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Are you on track financially to retire? How might you go about figuring out whether you’ll have enough income to support your desired standard of living in retirement?
According to Wade Pfau, author of the "Retirement Planning Guidebook," the best way to determine your financial readiness for retirement is with a three-step framework, which he shared in a new episode of Decoding Retirement (see video above or listen below).
Step one involves quantifying financial goals using "the four Ls" that translate into retirement expenses: longevity, lifestyle, legacy, and liquidity.
“This is really what you're seeking to fund in retirement,” Pfau said.
The second step is to assess available assets for retirement, including Social Security, investment assets, home equity, potential part-time work, and other future income streams to fund your liabilities and your future expenses.
Step three involves calculating the funded ratio — the ratio of your assets to your expenses — using a relatively conservative rate of return.
“I think that's really the best starting point for thinking about, 'Am I on track to being able to successfully cover my retirement expenses?'” Pfau said.
The funded ratio metric resembles how government and corporate pension plans assess their financial health, determining whether they have enough assets to meet the pension benefits promised to retirees and workers.
According to Pfau, a funded ratio of 100% or above suggests you’re in good shape. If your funded ratio is below 100%, however, you have several options to improve it.
"You need to either increase your asset base, which implies potentially working longer, or you need to decrease your retirement liabilities, which just means cutting expenses," he said. "Whether that's just trimming some of the discretionary expenses or maybe reducing the legacy goal, just reducing what you're trying to fund helps to get the funded ratio in alignment."
Coley Faulk Jr., retired from the Virginia State Police Department, outside of his RV at Cherry Hill Park in College Park, Maryland, on Sunday afternoon. (Andy Cross/The Denver Post via Getty Images) ·Andy Cross via Getty Images
Another option is to assume a higher investment return, but Pfau warned that this is a risky approach.
"If you're assuming you're going to earn a higher investment return and use a higher interest rate to calculate your funded ratio, that can make your plan look more funded," he said, "but it would correspond to a lower probability of success because there's less chance that you're going to outperform that return assumption that you're using."
Ultimately, a solid retirement plan is built on realistic assumptions, Pfau said. He added it's also important to remember that your funded ratio will fluctuate over time as market conditions change.
"Your funded ratio would fluctuate on a daily basis as the value of your investment accounts fluctuate," he said. While the goal is to outperform your assumed rate of return over the long run, monitoring your funded ratio regularly is key.
If your funded ratio improves, "it might even point to spending a bit more," Pfau suggested. On the other hand, if market losses cause your funded ratio to decline, "then you might want to revisit whether you need to reduce expenditures to help get that funded ratio back into alignment."
So, how might you go about estimating your retirement expenses?
In general, in the five to 10 years before retirement, people typically start to understand the cost of maintaining their lifestyle, which serves as a strong foundation for their planning.
“Of course, there's a lot of things that can change in retirement, but certainly the pre-retirement expenses that you have are going to be the most useful for figuring out what that might translate into post-retirement,” Pfau said.
When deciding how to fund the four Ls, Pfau explained that retirement assets can be categorized into three groups.
Reliable income assets are best suited to cover your core, fixed costs that need to be met regardless of how long you live. Ideally, Pfau said, these assets offer lifetime or contractual protection to ensure financial stability throughout retirement.
A diversified portfolio, consisting of investments designed to balance market growth and a risk-adjusted return, is typically allocated toward discretionary lifestyle goals and, potentially, legacy planning, Pfau said.
And once you've covered essential spending, longevity, lifestyle, and legacy needs, Pfau said any remaining reserves can be set aside to handle unexpected expenses in retirement. These resources might include home equity, surplus investment assets, or insurance policies.
Though common rules of thumb can offer a simple starting point, Pfau cautioned against relying too heavily on them. He argued the 70%-80% guideline for replacing income in retirement has its limitations, such as assuming a stable income.
“That rule of thumb starts falling apart because it's 70% or 80% of what?” he asked. “It's really implicitly assuming you always have the same salary” when, in reality, salaries fluctuate.
Pfau acknowledged that “the basic idea makes sense” for those who consistently spend most of their income. However, “in practical terms, you're probably better off spending the time figuring out what your budget is and then using that as that baseline for figuring out whether you're potentially able to fund that in retirement,” he said.
Managing retirement risks in 'the go-go years' and 'slow-go years'
In addition to saving, planning for retirement is about managing various risks, and longevity risk is one of the most critical.
“It’s great to live a long time,” Pfau said. “It’s just financially more expensive.”
If, for instance, you retire in your 60s with a life expectancy in your 80s, “there’s a 50% chance to live beyond your life expectancy,” he said. And this uncertainty raises key questions: “What if I outlive my assets?” he asked. “What if I have to plan to age 95 or plan to 100?”
To account for this possibility, retirees may need to spend less and ensure their investments can last over a long horizon. Other strategies can help mitigate longevity risk as well.
“Delaying Social Security helps to provide a lot of longevity protection,” Pfau said, particularly for the higher earner in a couple, since their benefit can later serve as a survivor benefit.
He added that risk-pooling products, such as annuities, can also help manage longevity risk, though they may not be the best approach to manage inflation.
Instead, inflation risk can be best managed through Social Security (with cost-of-living adjustments), Treasury Inflation-Protected Securities (TIPS), and a diversified investment portfolio for long-term growth.
Pfau also addressed how many retirees experience lumpy spending in their early years of retirement, such as travel, buying an RV, or helping fund a child’s or grandchild’s education. “You've got the idea of the go-go years, the slow-go years, and the no-go years of retirement,” he said.
While many assume that retirement expenses will always rise with inflation, Pfau noted that for most individuals, “spending does not keep pace with inflation throughout retirement.”
While healthcare costs may increase later in life, other expenses tend to decline. “So maybe after age 85, you don’t necessarily go on those world trips anymore,” he said. “You may not go to restaurants as often.”
Adjusting for these natural spending declines helps retirees stretch their assets. “That reduces your liabilities and increases your funding ratio,” Pfau said. “So it helps make sure you're on track for a successful retirement.”
