Planning for retirement can feel like trying to solve a puzzle without knowing exactly how the pieces fit together. How much do you need to save? How can you ensure your savings last as long as you do? And what’s the best way to estimate if you’re on the right track?
These are big questions with no one-size-fits-all answer. However, two prominent methods are often used to assess retirement readiness and guide financial planning decisions: the Funded Ratio and Monte Carlo simulations. Both approaches tackle the same question from different angles. Understanding how they work can empower you to make informed decisions for your financial future.
This article breaks down these two methods, explains their strengths and weaknesses, and helps you decide which might be the best starting point for your retirement plan.
What Is the Funded Ratio?
The funded ratio is a straightforward way to measure whether you are prepared to fund your lifetime retirement goals based on your available assets. Originating from the world of pension fund management, this method has since been adapted to individual retirement planning.
It works by comparing your total assets (i.e. savings, investments, and future income streams like Social Security) to your estimated retirement liabilities (your anticipated expenses). The funded ratio uses a fixed rate of return assumption to discount future cash flows into present value to show what they are worth in today’s dollars.
The result is expressed as a ratio:
- A funded ratio of 100% or higher means you’re fully prepared for retirement.
- A ratio of less than 100% indicates a shortfall and the need for adjustments to your financial plan.
For example, if the present value of your assets (including future income) is $1.5 million, and your estimated liabilities are $1 million, your funded ratio is 1.5 or 150%. You’re overfunded for retirement and in great shape to meet your future spending goals! On the other hand, if your assets total $800,000 and your liabilities are $1 million, your funded ratio is 0.8 (80%), signifying a funding gap.
Why the Funded Ratio Stands Out
The funded ratio is loved for its simplicity and clarity. With a single calculation, you get a snapshot of where you stand and what you need to work on. It also avoids relying heavily on speculative assumptions about market returns, providing a more conservative and tangible assessment compared to other methods.
If your funded ratio is below 100%, it gives you actionable insight into the steps you can take, such as:
- Reducing discretionary spending
- Delaying retirement to save more
- Exploring contractual income strategies like annuities to secure essential expenses
How Monte Carlo Simulations Work
Monte Carlo simulations, on the other hand, use a probability-based approach to evaluate retirement readiness. Instead of calculating a single funding metric, Monte Carlo runs thousands of simulations of potential financial scenarios based on variables like market performance, inflation, and spending patterns. The result is a “success rate” that tells you the percentage of simulations in which your retirement plan worked (i.e., you didn’t run out of money). For example, a success rate of 95% suggests that in 95 out of 100 scenarios, your plan was sustainable.
While Monte Carlo offers a comprehensive view of various financial possibilities, it has its challenges:
- Complexity: The process is heavily data-driven and can involve a steep learning curve for non-experts.
- Assumptions Matter: Monte Carlo relies on assumptions about market returns, volatility, and other factors. Small changes in these assumptions can lead to drastically different results.
- Misinterpretation: A “95% success rate” may sound like a guarantee, but it doesn’t mean your plan will definitely work. The details of the 5% failure cases (how much you might fall short by) can often be overlooked.
Monte Carlo analysis shines in situations where variable spending strategies are involved. For instance, if you plan to adjust your spending based on market performance, it can help model these adjustments effectively.
Funded Ratio vs. Monte Carlo Simulations: Which Is Better?
Choosing between the Funded Ratio and Monte Carlo simulations often depends on your goals and preferences. Each has its strengths:
- The Funded Ratio is a straightforward, actionable starting point. It’s particularly appealing for its simplicity and conservative nature, especially for retirees who value clear metrics.
- Monte Carlo Simulations are better suited for individuals with more complex financial plans or for those who want to explore “what-if” scenarios, such as variable spending strategies.
Ultimately, you don’t have to pick just one. Many financial advisors recommend starting with the funded ratio to establish a clear baseline, then using Monte Carlo analysis for additional insights into variable scenarios. By combining both approaches, you can get the best of both worlds.
It’s important to remember that retirement planning isn’t static; it requires periodic reviews and adjustments. Market conditions, personal circumstances, and expenses are likely to change over time. Revisiting your funded ratio and, if applicable, Monte Carlo simulation results ensure you remain on track and can adapt to new developments as needed.
Planning for retirement is one of the most important financial decisions you’ll make, and using tools like the funded ratio and Monte Carlo simulations can bring clarity and confidence to this complex process. Start with the funded ratio as your financial report card and turn to Monte Carlo for a deeper look into variable spending strategies.
Build Your Retirement Plan with Confidence
If you find retirement planning overwhelming or need help with calculations, you don’t have to navigate it alone. The right tools and resources can make the process more manageable and help you approach your financial future with confidence.
Inside the Retirement Researcher Academy, you’ll find expert-led courses, research-backed strategies, and practical insights to guide you. One valuable resource is the Funded Ratio Analysis tool, which helps you assess where you stand financially in relation to your future expenses. Plus, with a supportive community and expert guidance, you’ll have the clarity you need to move forward with confidence.
Explore how the Academy can support your retirement planning journey and see if it’s the right fit for you.
Want to learn more? Listen to Ep. 168 of the Retire With Style Podcast.
