Many of those thinking about their retirement like to ask if their money will see them through retirement and how much they might be able to pass on to their heirs. Unfortunately many people (and some financial advisors) look at investment returns through time as something that is static. They plug in some annual return assumptions and look at the results from there.
But the world of investing is anything but static. It is truly an ever-changing, dynamic situation and like any dynamic situation, it is best to look at it from a probabilistic standpoint. In other words, what are the odds that a person or a couple can retire and never run out of money?
So what is the alternative to a static look at one's retirement situation? The alternative is Monte Carlo analysis, which is a statistical tool that runs hundreds or thousands of scenarios and gives a person the probability that he or she will never run out of money. It does this by looking at the historical volatility (standard deviation) of the person's investments as well as the correlation among those assets. We then plug in a reasonable assumed average total return for each investment, either based on history or based on the user's projection, and the Monte Carlo simulator will shock these returns every year, generating many scenarios and the probability of not running out of money.
Let's take a look at how this works. I ran a couple's retirement plan in our retirement planning application. Here were my starting assumptions:
In the static case, I found that this couple would not run out of money before the end of their plan at age 95. In fact, they would have nearly $500,000 (in today's dollars) left in their plan when they're 95. However, this is a static look at things where we assume the total returns of their investments do not change from year to year. Using Monte Carlo analysis, we can have the returns changing from year to year (based on historical volatility) to find the probability that their funds are never depleted.
It turns out that in this case the probability that they never run out of money is only 50%. There are just too many scenarios where the total returns are bad enough to deplete their funds. Part of the problem is the volatility of equities today. The other problem is that this couple is not beating inflation with their treasury investments.
Remember that 25% of this couple's portfolio is invested in Treasuries earning a return well below the rate of inflation. As I pointed out recently here, inflation can simply ruin a portfolio's value over time. It is incredibly important to at least break even with inflation. So I moved the 25% of Treasury funds they own into a 50/50 combination of Treasury-Inflation Protected Securities (TIPS) and a portfolio of solid dividend paying stocks with a history of consistent dividend growth, such as Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), Exxon (XOM), Intel (INTC), and Wal-Mart (WMT).
I assumed no increase in the prices of these dividend payers, but I did assume they would continue to increase their dividends at their five-year growth rate. I also assumed that the dividend payers have a lower volatility than typical U.S. stocks, which is generally true given their steadier returns over time due to dividend payments. I assumed a standard deviation of 12% for them. Here is what I found:
Probability Of Never Running
Probability Of Never Running
The probability of never running out of money increased by a sizable 20%. From here this couple can tweak their plan further by saving more money or retiring later to increase the probability to an even safer number. As an example, if they push out their age of retirement to 67 they would increase the probability that they never run out of money to 80%.
I sometimes get feedback to the effect of, "I would not be able to sleep at night if my probability of never running out of money was only 80%." Of course, some people would be very happy with this number, but others find it way too low. So I wanted to ask a different question: How much money would this couple need at retirement (after moving to the dividend growth strategy discussed previously) such that their odds of never running out of money in retirement is 95% or greater? I ran some scenarios on this and found the answer to be a little over $1.1 million (in today's dollars). In other words, if this couple can manage to save $1.1 million or more by the time they retire, they are virtually assured of never running out of money in retirement.
We live in a world of change and nothing is static. Building a retirement plan is fraught with assumptions, even those that use Monte Carlo analysis. But we can give ourselves a more realistic look at how things might pan out if we use statistical tools such as Monte Carlo that give us a more dynamic view of how our plans might unfold.