Monte Carlo Simulations In Retirement Planning
This post discusses the right place for Monte Carlo simulations in retirement planning and how MoneyBee helps you navigate uncertainty.
A Monte Carlo simulation produces a range of investment outcomes to help you understand investment volatility. However, when making specific retirement planning decisions, such as what percent of pay to save for retirement, you need to settle on a single set of best estimate assumptions, and then manage volatility as it occurs.
What is a Monte Carlo simulation?
A Monte Carlo simulation generates a large number of random scenarios to identify a range of outcomes and their probabilities. In the context of investment analysis, a Monte Carlo simulation can give you the probability of achieving various investment returns.
How can a Monte Carlo simulation help in retirement planning?
Your investment return assumption is one of the most important inputs in retirement planning. Eventually, you will want to use your best estimate assumption about your investment return so you can make specific retirement planning decisions. However, if you are invested in risky assets (such as stocks), you may want to try a few what-if scenarios to see how your results may change if your investments performed worse than expected. That's where Monte Carlo simulations come in.
For example, suppose your investment adviser ran a Monte Carlo simulation on your current portfolio and told you that you have a 45% probability of achieving a 6% average annual return, 20% chance of averaging 5% and 10% chance of averaging 4%. Since there is a significant probability of getting an average return of 4%, you may want to run that scenario through a detailed retirement calculator like MoneyBee. Can you live with the results? If not, perhaps you have taken on more risk than you are prepared to absorb and may consider de-risking a portion of your portfolio.
Making retirement planning decisions, apart from investments
The ultimate goal of retirement planning is to find your optimal combination of how much you save for retirement each year, how early you can retire and what standard of living you can enjoy in retirement. To find your options, a retirement calculator needs to use a single set of assumptions, preferably your best estimate assumptions, skewed slightly on the conservative side. You need to settle on a specific set of assumptions in order to identify a specific course of action.
MoneyBee projects all financial aspects using best estimate assumptions regarding investment returns, general inflation, life expectancy, health care cost trend, college costs, etc. Then it lets you choose from a range of specific options. For example, you may choose to save 6% of pay each year, retire at age 65 and enjoy a personal budget in retirement (after taxes and required expenses) of $2,600 per month in today's prices.
What if assumptions don't hold?
Assumptions rarely hold exactly, even if made by professional financial forecasters. In some years they may be just slightly off, in some - totally off the mark. Your gains and losses may even out over time, or they may not. While a Monte Carlo simulation is a great tool to help you understand investment volatility, it tells you little about how to handle actual volatility when it occurs. Furthermore, investment returns are not the only volatile assumption. There is a long list of things that may not go according to plan. To manage volatility, you need a more practical approach.
Our recommendation is to re-run your MoneyBee model periodically, reflecting your latest data. MoneyBee will spread any gains or losses over your remaining lifetime and recalculate your options. This gives you a chance to make incremental adjustments to your plan along the way. It's a moving target approach. Here is an example to illustrate how this can play out in practice.
Example: After you updated MoneyBee with your latest data, it showed that if you wanted to continue saving 6% of pay and retire at 65, your personal budget in retirement would be $2,400 a month, down from $2,600 a month. Since this is just your discretionary cash, you may decide that $2,400 a month is just fine and do nothing. Alternatively, you can browse your updated options and see how much do you need to save now to keep your $2,600 personal budget target.
If you have confidence in your long-term assumptions and expect that things will even out over time, you can choose to wait out the storm. If things do get back to normal, MoneyBee will revert to its original options.
Some users take a more cautious approach. In bad years, they follow MoneyBee's stricter recommendations (for example, to save more). In good years, they ignore MoneyBee's relaxed recommendations (for example, to save less). This way, they build a cushion and will likely end up in a better situation than originally planned.
Things are slightly more complicated if you are already retired. Once you sell your stocks and spend the money, that portion of your investments will never bounce back. So retirees may need to cut down a little during downturns even if their long-term assumptions are holding up. However, rerunning MoneyBee can help you keep things in perspective and avoid overcompensating for a market downturn.
Reducing volatility through cash flow matching
Just because you have a reasonable approach to managing volatility, doesn't mean that you shouldn't take steps to reduce it. One way to do this is by investing in a staggered fixed income portfolio with payouts that exactly match your projected withdrawal schedule. MoneyBee facilitates this by developing a detailed withdrawal schedule broken down by year, by type of account and by individual (if married). This should give your investment adviser sufficient data to develop your cash flow matching portfolio. You can access this report by clicking "Cash flow summary" at the bottom of the "Year-by-Year Breakdown" box in the option details section.
Before you run your cash flow schedule, be sure to ask your investment advisor what would be a reasonable long-term annual expected return on a high investment grade bond portfolio. Be sure to use that as your investment return assumption in MoneyBee so you can get a more realistic cash flow schedule.
Sensitivity analysis
We already discussed running a worst case scenario where you set your investment return to the lowest rate with a significant probability, based on a Monte Carlo simulation. You don't have to stop there. You can add other adverse factors to your worst case scenario as well. For example, you can bump up your general inflation assumption and/or assume that you will not want to sell your expensive suburban home and move to a less expensive area.
There are two ways to do this in MoneyBee. You can simply change your inputs and let MoneyBee recalculate your options in real time. Alternatively, you can create a new "plan", where you can save your worst case scenario.
Conservative planning
If you are reading this article, you most likely don't need to be reminded to stay on the conservative side when planning for retirement. In fact, the trap that many of us are far more likely to fall into is to confuse worst case assumptions with conservative assumptions. As we try to be conservative, we still need to stay rooted in reality, making reasonable and prudent assumptions. The goal is to be just slightly south of what is most likely to happen - based on data, not on our worst fears. This way, the adjustments we will need to make along the way will likely be small and gradual.
Conclusion
Monte Carlo simulations can be a powerful investment analysis tool, especially in understanding investment volatility and selecting investments that fit your risk tolerance. It can also provide a range of reasonable long-term investment return assumptions for use in retirement planning.
However, when it comes to making decisions on how much to save or withdraw each year, you will need a more deterministic approach. Under such an approach, you would use your best estimate assumptions to identify a specific course of action. You would then update your model regularly to reflect your actual experience and identify timely course adjustments.