspect that it doesn't. Can you enlighten, or do I need to frame the question better?
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by alex_686 »

sean.mcgrath wrote: Tue Nov 22, 2022 6:11 pm
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
Ok, I understand all of this and thank you, BobK. My question remains: what is actionable for me with a 90% equities portfolio? (do realize that this is a theoretical question. I am at 50x assets to spend with an enormous amount of discretionary, and I have not even retired yet.). It does feel that if the funded ratio changes, my view of my assets should change, but I suspect that it doesn't. Can you enlighten, or do I need to frame the question better?
It means you have the ability to claw risk off of the table and go bond heavy.

Why would you in your position keep such a risky profile? There are reasons but not for your current goals.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by bobcat2 »

sean.mcgrath wrote: Tue Nov 22, 2022 6:11 pm My question remains: what is actionable for me with a 90% equities portfolio? (do realize that this is a theoretical question. I am at 50x assets to spend with an enormous amount of discretionary, and I have not even retired yet.). It does feel that if the funded ratio changes, my view of my assets should change, but I suspect that it doesn't. Can you enlighten, or do I need to frame the question better?
alex_686 has answered your question well IMO, but here is my stab at it using different words.

The FR is in a sense a measure of your retirement income risk. If you are well below 1.0 and near retirement you are obviously at risk of falling short of your retirement income goal or target.

But OTOH if you are near retirement and above 1.0 you are at risk if your portfolio is heavily invested in risky assets (stocks). With such a portfolio you could end up with much more income than your target, or much less income. As Robert Merton points out everybody likes 'or more', but it comes at a cost.

So if one wants to be safe, employ matching strategies with some of your portfolio using Ibonds, TIPS bonds or combination TIPS bond funds, and possibly life annuities. Personally I would want at least 75% of my retirement income to be safe using the above plus Soc Sec and DB pension benefits. Your mileage might differ. :happy

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.
sean.mcgrath
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by sean.mcgrath »

bobcat2 wrote: Tue Nov 22, 2022 6:59 pm
sean.mcgrath wrote: Tue Nov 22, 2022 6:11 pm My question remains: what is actionable for me with a 90% equities portfolio? (do realize that this is a theoretical question. I am at 50x assets to spend with an enormous amount of discretionary, and I have not even retired yet.). It does feel that if the funded ratio changes, my view of my assets should change, but I suspect that it doesn't. Can you enlighten, or do I need to frame the question better?
alex_686 has answered your question well IMO, but here is my stab at it using different words.

The FR is in a sense a measure of your retirement income risk. If you are well below 1.0 and near retirement you are obviously at risk of falling short of your retirement income goal or target.

But OTOH if you are near retirement and above 1.0 you are at risk if your portfolio is heavily invested in risky assets (stocks). With such a portfolio you could end up with much more income than your target, or much less income. As Robert Merton points out everybody likes 'or more', but it comes at a cost.

So if one wants to be safe, employ matching strategies with some of your portfolio using Ibonds, TIPS bonds or combination TIPS bond funds, and possibly life annuities. Personally I would want at least 75% of my retirement income to be safe using the above plus Soc Sec and DB pension benefits. Your mileage might differ. :happy

BobK
Interesting, and thank you BobK. I understand what you mean by "be safe," but I believe it is a question of time frame. If I want to die with 0, that is one calculation. If I want to leave all to my children, that is another. But (hopefully and statistically) when I die my children won't need it as they will be in retirement already. This will certainly be the case for my wife's father, and I hope for us as well. So we will help our children as we can, and the excess is for grand and great grandchildren. At that point, I go for 100% stocks....
alex_686
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by alex_686 »

sean.mcgrath wrote: Tue Nov 22, 2022 7:54 pm Interesting, and thank you BobK. I understand what you mean by "be safe," but I believe it is a question of time frame. If I want to die with 0, that is one calculation. If I want to leave all to my children, that is another. But (hopefully and statistically) when I die my children won't need it as they will be in retirement already. This will certainly be the case for my wife's father, and I hope for us as well. So we will help our children as we can, and the excess is for grand and great grandchildren. At that point, I go for 100% stocks....
Writing goals into a ISP is one of the hardest, nuanced, and important things to do.

You have 2 default options depending on your risk tolerance. You have a high ability but what is your willingness to take risk?

The first is to buy 50 years worth of income of TIPS and be done with it. You have won the game. Throw away your Bogleheads password and go out and live the good life.

