Monte Carlo Simulation Retirement Planning

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They Measure Market Risk But Dont Eliminate It And They Dont Consider All The Twists And Turns Life Can Take Instead Build A Plan To Create A Stable Income Throughout Your Retirement No Matter What

How to Stress Test Your Retirement Portfolio Using Monte Carlo Simulation

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When you sit down with a traditional financial adviser to plan your retirement you will provide her with the spending budget you have in mind. The adviser will adjust that amount for inflation and after running the numbers through a black box model, will predict how many years your retirement savings typically made up of cash, stocks and bonds will last.

The model to make this prediction is called stochastic a fancy way to describe what is a typical Monte Carlo simulation model.

Linear Analysis For Compounding Rate Of Return

Lets say you want to predict the future value of a stock investment with compounding returns.

In most simple financial calculations, you might enter your initial account value and the predicted rate of return. The system will apply that rate to every month or year and show you the results in a linear projection.

A simple way to think about linear calculations: + + = Outcome or Final Amount

The official formula is:

But, come on. That is not how things work in real life. The investment you are trying to predict will go up. It will go down. Sure, it is possible that it will grow at the same rate month over month and year over year, but that is highly unlikely. Spikes and dips in the stock price over time will impact your final outcome.

Simple compounding is not a terrible way of predicting the future. In fact, it can usually get you in the ballpark. But, it is a relatively simplistic way to determine outcomes.

Lets Do A Quick Monte Carlo Simulation

Considering that people planning to retire in the coming weeks or months could be retiring during a recession, lets go back to one of the examples that Drew used during the educational series event. Here are some important details for the sample couple that he used in this Monte Carlo simulation:

  • 60-year-old wife and 63-year-old husband
  • Most of the $1.2 million theyve saved is in their 401s
  • Their goal is to spend $5,000 a month in retirement and they havent done any Roth conversions yet
  • An initial 60/40 asset allocation

Given the information above, their probability of success with this Monte Carlo simulation would be 85%, as shown below.

FIGURE 1 Probability of Success

Again, this means that 85% of the time, you can accomplish your retirement goals without having to adjust your spending. But what about that other 15%? Well, dont fret. Even if that 15% comes into play, it means you might need to briefly adjust your spending at some level. You might need to consider some trade-offs in that scenario.

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How Does Newretirement Apply Monte Carlo To Your Plan

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In our Monte Carlo Analysis, we apply a normal distribution to the expected asset return rates under the assumption lens youve applied to your plan . We generate 1,000 random simulations and then randomize the values along a normal distribution each month of the simulation. We then divide the number of simulations where funds never run out by the total number of simulations, and reflect that number back to you.

FOR EXAMPLE:

The probability that your savings will last until your goal age of 90 is 87.00%.

The probability that your legacy goal of $100,000 will be achieved is 87.00%

This means that in 870 of the 1,000 simulations we ran, you were able to fund all of your projected expense and legacy goals.

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Understanding The Monte Carlo Simulation

The Monte Carlo simulation is a mathematical model used for risk assessment named after Monaco’s gambling mecca. People who are trying to plan for a secure retirement and can’t afford to lose their savings don’t want to take chances with their money. So why turn to a Monte Carlo simulation for guidance?

Although this name for the calculation may seem ironic, it is a planning technique used to calculate the percentage probability of specific scenarios based on set assumptions and standard deviations. The Monte Carlo method has often been used in investment and retirement planning to project the likelihood of achieving financial or retirement goals, and whether a retiree will have enough income given a wide range of possible outcomes in the markets.

There are no absolute parameters for this type of projection. Underlying assumptions for these calculations typically include such factors as interest rates, the client’s age and the projected time to retirement, the amount of the investment portfolio spent or withdrawn each year, and the portfolio allocation. The computer model then runs hundreds or thousands of possible outcomes using historical financial data.

The results of this analysis usually come in the form of a bell curve. The middle of the curve delineates the scenarios that are statistically and historically the most likely to happen. The endsor tailsmeasure the diminishing likelihood of the more extreme scenarios that could occur.

Getting Started On Personal Capital

FIRECalc is one mans passion project to help others for free. Personal Capital, on the other hand, is a for-profit investment institution.

Yes, they offer some of the best free financial software available. But they also offer wealth management services.

In a sense, they operate as many high-tech companies do: by using the freemium business model. That means their software is free you can download the app at no cost and use the free tools they provide.

Thats what the majority of people do including me.

The Personal Capital app is highly-rated in the App Store, with a 4.7/5 rating and over 16,000 reviews.

It works similarly to many other budgeting apps:

  • You get started by signing up on your smartphone
  • Once youve created your account, Personal Capital asks you to sync your current accounts, such as your investments, 401, credit cards , and checking and savings accounts.

Once your accounts are synced, youll have access to all of Personal Capitals free tools. If youre interested in learning more, read our full Personal Capital review.

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What Can A Monte Carlo Analysis Tell You About Your Retirement

A Monte Carlo simulation can be an important analysis tool. It can tell you your chance of success for any desired outcome. In financial planning, it is most commonly used to predict investment outcomes.

