Everything You Know About Retirement Planning Is Probably Wrong – ABC News

Everything you know about retirement planning is probably wrong.

During their working years, people scrimp and save to set aside capital to invest in the markets to fund their retirement. Throughout, they slavishly monitor their portfolio’s progress against key market indexes to assess their progress.

Social Security

Yet, in most cases, this common approach fails to accurately tell investors what they need to know the most: Where they stand relative to meeting their future retirement needs.

If you’re worrying about how your portfolio performs every year, you may be fine come retirement — or you could be in for a rude surprise when your assets come up short. You might find that everything you thought you knew about preparing for retirement was flat wrong.

Instead of fixating on relative performance, some institutional investors such as many pension funds, use a metric known as a funded ratio. Applied to an individual’s situation, this ratio is the sum of your current assets and retirement income streams (Social Security and any pensions) over your eventual retirement expenses, including taxes. If your assets and retirement income equal your expenses, your funded ratio is 1. Less than 1 means you may be underfunded, and more than 1 means you’re in good shape.

This may sound a bit technical, but at its core, it’s quite simple: It shows what portion of your future total retirement expenses you’ll likely be able to pay, based on where you are now. The reason that pension funds use this measure is that they have to write checks to investors who are withdrawing their pension assets when they retire. So it’s only logical for them to constantly monitor their status against this goal.

Your situation is probably similar. You’re saving and investing because you know you’ll have to write checks during retirement and you don’t want to come up short, so you should gauge your progress against that goal.

But if you’re obsessing over how your portfolio did last year against certain benchmarks you’re not doing that. In some years you may beat the S&P 500 and in others, you may not. But when it comes time to retire, if you’ve beaten the index a lot, does it matter if you still don’t have enough assets?

Gauging your performance against benchmarks is the mentality of fund managers who want to show investors how they did relatively well even in bad market years. If you’ve adopted this mentality and constantly worry about how your portfolio is doing at any given moment instead of looking at your big retirement picture, you have a lot of company. Most individual investors spend too much time thinking about how their investments are doing in the abstract instead of thinking about their total assets in the context of the cash they’ll actually need for retirement. Yet the value of your current assets is clear, and realistic retirement expenses are fairly predictable. The future performance of the markets is a big unknown.

And fixating on benchmarks when you should be focusing on your funded ratio can lead you to take actions that result in fewer retirement resources and a lower funded ratio — meaning an inadequate capacity to pay your expenses during retirement. Using a funded ratio keeps you in contact with the reality of your future life in retirement, and gives you cues to what you should or shouldn’t be doing now with your investments.

If your funded ratio is where you need it to be and a relatively large percentage of your portfolio is in stocks, perhaps you should reduce this percentage to reduce the greater risks that stocks carry and increase your holdings in high-quality bonds, which carry less risk. If you’ve already reached your goal, why jeopardize this success unnecessarily? Instead, you want to nurture and protect a good funded ratio.

If, on the other hand, your funded ratio is too low, you may have no choice but to increase your portfolio’s percentage of stocks. However, this is a situation you want to avoid by doing sound retirement planning early enough. If retirement isn’t far off, then you should probably take another look at your retirement budget to see if you can get by on less.

Embracing the concept of a funded ratio takes your attention away from irrelevant market noise and focuses your eyes on the real prize: your future.

Any opinions expressed here are those of the columnists and not of ABC News.