Using the Funded Ratio to Determine Retirement Readiness
Defined Benefit pension plans are required to use a funded ratio, also referred to as a solvency ratio, in determining whether the plan is sufficiently funded. This approach can also be used to assess the funding adequacy, or solvency, of your own retirement savings.
What is a Funded Ratio?
The definition of the funded ratio is straightforward: Assets divided by liabilities. If your funded ratio is greater than 1, that is, you have more assets than liabilities, you are doing fine. On that calculation, you have enough to pay all your liabilities. On the other hand, if your funded ratio is less than 1, then you have to start considering options to make up the gap.
Calculating the Funded Ratio
The paragraph above makes it sound so simple. But the challenge, as always when it comes to retirement planning, is in the assumptions you need to make. The reality is that not all your assets and liabilities occur at the same time. The $1,000,000 you have saved up today is not the same as the $1,000,000 you will spend throughout your retirement.
The Time Value of Money
Figuring out how far the money you have today will fund your retirement tomorrow requires using Time Value of Money (TVM) calculations. To many, I suppose this will sound insufferably boring. However, it is at least worth thinking about, however briefly. Think about the whole idea of earning interest in a savings account. A savings account from our perspective is a way to earn interest. From the point of view of the financial institution that holds the savings account, it represents a loan that they have received and upon which they must pay interest for the use of your money over the time that you allow them to have it.
As it applies to calculating your funded ratio for retirement, a dollar saved and invested today will usually be worth more in retirement. To keep things very simple, let’s suppose that you set aside $100 today in a savings account that is paying 5% annual interest. In one year, that $100 will be worth $105. That is the future value one year from now of $100 today. Looking at it the other way, let’s suppose you know that you will need $100 in one year. With 5% interest, how much do you need today? That’s a bit more challenging to calculate in your head but it works out to $95.24. That is the present value of $100 one year from now because you can earn 5% interest on your $95.24.
The challenge as it applies to retirement is that we will have multiple needs for cash over an extended period, possibly 30 years or more. Again, doing a little supposing, let’s imagine that on average, you, meaning a married or common-law couple, spend $6,000 per month now (excluding savings for retirement) and you think that pattern will continue into retirement. Beyond your typical daily expenses like groceries, utilities and other shelter costs, this also includes vacations, charitable donations, healthcare costs, debt payments, and anything else that might be relevant.
Your Government-based Assets
According to the Government of Canada, the average CPP recipient is paid $727.61 per month as of April 2022. For a couple that works out to $1,455.22 per month.
Let’s also assume that you will receive the full Old Age Security (OAS) of $666.83 per month. For a couple, that is $1,333.66.
Added together, from age 65 onward, you have almost $2,800 of your $6,000 in monthly income taken care of, leaving you with $3,200 to make up on your own, every month.
Your Employment-based Assets
This could take the form of a pension plan or a group Registered Retirement Savings Plan (RRSP, or some other type of employer-sponsored retirement savings scheme intended for your retirement. Let’s assume that between you and your spouse, you have $500,000 saved in employment-based savings.
Your Personal Investments
Beyond savings through your employer, you could also be saving and investing personally in personal RRSPs, Tax-Free Savings Accounts (TFSAs), and even non-registered accounts. Your personal investments are also worth $500,000 combined.
If you own your home without a mortgage, you may feel like you are living in a huge untapped asset. However, you need to live somewhere, and it will cost you one way or the other. You can get money out of your home by selling it and downsizing either to a rental property or to a smaller purchased property. Alternatively, you can stay where you are and take out a line of credit or a reverse mortgage. No matter what choice you make, it’s not as “clean” a retirement asset as purely financial investments.
You may receive an inheritance, but it is an uncertain asset at best. You don’t know when you will receive it, nor do you know how much it will be. You will probably do better not to rely on this potential source.
We have determined that you need to have enough money to cover $3,200 per month for the rest of your lives. Let’s assume that you retire at age 65 and live to age 95, 30 years. Also, what is a reasonable rate of return on your assets? Let’s assume 2% above the rate of inflation. You have $1,000,000 from employment and personal savings. Is that adequate to cover 30 years of retirement at a 2% real* rate of return? Let’s figure it out.
First, let’s try a simple way. If you need $3,200 per month, that works out to an annual need of $38,400. Over 30 years, that is $1,152,000. You only have $1 million so are you short your required amount? The problem is that this does not account for the time value of money.
We need to discount your future costs by your 2% rate of return over 30 years. Let’s try it again.
Number of years: 30
Discount rate: 2%
Payments required: $3,200/month
Future value: $0.00 (This calculation assumes you do not need to provide an inheritance).
Putting these figures together, we can determine that $3,200 in regular monthly expenses over 30 years can be met with savings of $865,755. With a million dollars, you have exceeded your desired funding ratio of 1. In fact, it is 1.155 ($1,000,000 ÷ $865,755).
There are a lot of assumptions that go into this calculation. Is $3,200 a month enough or is too high? Is 30 years a reasonable lifespan in retirement? What if one spouse dies well before the other? What if high inflation persists and 2% real returns are not realized? This is the challenge of dealing with the uncertainties of retirement but going through this process can help you gain a sense of where you stand.
This exercise is a snapshot in time, but it becomes more useful as the analysis is repeated at regular intervals and as you get closer to retirement. You can try this yourself by using a spreadsheet or a financial calculator or do an internet search for the “time value of money” as there are many free online calculators that will do it for you.
*The real return is the return above inflation. The nominal return is the figure that we see posted for a savings account or a Guaranteed Investment Certificate (GIC).
This is the 159th blog post for Russ Writes, first published on 2022-08-08.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.