Five Flaws with the Funded Ratio Approach to Retirement Investing
Don’t risk your future with the “Funded-Ratio” approach to retirement investing. Here are 5 reasons why.
One of the biggest, most pervasive worries suffered by retirement investors is the fear of retiring and then being whacked by an equity bear market—a lasting, fundamentally driven decline exceeding -20%—right out of the gate. This fear is so prevalent, some financial salespeople have designed tactics around it, such as U-shaped allocation strategies, the automatic reduction of equity exposure (even though your time horizon doesn’t change on the day you quit working), annuities and more. Occasionally, we come across articles featuring suggestions as to how investors can quell this fear. One such article hit the financial press recently, offering investors eight pieces of advice for how they can retire in a bear market. And it contains one piece of advice that is hazardous to your financial health in retirement.
The article isn’t a forecast, but a how-to guide—eight suggestions for how to manage your costs and cash-flow needs in a period when stocks are declining a lot. Some of the eight suggestions are fine. Some contradict one another. (Which has us wondering how you can act on this how-to guide.) Others are largely harmless but odd, like the suggestion to downsize your home in a bear market. Why odd? Homes are illiquid, for one—it isn’t so easy to downsize your home on demand. And two, this advice isn’t exactly something you can repeat. After all, your retirement could span thirty years or more and, in that time, there could be several bear markets. How many times can you go the “downsize” route before you wind up living in a shipping container? If your finances are stressed in retirement by the expense associated with your home, we’d humbly suggest you not wait for a bear to strike before downsizing.
Dangerous Advice: The “Funded Ratio”
While most of the advice is fairly innocuous and “vanilla-flavored”—things like “work longer” or “downsize”—one tidbit stands out to us as downright dangerous: The notion that you should calculate your “funded ratio—all your assets and income against your total spending needs through retirement”—and if it falls too far based on your assets declining in a bear market, the author argues you should sell and exit equities forever. Then, immediately consider buying an annuity instead to lock in lifetime income.
Maybe that doesn’t seem so dangerous to you. Maybe it even seems wise! But here is why we believe this “tip” is well wide of the mark:
- Your funded ratio is unknowable. Unless you have a direct line to the Man Upstairs and He is willing to divulge, you simply won’t know how long your money needs to last. After all, most folks need their retirement money to last until they pass away—sometimes longer, if they have a spouse who survives them. Without this unknowable information, you can’t calculate your funded ratio.
- Your funded ratio is unknowable, part two. You also don’t know what your expenses will exactly look like. Your and your family’s health, inflation, unforeseen events—all could and will shift and change. Again, you can’t calculate your funded ratio. Making long-term, irrevocable forecasts based on something you can’t actually calculate is a very risky move.
- The advice proffered by the article presumes you are investing with more money than you need to fund your retirement. Let’s pretend items 1 and 2 aren’t real issues (but they are real!) and assume your funded ratio is at, say, 135%—the figure cited in the article. Barring some other, non-retirement goal that may be unfunded, this leads us to wonder: What are you doing in stocks? If you know full well that you have 135% of all your lifetime needs, you don’t need equity-like volatility. Don’t wait for a bear. Exit now. But if you do have other goals and accept the impossibility of calculating your lifetime needs, or just realize you need growth to fund your retirement (Likely! Remember inflation and health advances!), then you may want to own some stocks. For the same reason, why buy an annuity? You have more money than you need! The suggestion to buy a guaranteed stream of income is a tacit admission the calculation doesn’t work.
- If you own stocks because you need growth, selling after a steep decline is a fundamental error. Stocks are not what we call “serially correlated.” That is a fancy way of saying yesterday’s movements—even the last month’s, quarter’s or year’s—are not relevant to tomorrow’s. One of the most common mistakes investors make is to presume downside will persist because it just happened. As our boss, Ken Fisher, wrote in his 2010 book, Debunkery:
If you have a long time horizon and goals requiring equity-like growth, a bear market doesn’t change that at all—or much of anything relative to what you should do moving forward. What folks fear is being in a hole they can’t get out of.The tricky part of investing is that selling and permanently exiting equity markets ensures you lock in the drop. You are permanently accepting the hole. Meanwhile, every equity bear market on record has been followed by a bull, and the jump off the lows is usually in a sharp, V-shaped pattern. The tables at the bottom of this article show historical S&P 500 bear-market returns and the full bull market that followed, with the first year of the bull broken out. History is no guarantee, but it is better than ensuring you lock in losses by selling after a decline.
- It encourages selling out of fear, using only a vague, impossible-to-calculate statistic as the basis. Once you accept that you can never calculate your funded ratio, it should be a dead giveaway that this is a strategy operating on pseudo-statistics. If stocks fall enough to threaten your funded ratio, that likely raises your level of angst, leading you to sell and cling to a mirage of rational decision making. During periods of volatility (corrections, bear markets, etc.), folks frequently attempt to rationalize emotion-based financial decisions. The funded ratio is no different.
Reaching Your Retirement-Investment Goals
In the end, the simple, basic logic for any retiree worried about a bear market or negativity striking is this: That risk will always exist. You can never, ever be 100% assured a bear isn’t lurking. The question you must ask yourself is: What are your goals, and how can you likely reach them? In many cases, stocks are going to play a crucial long-term role for you—giving you the growth you need to fund your later years and outpace inflation. Shunning this tool may turn your golden years to pyrite.
Table: Historical S&P 500 Bear Markets
Source: Global Financial Data, Inc., as of 5/16/2016. Bear markets from 1926 – 2016. S&P 500 price returns.
Table: S&P 500 Historical Bull Markets
Source: Global Financial Data, Inc., as of 5/16/2016. Bull markets from 1926 – 2016. S&P 500 price returns.