Advising a Retired Client Who Wants to Buy a Second Home (or Other Big-Ticket Item)

The household funded status under the AFP model is equal to the ratio of total household assets to total household spending liabilities. The AFP is a “two-bucket” model that separates essential and discretionary expense liabilities and anticipates separately funding them in a manner consistent with liability-driven investing (LDI). It also distinguishes between recurring and nonrecurring household expenses and expenses with different expected rates of future increases.

The funded status as of the valuation date is represented by the following equation …

Funded Status = (PV of Risky Assets + PV Nonrisky Assets) / (PV Discretionary Exp. + PV Essential Exp.)

… where “PV” stands for present value as of the valuation date, which is determined using different discount rates for the assets and liabilities in the two different risk-related buckets.

Recently, preeminent retirement expert Dr. Wade Pfau has become an actuarial approach convert and has discussed why he prefers the actuarial approach and its funded status metric (which he calls the “funded ratio”) to the Monte Carlo modeling approach frequently used by financial advisors (and its probability of success metric).

Episode 168: Funded Ratio vs. Monte Carlo: Which is Better? Retire With Style - Apple Podcasts

Estimating the net cost of big-ticket items

Some significant items are relatively easy to price. For example, the cost of an around-the-world cruise is essentially equal to the upfront cash outlay plus incidental costs expected to be incurred on the trip (generally all in one year). However, other big-ticket items may involve not just upfront cash outlays, but also ongoing annual costs and possibly some offsetting future income during the period of ownership or when the item is eventually sold.

Such big-ticket items could include, for example:

• A vacation home
• A camper van
• A boat
• An automobile
• An updated kitchen
• A rental property
• A business

To estimate the impact on your client’s funded status of the possible purchase of one of these big-ticket items, the advisor and the client will need to estimate:

1. The upfront purchase cost of the item
2. The present value of additional annual expenses associated with the item
3. The present value of any additional income expected from the item during the expected period of ownership and/or upon sale of the item

Once these items are estimated, the advisor will need to estimate a postpurchase funded status. This will generally be done by decreasing the client’s total assets in the AFP by the estimated upfront cost (No. 1 above), increase total assets by the present value of additional income (No. 3), and increase the client’s total spending liabilities by the present value of additional annual expenses (No. 2).

Let’s look at an example.

Our hypothetical financial advisor, Sue, has a long-term consulting arrangement with a now-retired couple, John and Mary. Sue determined their household funded status as of January 1, 2025 to be 140%, consisting of a total present value of assets of $2,100,000 and total spending liabilities of $1,500,000. In addition, the present value of their nonrisky assets (Social Security and pensions) covered the present value of their essential expenses as of January 1, 2025.

John and Mary would now like to know whether they can afford to use some of their risky assets to buy a lake house about two hours away from their residence for $400,000. Sue asks them how long they plan to own this second home and whether they plan on renting it out. They agree that they would like to own the property for about 10 years, not rent it out, and sell it at the end of that period.

They estimate that the additional annual costs of owning the property (property tax, gas and electricity charges, insurance, upkeep, transportation back and forth from their current home, etc.) will be about $10,000 per annum in 2025 dollars and will increase with inflation each year. They also assume that they will be able to sell this property after 10 years for the same price they paid for it (i.e., no increase due to inflation).

Sue estimates the couple’s postpurchase funded status as follows:

No. 1: Upfront cash outlay of $400,000. Note that if they take out a mortgage on the property, No. 1 would be the amount of the down payment, and No. 2 would include annual mortgage payments.

Number 2: Using the AFP, Sue enters the following amounts in one of the nonrecurring expense rows:

The PV Calcs tab of the AFP shows that the present value of this stream of nonrecurring expenses (determined using a discount rate of 8% per annum consistent with 100% discretionary expenses) is $81,541.

No. 3: Using the AFP, Sue enters the following amounts in one of the other asset rows:

The PV Calc tab of the AFP shows that the present value of this $400,000 payment 10 years from now using a discount rate of 8% is $185,277.

Sue estimates John and Mary’s postpurchase funded status by subtracting the purchase price of the lake house ($400,000) from their beginning-of-year asset value and adding the present value of the expected sale price 10 years from now ($185,277) to obtain estimated postpurchase assets of $1,885,277. She then adds the present value of the additional annual costs of $81,541 to their beginning-of-year spending liabilities of $1,500,000 to obtain an estimate of postpurchase liabilities of $1,581,541, and an estimated postpurchase funded status of 119% ($1,885,277/$1,581,541).

By crunching these numbers for John and Mary, Sue provides the couple with important, understandable information they can use to answer the question of whether they can afford to purchase their dream lake house. And Sue didn’t have to run 10,000 simulations to develop this information. Based on the assumptions used in the calculations, John and Mary’s 2025 funded status is expected to decrease from 140% to 119% as a result of this purchase.

Of course, they can ask Sue to vary the assumptions used to perform these calculations to further assess the financial risk of making this purchase (or of other parts of their plan). While they would still be above 100% postpurchase, their funded status is not quite as robust as the prepurchase level.

Each future year, Sue, John, and Mary plan to revisit this calculation as part of their annual funded status valuation. If actual experience differs from assumptions about the future — either relative to this purchase or to any other part of their financial plan — they may have to take actions to increase their assets (by selling the lake house earlier than planned, for example) or decrease other discretionary spending if their funded status drops below 100% in the future.

Summary

One of the most important financial questions for a retired household to address is, “How much can I afford to spend?” To help clients answer this question, financial advisors need to develop and use straightforward and understandable metrics that address not just what annual real dollar amount may be spent (or withdrawn from a portfolio) each year, but also:

• How will various important decisions affect the client’s financial health
• When to consider spending reductions (or increases in assets)
• When to consider spending increases
• How much can be spent on nonrecurring items including the big-ticket items discussed in this article

The name of our website is “How Much Can I Afford to Spend in Retirement?”, and answering this important question has been our primary focus for over 15 years. If you are interested in learning more about the actuarial approach and its funded status metric, I encourage you to visit our website, download our free actuarial financial planner Excel spreadsheets, and use them. You and your clients will be glad you did.

Ken Steiner is a retired actuary with a website titled, "How Much Can I Afford to Spend in Retirement?"

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