Monte Carlo process in retirement planning

By Scott Keffer

Dr. Ted Walters felt somewhat bad as his friend, Dr. Jack Lamonica, lamented, “I had those retirement projections run a few years ago. They said I would have enough money to buy the island of Madagascar. You know what I mean – Jackie and I would have a gazillion dollars. Now it looks like we’ll be asking the kids for money to go skiing! Today, those projections are not worth the paper they’re printed on.”

Ted, ten years Jack’s senior, was never one to miss a great chance to say ‘I told you so.’ Even though Ted had been a mentor to Jack, there was still a friendly competition between them. So Ted reminded Jack, “You remember I warned you about relying on those kinds of projections. That’s the problem with them – they use an average annual fixed rate of return.”

“You know what they say about averages,” Ted said “you can drown in an average of 18 inches of water. Think about it another way: If you put your feet in the freezer and your head in the oven, the average temperature will be a comfortable 78 degrees – but will you be comfortable?”

Ted continued, “You remember that Wall Street Journal article when the Dow Jones was 10,000. It said that stock market winners in Chicago were buying perfectly beautiful homes and leveling them to build bigger ones, and then stuffing them with antiques and other expensive stuff. Then, it described that man in Asheville, NC, who made parachutes. He said that the market had provided him a backup chute, with enough money to put his daughters through college and to provide for his own retirement.”

Jack popped in, “Where’s he now without his backup chute – squished like a bug on the ground? Anyway, what’s the alternative to those kinds of projections?”

“Monte Carlo!” Ted announced.

“Oh good, more gambling. Why not just roll dice?” chuckled Jack.

“In a way, that’s what Monte Carlo is – rolling dice over and over and over again.” Ted explained.

“How will rolling dice help my retirement planning?” Jack asked.

“Let me start with some history.” Ted continued, “The Monte Carlo process is named after the city in the Monaco principality, because of the roulette. When you think about it, the roulette is nothing more than a simple random number generator, like rolling dice.”

“By the way, here’s a bit of trivia: 100 years ago, a British accountant tried to break the bank at Monte Carlo by hiring people to watch the roulette wheels and track the outcomes for several days. He found a bad wheel, which he hoped to take advantage of. However, the first night the accountant won big, the casino figured something was wrong. So, the next night they rearranged the wheels. He found it again. This time, the casino removed it and ordered a new one from Paris. He never did break the bank.” Ted went on.

Ted, as was his custom, was on a roll now, “The concept behind the roulette itself, and the city itself, spawned the name and the development of the Monte Carlo process, which really began to blossom around 1944. Using the Monte Carlo process as a research tool stems from its use in the development of the atomic bomb during World War II. Scientists were trying to simulate the probabilities attached to the various problems that could occur with random neutron diffusion. The Monte Carlo process was the answer.”

Ted continued, “With the progress in modern computers, the further development of the Monte Carlo process and the subsequent use has really grown in the past decades. Monte Carlo process and methods have been used for everything from integral equations to turbulence simulation to aerosol science to chemical combustion. Now it’s being used to help people retire successfully.”

“Here’s how it works in retirement planning: First, start by focusing on one of the most important questions: ‘What kind of standard of living do you want in your retirement/transition?’ or ‘How do you want to live the next 30 years of your life?’ Then, you’ll need to quantify four key variables that will have a direct effect on whether or not you’ll be able to retire successfully. Give me a piece of paper and I’ll write them down for you,” Ted said as his eyes scanned for paper.

Ted always liked bullet lists, so he wrote the following on the scrap that Jack pulled from his shirt pocket:

• Your current age and desired retirement/transition age.

• Your sources of income and cash flow needs.

• Total amount of taxable and tax deferred assets.

• Assumed income and capital gains tax rates.

“You will also need to have a handle on your tolerance for investment risk.” Ted instructed.

“These assumptions are then plugged into a Monte Carlo simulation software program. The program will simulate thousands of possible futures, or scenarios, taking into account changes in “real-world” factors such as inflation, interest rates, dividends, etc.” Ted said as he swept his hand across the horizon to show the breadth of the process.

Ted proceeded, “One way to explain a Monte Carlo is to imagine flipping a coin six times and recording the number of heads that come up. For each set of six flips, the actual number of heads will range from zero to six. With more and more sets of six flips, data will accrue about how many times no heads appear, how many times one head appears, two heads, three heads, and so on. At the end, what you’d have is this: a good sense of how likely it would be that a given number of heads would be obtained if you flipped a coin six times.”

“Using this very same concept, it is possible to take your key variables and input them into a software program utilizing the Monte Carlo method. The result would be a range of thousands of possible future outcomes, given the parameters you’ve set for yourself. From that, it’s possible to calculate how likely it will be that you can maintain your chosen lifestyle throughout your retirement years.” Ted emphasized.

“In other words,” Ted summed up, “you would have some sense of how likely it is that you will be able to retire – given your goals and desires. Do you see the value of moving away from predicting the future to understanding the probability of success?”

Jack, who was catching on to the concept, asked, “What happens if you don’t like the likelihood of success?”

“Good question,” Ted replied, sensing that his friend was catching on. “You’ll need to tweak the different variables – your retirement age, your cash flow need, or the amount of investment risk you are willing to accept. Then, continue to run the Monte Carlo simulation program until the probability of reaching your goal is at an acceptable level. For me, I like at least an 85 to 90 percent probability of success.”

Jack wondered, “If I don’t want to change my retirement age or my cash flow during retirement, are there other options?”

Ted clicked into his role as mentor and teacher. “Remember that one of the key principles of the Noble Prize winning modern portfolio theory is that diversification is much more than simply not putting all your eggs in one basket. You need to create a mix of asset classes whose price movements aren’t highly correlated – in other words, the price movements don’t move in the same direction. The designed result is the highest rate of return for each level of risk. The concept is brilliantly simple: if you have one asset class in your portfolio that goes down, you need to have other asset classes that are likely to go up. It’s what I call yoked asset classes versus seesaw asset classes. Yoked asset classes are those whose price tends to move in sync with one another – like US large and US small. Seesaw asset classes are those whose price tends to move opposite one another – like money markets and international small.”

Ted continued, “Your portfolio can contain 15 different asset classes – like small and large company stocks, focused on either growth, value or a combination. Then there is international, emerging markets and fixed income. By changing your asset class mix, you change your level of risk, and potentially increase your rate of return. The trick is to take the least amount of investment risk that is required to hit your retirement goals.”

Jack jumped in: “Where do you get all this infor… I know, I know, your wealth preservation specialist.”

Ted beamed, “That’s right!”

“Well, has it helped you during these tough times?” Jack challenged.

“You bet,” Ted answered. “The Monte Carlo report he did for me simulated the ups, and the downs, of the market. It gave me a probability of success, along with a clear path to follow. I have actually made some further strategic adjustments just recently as a result of the report. It’s great to have peace of mind and direction during all this uncertainty. Well?”

“Well what?” Jack said, knowing the answer.

Ted continued, not even hearing Jack, “You know that research has shown that less than a third of all Americans have an actual goal in mind for their retirement – and only a small percentage of them have any strategy for reaching that goal. On a day-to-day basis there’s always going to be volatility and change in the financial markets – that’s inevitable. However, once you’ve done this, you’ll have a strategic framework on which to respond to changes when they do occur. You better find out what probability your plan has of succeeding!”

“So,” Ted asked again, “Are you going to call my wealth preservation specialist and get a Monte Carlo simulation done? It helped win World War II, why not let it help you retire successfully!”

Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh.

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