The second is to redefine your goals upwards. You have meet your desired and required goals but what about your stretch goals? First on the list is to provided for family, which you have already referenced. Maybe a legacy? Know of a library that needs your name? Charity to leave the world better? Maybe buying that Porsche car that I keep on seeing popping up in the threads.

If none of these are exciting you then you probably want to drift over to option #1. No reason to take unnecessary risks. But figuring this stuff out is both hard and important.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by Northern Flicker »

Horton wrote: 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.
This is a correct observation. I've posted before that funding future retirement expenses did not actually get more expensive despite inflation because rising rates increase the discount rate for discounting future liabilities back to a present value. That is another way of saying the same thing.

An easy way to see it is to look at the value of a TIPS portfolio duration-matched to liabilities.

The TIPS fund FIPDX is down about 12% this year. The net present value of a set of real liabilities with duration matching that of FIPDX is down about that much as well.
Last edited by Northern Flicker on Tue Nov 22, 2022 11:59 pm, edited 1 time in total.
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calmaniac
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by calmaniac »

Horton & BobK,

Thanks for raising the funded ratio topic. I have been meaning to look into it after hearing Wade Pfau discuss.

Question: What is the advantage of using the funded ratio of present value versus examining cash flow?

In other words, what is the advantage of calculating PV of our retirement income (SS plus pensions) and expenses, rather than simply using the actual cash flows themselves? I would think the addition of the PV calculation would add another level of complexity and imprecision relative to using the actual cash flows, but presumably there is a benefit to this approach.

I would be grateful for any clarity you can offer on what insights funded ratio gives you that other approaches do not.
≈63yo. AA 75/25: 30% TSM, 19% value (VFVA/AVUV), 18% foreign LC, 8% emerging, 25% GFund/VBTIX. Fed pensions now ≈60% of expenses. Taking SS @age 70--> pension+SS ≈100% of expenses. What me worry?
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Horton
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by Horton »

calmaniac wrote: Tue Nov 22, 2022 8:45 pm Horton & BobK,

Thanks for raising the funded ratio topic. I have been meaning to look into it after hearing Wade Pfau discuss.

Question: What is the advantage of using the funded ratio of present value versus examining cash flow?

In other words, what is the advantage of calculating PV of our retirement income (SS plus pensions) and expenses, rather than simply using the actual cash flows themselves? I would think the addition of the PV calculation would add another level of complexity and imprecision relative to using the actual cash flows, but presumably there is a benefit to this approach.

I would be grateful for any clarity you can offer on what insights funded ratio gives you that other approaches do not.
Hi calmaniac -

The first step is to derive the cash flows. There’s no need to calculate the PV of SS and pensions. Instead, you can develop the cash flows net of SS and pensions. The value of your assets divided by the PV of these net cash flows is the funded ratio.

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

Post by calmaniac »

Horton wrote: Wed Nov 23, 2022 10:12 am
calmaniac wrote: Tue Nov 22, 2022 8:45 pm Horton & BobK,

Thanks for raising the funded ratio topic. I have been meaning to look into it after hearing Wade Pfau discuss.

Question: What is the advantage of using the funded ratio of present value versus examining cash flow?
Hi calmaniac -

The first step is to derive the cash flows. There’s no need to calculate the PV of SS and pensions. Instead, you can develop the cash flows net of SS and pensions. The value of your assets divided by the PV of these net cash flows is the funded ratio.

Hope that helps!
Thank you Horton! Your explanation makes a lot of sense and aligns with my intuitive sense (not that intuition is always correct).

Just to make sure I have it right, I'll run this example by y'all. Since our COLA'ed federal pensions and SS at age 70 pretty well match our expenses, I don't expect our expenses in retirement to overshoot by more than, say $50,000/year (high-end of expected expenses, for example once in a lifetime vacation or long-term care needs for one spouse). Assuming a discount rate of 1.6% and a 30 year payout, the NPV needed to support that income stream is $1.2 million. Thus, if we had assets of $3.6 million, our funded ratio would be 3. Is that correct?

Question: My (novice) understanding is that in this model the $50,000/year are dollars that have appreciated by the discount rate each year. For example, in year 4 we would be receiving $50,000x(1.016)3 = $52,438.60. Is that correct?

