How much money will I have in my retirement portfolio when I retire? Will I have enough money to maintain my desired lifestyle? When can I afford to retire? How much money will I get from Social Security? Will I need to work part-time? Can I retire and still send my children to college? How do I budget for unanticipated outlays, such as a major illness? As the leading edge of the baby boomer generation approaches retirement in 2010, these are just some of the questions they are facing.
These are difficult questions that are not easily answered. However, financial planning software, using estimates of the expected return from the respective asset classes represented in your portfolio, can provide an approximation of your portfolio's future value and help provide some answers.
The problem we face is that while it is possible to estimate annualized investment returns over long periods of time, from one year to the next returns can fluctuate dramatically and can't be predicted with any degree of accuracy. Even knowing the average annualized total return for the period correct doesn't guarantee success. If the timing of these returns is skewed one way or the other, your calculations will be inaccurate.
But there is hope. A tool called "Monte Carlo simulation" has emerged in financial planning models, that takes into account the uncertainty of investment returns when projecting the future value of a portfolio. Although it sounds like something out of Las Vegas, this process has nothing to do with gambling. In fact, it employs statistical techniques of modeling multiple alternatives to come up with a likely range of probable results. Traditional financial planning models employed long-run averages to model both short and long-term results leading to, at best, low probability outcomes. Stanford University professor and noted Monte Carlo modeling expert Dr. Sam Savage calls this the "flaw of averages." He notes that when faced with an uncertainty, such as future investment returns, people succumb to the temptation of using a single average value. Hence, the flaw of averages states that plans based on average assumptions will be wrong on average!
Using Traditional Cash Flow Analysis in Retirement Income Planning
Planning for retirement would be easy if you could count on earning a consistent level of total return from your stock and bond holdings year after year. Real life planning, however, is far more difficult because you have to account for unpredictable fluctuations in annual investment performance. The timing of the market's ups and downs, relative to the timing and level of annual withdrawals, is especially important. For example, between 1972 and 2003, the average annualized return on a hypothetical $500,000 portfolio consisting of 40% stocks (S&P 500 Index), 40% bonds (Intermediate Government Bond Index), and 20% in 30-day Treasury bills, would have been 9.51%. If we use this average in our calculations, as opposed to the actual annual return, and assume a 7% initial withdrawal rate with subsequent annual withdrawals adjusted 3% annually for inflation, the entire portfolio would have been depleted sometime in 2003. However, using actual returns, the portfolio would have been depleted in 1995, eight years earlier. The hypothetical portfolio was so depleted by the toxic mix of weak markets combined with high annual distributions in the mid-70's that when the market did finally stage a strong recovery in the 80's and 90's there wasn't enough money left in the account to take full advantage of it. This example reflects the fundamental flaw in traditional cash flow analysis.
The Risk of Withdrawing Too Much
Determining the amount of annual withdrawal that your portfolio can withstand, and when it should begin, is a crucial step in the financial planning process. If the initial level of annual withdrawal (from our hypothetical portfolio), were set at 4% of assets, instead of 7%, and were increased by the same 3% rate of inflation annually, the market value of our portfolio at the end of the retirement period (2003), would have been slightly more than $3 million. Between 1972 and 1980, the two portfolio ending values were very close to their $500,000 initial values. The real difference would have begun in 1982 when the bull market in stocks started in earnest. The 7% withdrawal portfolio would have continued to erode its market value while the 4% withdrawal portfolio would have continued to add to its principal sufficient amounts to allow for meaningful participation in the market's subsequent advance. By 1988, the 7% withdrawal portfolio is worth less than $400,000, while the 4% portfolio is worth over $1 million. By 1995 when the 7% withdrawal portfolio is depleted, the 4% withdrawal portfolio is worth approximately $2.2 million.
The Monte Carlo Advantage
Traditional planning tools have based their projections on historical average rates of return. This assumes that past will be prologue. However, Monte Carlo Simulation uses actual rates of return for each year of the retirement period. Of course, with the aid of the computer, running 500 unique scenarios is easy. A simple example will illustrate why this is crucial to the planning process. The key here is the difference between extrapolating historical averages to each future year versus simulating actual returns for each of those years.
Suppose you have $1,000 to invest and you earn 10% per year on average for four years. You will have $1,464 after four years. However, if you actually earn 25%, -5%, -10%, and 30%, you will only have $1,389 after four years even though your average return still is 10%. The difference here is approximately 5% after four years or 1.25% per year. This may not seem so significant but if we extrapolate this example for twenty years or more and multiply by tens of thousands of dollars, the difference is very significant. Similar to the above example of the 7% versus the 4% withdrawal rate, small differences compounded over several decades become meaningful. The real difficulty lies in our own ability to think long-term.
Monte Carlo simulations give us a better shot at planning for an annual income that will not expire before we do.
Interestingly enough, the simulation success rate (or probability of achieving your objective) does not necessarily correlate with how aggressive or conservative your asset allocation is. If you anticipate a relatively short time horizon and do not perceive inflation to be a meaningful threat, your highest simulation success rate may be achieved with a very conservative portfolio of mostly bonds and cash. If, however, you have time on your side, say twenty years or more before retirement, a portfolio concentrated in various classes of common stock may offer the highest success rate. Matching an appropriate asset allocation (or mix of available asset classes within and among common stocks, bonds and cash equivalents) with a sustainable level of annual withdrawals is probably the single most important issue in determining how successful you will be in planning your retirement and achieving your goals.
At Marc J. Lane Investment Management, Inc. we are now using this helpful tool to assist clients in ascertaining when they can retire, what an appropriate allocation among stocks, bonds and cash equivalents might be, and what an appropriate level of annual distribution would be based upon their pool of assets and tolerance to risk.
Monte Carlo simulation helps us understand the many faces of risk. One need not invest in a highly volatile portfolio of all stocks to assure long-term investment success. With an appropriately allocated portfolio combined with realistic annual distributions, we can help you look beyond short-term market fluctuations and focus on avoiding the risk of having too much "month" left at the end of your "money".
We'll be happy to discuss Marc J. Lane Investment Management, Inc.'s Monte Carlo simulation capabilities with you. Just call Marc personally at (312) 372-1040 ((800) 372-1040, nationwide), or email him at email@example.com.
Kenneth N. Green, C.P.A, B.S. (in Finance, University of Illinois), and M.B.A (in Finance, University of Michigan), is Senior Vice President and Director of Investments of Marc J. Lane & Company and Marc J. Lane Investment Management, Inc., the investment affiliates of The Law Offices of Marc J. Lane, A Professional Corporation.
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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.