In a recent episode of the Bogleheads on Investing podcast, I mentioned the idea of calculating a funded ratio — and how that can be more useful than “4% rule” -style guidelines, especially when a household’s level of non-portfolio income will be changing materially at various points through retirement.

One limitation of “safe withdrawal rate” rules of thumb is that they assume that the amount you have to spend from the portfolio does not change from one year to the next (other than due to inflation). In real life, however, most households find that the amount they must spend from the portfolio does change significantly at various points in time, as their level of income from non-portfolio sources changes.

EXAMPLE: Raman (age 55) and Nisha (age 57) are married and both are still working. Raman plans to retire at age 60 (5 years from now), and Nisha plans to retire at age 65 (8 years from now). They each plan to file for Social Security at age 70.

When Raman retires, they’ll initially have to spend about 3% from their portfolio each year to cover their expenses. When Nisha retires, they project that their spending rate will go up to about 7% of the portfolio balance each year. When Nisha’s Social Security kicks in, their spending rate will fall back to about 5%, and when Raman’s kicks in it will fall to around 2%.

Based on guidance like the 4% rule, it’s hard to tell if Raman and Nisha’s plan is safe (because they’ll be spending less than 4% most years) or unsafe (because they’ll be spending considerably more than 4% for some years early in retirement).

Guidelines like the 4% rule simply can’t account for such situations very well. And for some households there could be even more stages to account for, if either person has a pension or is planning on a “phased” retirement in which they scale back work gradually.

Calculating your “funded ratio” is one way to get a sense of your retirement preparedness, when you anticipate that your amount of non-portfolio income will change from one year to the next.

### What’s a Funded Ratio?

Your funded ratio is the sum of your current portfolio value and all of your future non-portfolio income, divided by the sum of all of your future expenses.

Or more precisely, it’s the sum of your current portfolio value and the present value of all of your future non-portfolio income, divided by the present value of all of your future expenses. The point of this “present value” wording is simply to account for the fact that dollars in the future are less valuable than dollars today. For instance, if you received \$1,000 of income today, you could use that sum to pay for more than \$1,000 of expenses 20 years from now, because you could invest the money between now and then. (See this article for a more thorough explanation of the present value concept.)

Said yet another way, your funded ratio is the ratio of your income and assets to future liabilities, if we assume that the assets will grow at a conservative interest rate.

Funded ratios are often expressed as a percentage. If your funded ratio is at least 100%, that indicates that your portfolio and future income should be enough to cover your future expenses. A funded ratio of less than 100% indicates that something in the plan should be changed (e.g., working longer, thereby increasing the sum of your future income, or cutting expenses).

### A Simple Funded Ratio Example

Below you can find a spreadsheet that gives a simple example of a funded ratio calculation:
https://obliviousinvestor.com/FundedRatio.xlsx

Note that in the example spreadsheet, I have lumped income all into one column and expenses all into one column. You may prefer instead to separate them out by source (e.g., a column for work income, a column for Social Security, etc.).

### Funded Ratio Caveats

There are a few caveats to keep in mind when calculating your funded ratio.

Firstly, it’s critical to use a conservative discount rate. The discount rate can be thought of as the rate of return that the portfolio will earn. And there is no uncertainty reflected. In other words, we’re assuming that the portfolio will earn this rate of return every year, without fail. So if you choose an aggressive discount rate (such as the return you’d expect from a portfolio with a considerable stock allocation), you’re setting yourself up for failure if your portfolio happens to earn a lesser return. Hence, the expected return from very safe assets should be used.

Second, in addition to being sensitive to the discount rate input, a funded ratio calculation is sensitive to the planning horizon input. That is, it’s up to you to make an assumption about how long you’ll need your savings to last. Picking a shorter planning horizon can make your funded ratio look much better — and can again set yourself up for failure, if you live beyond that point.

Finally, I don’t think that a funded ratio calculation should be the only type of retirement-preparedness analysis that you do. Additional tests with Monte Carlo simulations (or potentially historical simulations) can be informative as well.

### What is the Best Age to Claim Social Security?

Read the answers to this question and several other Social Security questions in my latest book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less

Disclaimer:Your subscription to this blog does not create a CPA-client or other professional services relationship between you and Michael Piper or between you and Simple Subjects, LLC. By subscribing, you explicitly agree not to hold Michael Piper or Simple Subjects, LLC liable in any way for damages arising from decisions you make based on the information available herein. Neither Michael Piper nor Simple Subjects, LLC makes any warranty as to the accuracy of any information contained in this communication. The information contained herein is for informational and entertainment purposes only and does not constitute financial advice. On financial matters for which assistance is needed, I strongly urge you to meet with a professional advisor who (unlike me) has a professional relationship with you and who (again, unlike me) knows the relevant details of your situation.

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