Press Room

March 21, 2014

The Importance Of A Capital Sufficiency Analysis In Retirement Planning

Today’s Retirement Challenges

The primary goal of retirement planning is to accumulate enough financial capital to last throughout retirement while funding all of one’s goals and objectives. Unfortunately, retirement planning in today’s environment has become more difficult than ever for a variety of significant reasons. First, private employers have been shifting away from defined benefit retirement packages (such as pension plans) and into defined contribution plans where employees bear all of the investment risks and are responsible for managing their own retirement accounts. Unlike pension plans, which guarantee a certain payment every year, defined contribution plans create more uncertainty as to how much will be available during retirement. Furthermore, the average life expectancy has risen dramatically over the last two decades, increasing the risk that retired individuals will outlive their financial assets. Finally, the volatile equity market over the past 15 years and the persistent low interest rates in the fixed income market over the past five years have significantly affected the values of investors’ portfolios and may have negatively impacted their retirement plans.

Based on these challenging issues, retirement planning is more difficult and more important than ever. Although individuals cannot control these challenges, they can take certain steps to place themselves in the best position to meet their goals. One effective tool every investor should consider is putting their current financial assets through a capital sufficiency analysis.

A Framework For Evaluating Your Financial Strength

A capital sufficiency analysis is the process of determining the likelihood that an investor will have enough financial resources to last his or her entire life. More specifically, the analysis is used to evaluate whether an investor’s current and future financial capital will allow for the achievement of all financial goals and objectives, which can include everything from meeting basic lifestyle needs and health care costs to leaving a legacy for heirs and philanthropic bequests.

The process of completing this type of analysis starts with a current balance sheet, an estimate of all cash flows in current and future years (including everything such as taxes and modest social security estimates), a retirement age and life expectancy, and overlaying capital market assumptions, such as the rate of inflation and the expected rate of return on the portfolio (this will include a distinction between retirement accounts and non-retirement accounts, which have different return expectations due to different tax considerations). When projecting these variables into the future, one can see how stable his or her balance sheet is and whether or not it is projected to run out early.

Of course, the variables involved in estimating events in the distant future mean the results of an analysis should only be used as a general frame of reference, as capital market expectations often do not materialize as projected and the expected return used in a forecast may not accurately reflect volatility involved in the markets (i.e., a portfolio may significantly under perform in certain years but will statistically average a certain return in the long run). Most of the inputs used are only assumptions, such as life expectancy, living expenses and tax rates, so a capital sufficiency analysis can only provide a base case framework since there is no way to know all of the variables precisely.

The Metropolitan Corporate Counsel
March 2014 Issue
Read the entire article here.

    About the Author

  • Adam Levy
    New York, NYWest Palm Beach, FL