Liability-driven Individual Retirement Planning

A straightforward beginning to thinking about retirement planning is to recognize and accept the inescapable truth that an individual cannot know with certainty two core retirement concerns. These truths, which affect retirement planning for all individuals, are: (a) How long will I live? and (b) What will be the conditions (health, market, estate planning) of my life within that unknown longevity?¹ Retirement planning in this individually uncertain context requires different perspectives and tools than those typically used in the financial planning industry.

If you agree that these two questions can never be known with certainty and you want an individualized retirement plan, then a liability driven approach to retirement planning is right for you. Adopting a liability-driven approach to retirement planning finds its roots in liability-driven investing — a proven strategy for matching assets to liabilities over time. 

The concept of liability-driven investing (LDI) has been used for years by the pension world to provide retirement income to pensioners for their lifetime.² This approach matches income producing assets to retirement liabilities to provide a stable, secure, and sustainable income for life.

Conventional retirement planning advice and online calculators begin by asking how much current income a pre-retiree wants to replace. By asking this question first, the focus of the pre-retiree is drawn toward thinking about current income replacement in retirement — a misdirected step in the retirement planning process that has severe negative consequences. In contrast, if retirement planners present retirees with liabilities that must be paid for over the retiree’s life, then pre-retirees should start their planning by classifying on-going and mandatory base expenses (housing, medical, insurance, transportation, clothing, food) rather than current income replacement. Liability-driven retirement plans view the nature of expenses as items that must be funded today and in the future. Once these expenses have been determined and classified, the base retirement income needed can be quantified and optimized for tax efficiency.

Implementing a liability-driven approach for a retirement plan can help retirees create sustainable retirement income because it can help clarify and prioritize the use of savings and investments. 

As approximately 10,000 baby-boomers per day turn 65 — a projected trend for the next 19 years — concerns for how to retire and stay retired have never been higher.³ Qualified financial advisors, employing the proper decision making framework, can help retirees assess their preparedness for retirement, as well as provide advice for ways to achieve a sustainable retirement for life. 

¹ “Modern Retirement Theory”, Journal of Financial Planning’s Retirement Distribution Supplement, December 2009. Copyright Jason Branning and Ray Grubbs.
² http://www.investopedia.com/terms/l/ldi.asp#axzz1YmvAFMyz 
³ Dave Carpenter. “Baby boomers near 65 with retirements in jeopardy.” December 27, 2010.  Retrieved on September 23, 2011. http://finance.yahoo.com/news/Baby-boomers-near-65-with-apf-654311409.html 

FPA member Jason Branning, CFP^®, is a fee-based investment adviser and financial planner with CS Planning Corp. in Ridgeland, Miss. He owns Branning Wealth Management LLC.

Ray Grubbs, Ph.D. is a professor of management at the Else School of Management at Millsaps College in Jackson, Miss. He consults with numerous private, public and nonprofit organizations.