Very much appreciated!
≈63yo. AA 75/25: 30% TSM, 19% value (VFVA/AVUV), 18% foreign LC, 8% emerging, 25% GFund/VBTIX. Fed pensions now ≈60% of expenses. Taking SS @age 70--> pension+SS ≈100% of expenses. What me worry?
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Horton
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by Horton »

calmaniac wrote: Wed Nov 23, 2022 8:37 pm Just to make sure I have it right, I'll run this example by y'all. Since our COLA'ed federal pensions and SS at age 70 pretty well match our expenses, I don't expect our expenses in retirement to overshoot by more than, say $50,000/year (high-end of expected expenses, for example once in a lifetime vacation or long-term care needs for one spouse). Assuming a discount rate of 1.6% and a 30 year payout, the NPV needed to support that income stream is $1.2 million. Thus, if we had assets of $3.6 million, our funded ratio would be 3. Is that correct?
That sounds right. You're in a great spot having pensions and SS that cover your non-discretionary expenses. When your funded ratio gets to a certain point - maybe larger than 1.5 - it begins to not really matter. You have the opposite problem - you need to figure out how to spend (or give) the money.
calmaniac wrote: Wed Nov 23, 2022 8:37 pm Question: My (novice) understanding is that in this model the $50,000/year are dollars that have appreciated by the discount rate each year. For example, in year 4 we would be receiving $50,000x(1.016)3 = $52,438.60. Is that correct?
I prefer to think of the present value (today's value) rather than the future value. So, you need real spending of $50K in year 4. The present value of that spending is $50,000 / (1 + i) ^ n, where i is the discount rate and n is the number of years (e.g., 3 if withdrawn at the beginning of the year, 3.5 if withdrawn mid-year, or 4 if withdrawn at the end of the year).
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by marcopolo »

calmaniac wrote: Wed Nov 23, 2022 8:37 pm
Horton wrote: Wed Nov 23, 2022 10:12 am
calmaniac wrote: Tue Nov 22, 2022 8:45 pm Horton & BobK,

Thanks for raising the funded ratio topic. I have been meaning to look into it after hearing Wade Pfau discuss.

Question: What is the advantage of using the funded ratio of present value versus examining cash flow?
Hi calmaniac -

The first step is to derive the cash flows. There’s no need to calculate the PV of SS and pensions. Instead, you can develop the cash flows net of SS and pensions. The value of your assets divided by the PV of these net cash flows is the funded ratio.

Hope that helps!
Thank you Horton! Your explanation makes a lot of sense and aligns with my intuitive sense (not that intuition is always correct).

Just to make sure I have it right, I'll run this example by y'all. Since our COLA'ed federal pensions and SS at age 70 pretty well match our expenses, I don't expect our expenses in retirement to overshoot by more than, say $50,000/year (high-end of expected expenses, for example once in a lifetime vacation or long-term care needs for one spouse). Assuming a discount rate of 1.6% and a 30 year payout, the NPV needed to support that income stream is $1.2 million. Thus, if we had assets of $3.6 million, our funded ratio would be 3. Is that correct?

Question: My (novice) understanding is that in this model the $50,000/year are dollars that have appreciated by the discount rate each year. For example, in year 4 we would be receiving $50,000x(1.016)3 = $52,438.60. Is that correct?

Very much appreciated!
Your first assertion is correct.
The second one is not.

It is called a discount rate because it discounts how much you need today to keep the same cash flow in the future.
Without any growth, $50k for 30 years would require $1.5m.
The $1.5m gets discounted to $1.2m because the money grows at the 1.6% rate.

If the 1.6% is a nominal rate then you would get $50k in the future. If the 1.6% is a real rate then you would get $50k adjusted for inflation each year. But, in both cases the payout would not be affected by the discount rate because that was already taken into account to lower your initial portfolio value.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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Horton
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by Horton »

Coincidentally, actuary and financial planner Joe Tomlinson recently wrote an article at Advisor Perspectives that covers many of the points presented and discussed in this thread.

For those interested in Monte Carlo models, he also presents results for several examples.

Here are some relevant excerpts (emphasis mine):
We can now turn to the expense or liability side of the household balance sheet. For example, if have a new retiree who plans to utilize their savings to spend $30,000 per year (with annual inflation increases) and we assume a 30-year retirement, we can calculate present values using TIPS yields, because the future spending is in real dollars. If we use a TIPS yield of -0.5%, from the beginning of 2022, the present value comes out to $974,000. Because the assumed TIPS yield is negative, this amount exceeds the total future cash flow of $900,000 in real dollars. If we then raise the TIPS yield to the present-day positive 1.5% and redo the PV calculation, we get $720,000

The present value of future expenses decreased by 26%.

