A few blog posts ago, we examined the 4% retirement rule of thumb. The 4% rule was based on William Bengen’s examination of every rolling 30-year period from 1926 to the mid-90’s. He found that during that time period, a retiree could withdraw 4% of their starting retirement account value, increase it each year for inflation, and never run out of money given a 50/50 stock bond allocation. This 4% rule is a great start when it comes to retirement planning, however, there is a key flaw in the study. Because Bengen’s study only focuses on the past performance of the US stock and bond market, it only looks at one possible outcome: the one that actually occurred over that time period. It would be highly unlikely that the next 70 years look exactly like the last 70. Monte Carlo analysis gives us an opportunity to look at hundreds or thousands of different future scenarios, from there we generate a probability of success for the retirement and financial goals specific to each person. Read on to learn more about how we use this type of analysis to prepare financial plans at Innova Wealth Partners.
The origins of Monte Carlo analysis began with Polish-American mathematician, Stanislaw Ulam while he was stuck in bed from a prolonged illness in 1946. While confined to bed, Ulam played hand after hand of solitaire. As scientific minds tend to do, Ulam began to wonder if there was a way to predict the chances of a successful hand of solitaire. After first trying to work out the probability using more rudimentary calculations, Ulam realized that a better method would be to deal out a large number of hands and simply observe the number of successful hands. Computing power at the time had reached the point where a large number of calculations like he envisioned could be done in just a few short hours (and just a few milliseconds using today’s technology). He described his idea to fellow mathematician John von Neumann and the two began their work on a new type of simulation that would eventually be used in the creation of the first atomic bomb. Because of the secrecy of their work, the two mathematicians needed a code name. With such a focus on probability and statistics, borrowing the name from the Monte Carlo casino in Monaco seemed a perfect fit.
So how is this form of calculation valuable for financial planning?
The financial planning industry has yet to find a crystal ball, so predicting the future is still an impossible task. Because of this, our next best option is to rely on a probability of outcomes. Monte Carlo analysis gives us the opportunity to view hundreds of different possible scenarios. The planning software used at Innova Wealth Partners, for example, takes a look at 1,000 different scenarios. Much like Ulam laying out hand after hand of solitaire and observing the outcome, we do the same with financial variables.
Monte Carlo analysis allows us to include many different variables into our projections. Variables like; investment returns and standard deviation, interest rates, inflation, income needs, Social Security benefits, inheritances, real estate transactions, Roth conversions, etc. the list is truly endless. Examining all of these different variables in a Monte Carlo analysis gives us a much more realistic look at potential outcomes than solely relying on an average rate of return or looking back at what has happened over the last few decades. To help visualize the concept, here is an example of the output from one of our Monte Carlo projections.
This chart is the graphical representation of 1,000 different market scenarios overlayed with a client’s specific goals. The light blue shading above the dark blue line shows all outcomes that resulted from generally favorable market conditions, and the darker blue shading below that line shows all outcomes that resulted from generally unfavorable conditions. In this case, every one of the simulations – even when market returns were less than ideal – resulted in a successful retirement, i.e., not running out of money during retirement. While it’s great to know that this client can be confident in their retirement as it is currently laid out, we can also use these results to examine changes to a retirement outlook should we decide to tweak some of our variables. Here’s that same scenario should the living expenses of these retirees double.
Not as rosy a picture for sure, but this is very valuable information. In this case, we’ve found that a doubling of living expenses makes a successful retirement basically a coinflip. While we would likely not want to leave our retirement wellbeing up to chance like this, this projection has given us new information. If spending twice what was originally planned brings our probability of success to 53%, what would it look like if spending only increased by 25%. What would it look like if spending was reduced but a vacation home was purchased? All of these questions can be addressed by using Monte Carlo analysis like we use in our financial plans.
The future will always be a mystery, but through Monte Carlo simulations and a thoughtful planning process, we can shed some light on some of the biggest threats that may face us in the future. Or, if we’re lucky, we can see that our hard work and saving has paid off and that we can weather almost any storm. If you would like to see how your financial goals could play out over your lifetime, reach out to us at Innova Wealth Partners!
INNOVA is a SEC registered investment adviser. Information presented is for educational purposes only intended for a broad audience. INNOVA is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.