Monte Carlo and Your Probabilty of Success

Are You saving enough for retirement?

How much can you withdraw from your retirement portfolio?

Does your retirement plan give you a probability of success?

A retirement savings/investment plan should take into account how much you are saving, how that money is invested, and what your spending will be in retirement.

Planners often use the above mentioned factors along with a probability simulator (known as a Monte Carlo Simulator) to determine your chance of success in retirement. When the probability is low, adjustments need to be made.

Monte Carlo simulators have been around since World War II, and with the power of personal computers, it is available to financial planners. Monte Carlo will use the historical risk and return characteristics of your investment portfolio , combined with your anticipated withdrawals, and simulate 10,000 different possibilities in order to give probabilities of success.

Monte Carlo will produce outcomes much different than assuming your money will grow at a constant return. Constant returns do not occur in the real world. Investors do not receive a constant 7% or 8% on their investment portfolio. One year they may be up 12%, the next down 3% etc. Over time, the average may be 7% but the ups and downs result in very different outcomes, especially when one is withdrawing money every year from the portfolio.

Years of study by academics and financial planners using monte carlo analysis has shown that withdrawing more than 4% per year out of a 50% stock/50% bond portfolio could result in a retiree running out of money before he/she dies.

This topic is an important area of study for planners for obvious reasons. telling a client that they can spend more per year than they can afford is disastrous. A simple rule is offered by William Bernstein in his book “The Investor’s Manifesto”

“At a 2 percent withdrawal rate, your nest egg will survive all but catastrophic institutional and military collapse; at 3 percent, you are probably safe; at 4 percent you are taking real chances; and at 5 percent and beyond you should consider annuitizing most, if not all, of your nest egg,”

What Bernstein means by annuitizing at 5% and beyond is that if you need to withdraw more than 5% from your retirement portfolio you may want to purchase an immediate fixed annuity. This is an insurance product, where you turn over your portfolio to an insurance company and they guarantee you a fixed monthly payment for life. Even in today’s low rate environment, one can purchase annuities at 6% returns.The trade off is that you lose access to your nest egg. If you die 2 months after you purchase the annuity, the insurance company keeps your money.

Canadian planner and author of “Unveiling the Retirement Myth,” Jim C. Otar, who uses historical returns to generate his data, specifies 3.8% as the max withdrawal rate from a diversified stock/bond portfolio.

Finally, an October 2007 Journal of Financial Planning article by three professors from the State University of New York at Brockport confirms the above discussion. They use Monte Carlo to create safe withdrawal rates for different stock/bond allocations. Once again, withdrawal rates exceeding 4% in a 50% stock/50%bond portfolio show increasing fail rates.

The important point in all the analysis is that there is no investment magic that will allow a retiree to withdraw more than 4% per year and not risk running out of money in retirement. That is why it is important to develop a savings plan before retirement in order to build enough savings so that you can live the lifestyle you want in retirement.