If we assume a new retiree invested in 60% Vanguard Total Stock Market Index (-24% YTD) and 40% Vanguard Intermediate Term Treasury (-12% YTD) they would be down 20% for the year on the asset side, but down 26% on the liability or future expense side. They would be ahead of the game. That’s quite a different picture than their quarterly investment statements have been showing.

Although this result might seem to involve finance sleight of hand, the explanation is quite straightforward. In bond-math terms, this is a case where the duration of the expenses exceeds the duration of the assets, so there is a greater impact on the PV of future expenses.
What’s important in this analysis are not the numbers I have chosen, as much as the general concept of looking beyond investment statements when assessing the impacts on financial plans. Be cognizant of both sides of the financial planning balance sheet.
NiceUnparticularMan
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by NiceUnparticularMan »

So I think it is important to summarize accurately what is really going on here.

You have 30 years of real liabilities you are trying to provide against. This will have some presumably high "duration", in the sense of the sensitivity of its present value to real market interest rate changes.

If you used something like a 30 year TIPS ladder that exactly matched your liabilities, it should have the same "duration".

So if you did that, your "funded ratio" shouldn't change when real market interest rates change, as both the liabilities and your ladder would react the same in terms of present value.

OK, but now assume instead of investing in a TIPS ladder with the same duration as your liabilities, you instead invest in a mix of stocks and bonds with a significantly shorter duration than your liabilities.

And then . . . voila! When market interest rates increased, your "funded ratio" improved. Because your investments, with their shorter duration, lost less present value than your liabilities, with their longer duration.

So, is this actual good news, or just an accounting illusion?

Well, consider the following reasoning.

One might ask WHY you used a portfolio with a significant shorter duration than your liabilities in the first place. And one possible explanation would be simply that you were betting on the direction of market interest rates. Specifically, you were betting it was more likely than not they would go up than down. Therefore, it made sense to go shorter with your duration in your investments while you waited for rates to go up.

And then they did! Your speculation worked out. Basically, what is happening is you are assuming you will now be able to reinvest the proceeds from your shorter-duration portfolio at a higher rate starting now, and continuing through the end of your 30 years. So, your decision not to lock in rates that whole period, but to "keep your powder dry" and hope rates will increase, has paid off.

Now strictly speaking, to lock in the benefits of your successful bet, you should now "cash in" and now buy a portfolio that actually matches the duration of your liabilities. If you don't, basically you are going for "double or nothing"--if interest rates further increase, you win again! But if interest rates go back down, the present value of your liabilities will go up more than your portfolio, and you might be right back where you started in terms of "funded ratio". Or indeed even worse.

So, how lucky do you feel?

Here is an alternative perspective. At least with the stocks in your portfolio, you didn't really have a "choice" about their duration. So if you are using a lot of stocks to provide against long-term real liabilities with a higher duration than stocks, yeah, maybe that is a de facto bet on interest rates increasing, but it was a bet that was forced on you.

And if you now stay invested in stocks, including reinvesting, you are going double or nothing. But it is still being forced on you.

But still, are those changes real changes in your likely fortunes, or just accounting illusions?

Well, that really depends on what you believe about the future of real returns from your stocks over the next 30 years, including reinvestment. Do you believe they have gone up with unexpected inflation, like with TIPS? Do you believe they have gone up even better than with TIPS? Or do you believe they have perhaps gone up worse with unexpected inflation than with TIPS?

I am personally a bit skeptical about the idea that your stocks can now be expected to return more, even including reinvestment, over the next 30 years. I think it is conceivable the effects could be neutral in the long run. I am quite skeptical they are notably positive, though.

Which means it is a bit of a puzzle to me still why the duration of stocks is apparently so short. But it is what it is, and so it does appear that if you were now willing to cash out your bet on stocks and buy a full TIPS ladder, you would come out ahead. In that sense, the increase in the funded ratio applied to a stock portfolio WHEN you are willing to cash out early is actual good news.

If, however, you are committed to sticking with stocks over the long haul? I am not so convinced you really gained anything recently. But maybe you didn't lose anything either, or not much.
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by dknightd »

I have a plan. I hope it works out!
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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Horton
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by Horton »

NiceUnparticularMan wrote: Mon Nov 28, 2022 10:55 am You have 30 years of real liabilities you are trying to provide against. This will have some presumably high "duration", in the sense of the sensitivity of its present value to real market interest rate changes.

