Why use multiple rates for discounting goal levels?

The Household Balance Sheet provides three priority levels for goals: Necessary, Target and Aspirational. Each goal may be divided among these three levels. The system functions such that Necessary goal amounts are funded ahead of Target amounts and Target amounts are funded ahead of Aspirational amounts. Thus a useful way to think of the priority levels is as three supermarket baskets where the Necessary basket contains the items which it is essential to fund, the Target contains the items which are important to fund and the Aspirational basket contains the “nice to haves.” By implication, changes in the Necessary goal level would generally imply large changes in the household’s life plans whereas changes in the Aspirational goal level would represent minor adjustments. Thus the priority structure captures the financial flexibility that exists in the household’s goal structure.

To achieve comparability, the system values each goal on the basis of how much money should be set aside today to fund the goal. Most goals define sequences of cash flows which should be made through time. Thus, a living expense goal calls for an annual expenditure, potentially for the rest of the household’s life and usually with some degree of escalation through time to deal with inflation. In contrast, a capital purchase goal calls for a one-time cash flow at a point in time. Valuing goals includes discounting the expected cash flow of the goal. Here are the details:

• For the Necessary goal level no shortfall in funding can be tolerated. The result includes discounting the goal amounts using the rate of return on a portfolio with after tax cash flows that provide the required cash flow with low risk. Currently, 3.2% is the default rate used for discounting the Necessary goal amounts, but a user has the option of entering a different rate for each plan.

• For the Target goal level some shortfall is permissible, and the expected return typical of a moderately risky portfolio is used as a discount rate. Currently, 5.0% is the default rate used for discounting the incremental Target goal amounts, but a user has the option of entering a different rate for each plan.

• For the Aspirational goal level, where considerable shortfall is permissible, the expected return of a fairly aggressive portfolio is used as the discount rate. Currently, 6.8% is the default rate used for discounting the incremental Aspirational goal amounts, but a user has the option of entering a different rate for each plan.

The following table summarizes how the goal discount rates are currently determined:

Discount Rate	Portfolio Proxy	Rate	Asset Class Mix  (Stocks/Bonds)	Asset Classes
Aspirational Goals	Aggressive	6.8%	80%/20%
Stocks - Large Cap
Bonds - US Gov't
Target Goals	Moderate	5.0%	50%/50%
Stocks - Large Cap
Bonds - US Gov't
Necessary Goals	Conservative	3.2%	20%/80%
Stocks - Large Cap
Bonds - US Gov't
Discount Rates Based on Long Term AP Assumptions
US Large Cap Equity Returns	8.0%
US Intermediate Treasury’s	2.0%