Have you ever wondered why your financial advisor describes your retirement readiness in terms of a known gambling mecca? Is he or she so uncertain of their advice, that they are actually saying it’s all just a crap shoot?
It might help to explain the progression of retirement projection techniques by giving a little history.
In the beginning (of retirement projections, not life on the planet), there were spreadsheets. Yes, people would enter their desired spending in one Column A, their Social Security/Pension incomes in Column B, create a clever macro in Column C subtracting B from A, to come up with an annual withdrawal number in column C.
In Column D would be their retirement savings, and a clever macro increasing that amount by some assumed average rate of return. In the dot com boom of the late 1990s, this number was an often something outrageous like 25%/year (because those returns would obviously go on forever). Let’s say now people would use something more reasonable like 6% or so.
Sometimes, a clever spreadsheet-er would remember to add inflation to Column A to adjust for the fact that prices go up, even after you retire. Many times, they wouldn’t.
All this to say, that if you followed the spreadsheet predicitons, where your assets went up, up, up, every year, the projections for your retirement would look pretty rosy.
Unfortunately, recessions, like inflation, don’t stop happening just because you stop working. Some of those up years in the spreadsheet should be negative in to give a realistic picture of the feasibility of your proposed retirement spending.
As time goes by and software becomes more sophisticated, enter the Monte Carlo Simulation. Here is how it works: Say you go to Monte Carlo and roll the dice 10,000 times. And your average roll over 10,000 tries equals 6 (aka a 6% average annual investment return).
Well, that doesn’t mean you rolled 6 on the dice any more times than any other number. Six is the average of the highs and lows and in-betweens of the 10,000 throws.
Same with investment returns. Just because you may average 6% growth over time – and I’m talking 30 + years – that doesn’t mean you actually had ANY years where your portfolio made 6%.
The Monte Carlo simulation allows us to put real market returns over multiple thousands of slices of time against your proposed spending and assets. Instead of saying, “Yes, Arnold, you can retire and spend $80,000/year and never worry about running out of money,” the Monte Carlo simulation shows a variety of outcomes that could have happened based on historical market returns.
How is this reported to you? In a confusing number called the Probability of Success. Many financial services firms or online calculators want you to achieve a 90% or more Probability of Success.
However, this high probability will likely leave tons of money unspent at your life expectancy. That means you could have spent more and had more fun if not for the interpretation of the Probability of Success by the calculator or advisor you are using.
You know the basics. Tune in to next week’s blog about how to interpret the nuances of Monte Carlo projection results.