If you used something like a 30 year TIPS ladder that exactly matched your liabilities, it should have the same "duration".

So if you did that, your "funded ratio" shouldn't change when real market interest rates change, as both the liabilities and your ladder would react the same in terms of present value.

OK, but now assume instead of investing in a TIPS ladder with the same duration as your liabilities, you instead invest in a mix of stocks and bonds with a significantly shorter duration than your liabilities.

And then . . . voila! When market interest rates increased, your "funded ratio" improved. Because your investments, with their shorter duration, lost less present value than your liabilities, with their longer duration.
The way you invest your assets has no impact on the derivation of the liability. The funded ratio is assets divided by liabilities, so the funded ratio changes in the future as these change. If you want to mitigate funded ratio volatility, then you could invest all or a portion of your assets to match the liability as closely as possible. If you don’t mind funded ratio volatility, then invest however you like. But, that doesn’t change the way the liabilities or funded ratio are derived.

BTW, at the beginning of the topic I showed how the funded ratio would have changed in 2022 for a variety of asset allocations. Again, the numerator changes in the analysis, but not the denominator.
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Re: Funded Ratio Offers a Glimmer of Hope in 2022

Post by NiceUnparticularMan »

Horton wrote: Mon Nov 28, 2022 11:31 am
NiceUnparticularMan wrote: Mon Nov 28, 2022 10:55 am You have 30 years of real liabilities you are trying to provide against. This will have some presumably high "duration", in the sense of the sensitivity of its present value to real market interest rate changes.

If you used something like a 30 year TIPS ladder that exactly matched your liabilities, it should have the same "duration".

So if you did that, your "funded ratio" shouldn't change when real market interest rates change, as both the liabilities and your ladder would react the same in terms of present value.

OK, but now assume instead of investing in a TIPS ladder with the same duration as your liabilities, you instead invest in a mix of stocks and bonds with a significantly shorter duration than your liabilities.

And then . . . voila! When market interest rates increased, your "funded ratio" improved. Because your investments, with their shorter duration, lost less present value than your liabilities, with their longer duration.
The way you invest your assets has no impact on the derivation of the liability.
Correct.

It does, however, have an impact on what will happen to the assets' present value in response to market interest rate changes.

So, if you have expected liabilities of duration N, and then invest your savings in assets with a duration of N/2, you know that your funded ratio will go down if market interest rates go down, and conversely your funded ratio will go up if market interest rates go up (controlling for any other contemporaneous factors that may be affecting asset prices).

In this case, a 60/40 portfolio has a significantly shorter duration than a 30-year liability inflation-adjusted income stream.

So, when market interest rates went up, if you had invested in a 60/40 portfolio in order to provide for such a 30-year inflation-adjusted income stream, your funded ratio went up. Because you chose assets with a significantly shorter duration than your liabilities.
If you don’t mind funded ratio volatility, then invest however you like. But, that doesn’t change the way the liabilities or funded ratio are derived.
As always, I am concerned when people use terms like "volatility" because I think some people think of volatility as only a short-term thing.

In this case, if you invest in assets with a significantly shorter duration than your liabilities, your "funded ratio" may not vary just over the short term, it may vary over the long term too. As in, if market interest rates generally go up, you will end up being able to fund more liabilities. Yay! But if market interest rates generally go down, you will end up being able to fund fewer liabilities. Oops.

So that mismatch between the duration of your assets and the duration of your liabilities is not just about short-term noise. It can make an actual significant difference to what happens in the long run.
BTW, at the beginning of the topic I showed how the funded ratio would have changed in 2022 for a variety of asset allocations. Again, the numerator changes in the analysis, but not the denominator.
Again, correct.

As your calculation showed, there was no change in the funded ratio if you used duration matched TIPS. That is as expected since you matched duration.

Total Bond and Total Stock both showed an increase in funded ratio, because Total Bond and Total Stock both have a duration significantly shorter than your assumed liabilities.

Wellesley, Wellington, Balanced Index, and Target funds all then ALSO showed an increase in funded ratio, because they all also have a duration significantly shorter than your assumed liabilities.

So, you are just confirming that if you have assets with a duration significantly shorter than your liability, then (holding aside other effects), your funded ratio is expected to improve in the event that market interest rates go up. Which again is basically because you "kept your powder dry" and are now assuming you will be able to reinvest at a higher rate, as opposed to locking in at a lower rate with a duration-matched investment.
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