Monte Carlo and Retirement Success

  • What's the likelihood that your retirement assets will allow you to maintain your lifestyle in retirement?
  • What rate of return do you need to earn in retirement to maintain your lifestyle?
  • What asset allocation is consistent with your need to generate retirement income while providing growth to protect your future purchasing power?
  • When is the optimal time for you to start Social Security?

The average person works 80-90 thousand hours in their lifetime, but spends less than 10 hours planning for their retirement. That seems unbelievable, but it is true. Monte Carlo analysis is a detailed way to test the probability that your retirement assets will last the rest of your life while maintaining your lifestyle. Key factors in this analysis are your income sources, expenses, rate of inflation, life expectancy, and the expected long-term return for your investments. Some of these factors are controllable or dependable like expenditures and Social Security while others can be forecast with some level of confidence. 

Income in retirement usually consists of Social Security and retirement account distributions although pensions still exist for some people.  Social Security can start as early as 62, but the full retirement age is currently around 67. If Social Security is taken before 67 you will receive a discounted payment while delaying your payments will increase your benefits. Generally speaking, you would need to live until age 82 or 83 to justify delaying your Social Security benefits to age 70.    

SS breakeven

For most retirees distributions from retirement accounts (IRA’s, 401k, 403b) will serve as another major source of income.  Investing your retirement accounts to produce income while providing growth to protect your future purchasing power requires a properly diversified portfolio that is structured to meet BOTH objectives.  Tactical rebalancing of your portfolio to control risk and capture profits to fund distributions will also play an important role in determining your long-term viability.  Required Minimum Distributions (RMD’s) from retirement accounts (ROTH IRA’s are the exception) are currently required by law beginning at age 70 ½. Current legislation called the SECURE Act could increase the age to 72. 

Your expenditures/withdrawal rate are the most controllable portion of this analysis and can have a significant impact on the probability that your money will last the rest of your life. Inflation and life expectancy are uncontrollable variables that can still be forecast with some level of confidence. See http://www.vonholt-fa.com/our-blog/51-risks-retirees-face.html for a further explanation of these topics.

How Monte Carlo works

Fixed income sources such as Social Security and pensions can be forecast with a high degree of confidence.  A strong understanding of past spending patterns and forecasts of non-recurring expenses such as travel or renovations are the only variables that are under your direct control.  An assumption with regards to longevity should be conservative rather than using an average so that you do not outlive your assets. Long-term forecasts for inflation and rates of return can be made with a fairly high degree of certainty although the sequence and variability can substantially impact your chances for success.  

To address the concerns about the sequence and variability of inflation and rates of return a Monte Carlo simulation should be completed. Monte Carlo attempts to show what might happen in a situation where inflation varies and the returns on assets are positive in some years and negative in others. The simulation runs 10,000 iterations through life expectancy to test the sequence and variability of inflation and returns to provide an average outcome and the probability of maintaining your lifestyle through certain ages. 

Below is an example of a Monte Carlo simulation which shows a client’s probability of living their desired lifestyle to certain ages. Monte Carlo analysis should be updated to reflect material changes in your life situation or goals and can include multiple alternatives. 

Monte carlo

Anyone less than 10 years from expected retirement should complete this type of analysis and understand the impact key variables may have on their chances for a financially successful retirement. This analysis is a good way to start the process of retirement planning to ensure that a lifetime of work leads to a long and comfortable retirement.