How to Assess Your Retirement Readiness

Dana Anspach of Sensible Money describes a cash-flow-based projection model with a defined set of assumptions to administer three specific retirement readiness tests.
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How might you go about assessing your retirement readiness?

The first place to start is with this fact. “It probably means different things to different people,” Dana Anspach, CFP, RMA, president and founder of Sensible Money, said in a recent interview.

Some people think of it in financial terms. Can they afford to retire? What kind of lifestyle can they afford? What happens if they need a new car or want to take a big vacation or have health problems? Can they afford those things?

And some people think of it in psychological terms. Are they emotionally career-wise ready to retire?

In her experience, Anspach said you have to think of retirement readiness in both financial and psychological terms, and not just the size of one’s nest egg. “I actually think the size of your nest egg can be quite misleading when it comes to whether you're financially ready to retire,” she said.

Common ways of assessing retirement readiness

The 4% Rule

For instance, when some people assess their financial readiness to retire, they might use the 4% rule to gauge whether they have enough money to fund their lifestyle throughout retirement. That rule says you can withdraw 4% of your financial assets each year on an inflation-adjusted basis over an estimated 30-year life expectancy. So, if you had $1 million in your nest egg, you could withdraw about $40,000 per year. “Unfortunately, we don't actually spend that way,” said Anspach. “Some of us retire at 55 and some at 60 and some at 65 and sometimes Social Security doesn't start till 70 or a pension will start at a different age. So, you don't need the exact same amount of money each year. And so, the 4% rule becomes difficult to use in those situations.”

Linear asset value projection

Another common way to assess retirement readiness is to do a linear asset value projection. In this case, you would assume a rate of return, a distribution rate, and project whether you’d have any money left at the end of life.

Monte Carlo

A third way to measure retirement readiness is something called Monte Carlo. “With Monte Carlo you're simulating all types of future possibilities,” said Anspach. “A Monte Carlo analysis simulates your financial accounts over a random pattern of returns and gives you a probability of success.”

According to Anspach, this method can be quite misleading if you don't to interpret the numbers. “And sometimes that can cause people to think that their situation is worse than it actually is,” she said.

Aftcasting or historical audit.

Aftcasting, which was popularized by Jim Otar, “uses the actual market history, including growth rate and inflation, as they exactly happened in history. It reflects the actual sequence of events, actual sequence of returns (stocks, interest rates and inflation), and actual correlation between stocks, interest rates and inflation, actual volatility, actual black swan events exactly as they occurred since 1900.”

Aftcasting shows not only the impact of random, but also fractal events of the past, according to Otar.

“With aftcasting, you're simply testing your plan,” said Anspach. “Would it have worked? For instance, you're testing your plan as if you had retired in the 60s where we had a prolonged period of time with below average market returns.”

But the bottom line when it comes to these three retirement readiness tests is this: “None of them are perfect,” said Anspach. “They all have their pros and their cons.”

A Better Way

In her practice, Anspach uses a comprehensive cash-flow-based projection model with a defined set of assumptions to administer three specific retirement readiness tests. “With each test, we have a metric that we apply, and for us to consider the client to be retirement-ready, their plan needs to meet or exceed a passing grade,” she said.

All three tests begin with the client's current amount of financial capital and then assume customized inflation-adjusted withdrawals are taken for life.

The first of the three tests, she said, is a standard Monte Carlo analysis using 5% returns with a 13.85% standard deviation. An 80% success rate or better result would be the desired result.

The second test is a "fundedness" test, which was derived from a concept in the Retirement Management Analyst curriculum. That test works much like a pension plan's annual fundedness analysis (the fair market value of the plan's assets minus the present value of its projected benefit obligation).

To apply this test, Anspach discounts the client's projected withdrawals by 4% to determine their present value. “We compare this to their current financial capital and want to see a fundedness ratio of 110% or greater,” she said.

The third test is a historical audit aftcast. To illustrate this, Anspach sends data to the firm’s investment partner, Asset Dedication. “They run the historical audit, which shows how the portfolio would have held up in the past given that sequence of withdrawals,” she said.

And with this test, portfolios must have a 100% success rate through past market cycles.

Then, Anspach applies these tests every single year to determine if a client’s retirement readiness is getting better, or worse or staying the same. “It gives us the confidence to say, yes, we feel 100% confident that your plan will work,” she said. “This retirement date works, and this level of spending works. And it's that peace of mind that all of these calculations help us bring to our clients.”

Other metrics

In addition, Anspach said there are other metrics that can be used to determine if a decision is likely to improve the outcome of your plan. These include:

  • Liquidation value at end of plan. This would be the after-tax value of one’s assets at the end of the plan. It could be viewed as the amount your heirs would inherit. “This value,” said Anspach, “allows us to measure the impact of actions such as Roth conversions or how we draw down the accounts. So, if leaving assets to heirs is important, then we need to measure what we're leaving on an after-tax basis.”
  • Coverage ratio. This is the percent of your living expenses that are covered by guaranteed source of income such as Social Security, pensions and annuities. As a rule, Anspach aims for a coverage ratio of 50% or more at age 70 or 72. Among other things, having a high coverage ratio is helpful should cognitive decline become an issue later in life. “That's when having that guaranteed income becomes most important, during those times where you could be at greater risk, just due to your behavior,” she said.
  • Survivor cash flow. Cash flow today isn't the only factor to consider when deciding which pension payout option to choose or when to claim Social Security. You also need to consider how much income your surviving spouse might receive if something happens to you early in retirement. “So, measuring things simply in terms of maximizing cashflow doesn't always work,” she said. “Couples have to look at the amount of survivor income that someone would have.”

“Those are some different ways you can measure success rather than simply looking at the gross amount of net worth or financial assets,” said Anspach. “And I think all of these ways add value to a retiree as they're trying to plan ahead.”

Anspach also said she uses these tests and a few other metrics to address common questions such as:

  • Which is better: contributions to a Roth or traditional 401(k)? Did it improve your fundedness and liquidation value at end of plan?
  • Should I buy an annuity? How does it impact fundedness, liquidation value, coverage ratio and survivor income?
  • Can I afford to take the family to Disney? Buy a second home? Buy this RV? How do these expenses impact fundedness and Monte Carlo?
  • Can I spend more?

In essence, all these tools measure whether a decision actually improves the outcome, confidence level peace of mind. “So instead of guessing, we now have a mathematical way to run the numbers,” said Anspach, and prove whether an action improved the outcome or not.

And that last bit of guidance Anspach offered was this: If you’re planning to retire in the next five years and you haven’t started planning yet, do so now. “There's a lot of research that shows that people who start planning at least five years out from retirement are the happiest,” she said. “They have the most successful transitions into retirement. If you are thinking you want to retire in the next five years, you really want to start that planning process now. It'll alleviate your stress. It will make the whole thing a lot easier.”