However, with regards to retirement, it can tell you how likely are you to be able to fund your retirement through your longevity.

See your personalized Monte Carlo analysis for the probability of having enough money for retirement in the NewRetirement Planner.

We Can Help You With Determining Your Probability Of Success

Monte Carlo Simulation for Wealth Planning in Excel – Part 2

We hope that this article has given you a better perspective on what a Monte Carlo simulation is and how it can relate to your retirement. Once again, you can try some Monte Carlo simulations out for yourself with our industry-leading financial planning tool. Just click the Start Planning button below to begin building your plan and see what your probability of success for retirement will be, whether thats in the next couple of years or 10 to 15 years down the road.

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Retirement Spreadsheet Recommended By Reddit

The inputs for this spreadsheet include:

  • Working ROI Estimated annual return on investment during working years.
  • Retired ROI Estimated annual return on investment during retirement.
  • Retired SWR Safe Withdraw Rate, or amount of total investment you plan on withdrawing annually during retirement.
  • Savings Rate Percentage of income you will save during working years.

What Is A Monte Carlo Simulation

Analysts can assess possible portfolio returns in many ways. The historical approach, which is the most popular, considers all the possibilities that have already happened. However, investors shouldnt stop at this. The Monte Carlo method is a stochastic method to solve a statistical problem, and a simulation is a virtual representation of a problem. The Monte Carlo simulation combines the two to give us a powerful tool that allows us to obtain a distribution of results for any statistical problem with numerous inputs sampled over and over again.

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Monte Carlo Analysis In Financial Planning Software

Monte Carlo analysis can look different in different financial planning software, and the various calculations behind the scenes might look a little different too.

When youre looking to add financial planning software to your advisory firm, get into the details and ask the providers youre reviewing to explain their assumptions so you can know with certainty what youre showing to clients when you run a Monte Carlo simulation.

When you use the Monte Carlo simulation in Orion Planning, you get a full explanation of the assumptions were using each time you run a report. You also have full control over assumptions with a set of What If settings to tweak inputs like savings rates.

More than simply looking at if a client has money at the end of a given timeframe, the Orion Monte Carlo simulation puts a focus on instances where a client might run out of money.

Longevity risk is real for many investors, especially mass affluent clients, and by using this type of analysis, you can have better conversations with clients about the risks and behavior they need to be aware of as they work toward their financial goals.

Monte Carlo Simulations: A Sophisticated Way To Predict Your Chance Of Financial Success

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Kathleen Coxwell

If you hear Monte Carlo simulation and think of luxurious casinos, the Mediterranean, high stakes poker, and extreme wealth, you arent necessarily wrong, but no, that is not what we are talking about here.

Monte Carlo simulations actually have nothing to do with gambling. Though, like their namesake, they are related to your possible wealth. Specifically, they are a useful tool for predicting the possibility that you will enjoy a financially secure future.

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Summary: How Long Will My Money Last

Figuring out your monthly income and how long your money will last in retirement is a complex calculation. But with the help of freely-available software, it becomes possible to have a realistic look at how your portfolio will fare.

But there are some shortcomings to the DIY method, mainly because every financial situation is unique. There are variables like life insurance, capital gains taxes and unexpected changes in income that cant be easily considered by financial software.

If youre finding yourself with more questions than answers, you may want to find a local fee-only financial planner ideally, a CFP® Professional who specializes in retirement planning.

Is There One Best Free Retirement Calculator

Free retirement calculators are plentiful on the web. These are three of the best retirement calculators, in my opinion. Try them. Try more than one. But use them all with caution!

Understand that retirement calculators arent giving you the answer to a simple mathematical equation. They are actually attempting to model the future. Thats a tough assignment, even for the best retirement calculator. One that is actually impossible, in any precise sense.

I dont recommend relying on any of these tools, and then resting on your laurels. Consult them, at least annually, to optimize your near-term financial decision making, while understanding that the future will inevitably turn out different than planned.

And, of course, your opinion or experience could well be different from mine. Do you have a preferred retirement calculator? Leave a comment about it below with the pros and cons. For extra credit, run the retirement scenario through it, and let us know the results!

Want More on Retirement Calculators? Review Our Curated List of the Best Retirement Calculators

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This articles was originally published on March 19, 2013 and was most recently updated on October 16, 2021.

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Bringing The Other Monte Carlos Back Into The Picture

As we bring this article full circle, we have a fun Monte Carlo fact to share. Do you know why a Monte Carlo simulation is called a Monte Carlo simulation? Well, it has to do with the Casino de Monte Carlo thats in the Monaco resort that we mentioned in the opening paragraph.

There can be many random variables that can suddenly change how you go about life in retirement. On the bright side, you could become a grandparent and want to help pay for your grandchildren to go to college. Or maybe you want to go on a dream trip to a place like Monaco and make a big purchase .

And on the flip side, there are things like a long-term care stay or an early death of a spouse that can completely change the direction of your retirement. Youre factoring in different variables like that and many more to determine your probability of success. Games like roulette, dice games, and slot machines that you can find at the Casino de Monte Carlo also have quite a few random factorsall which go into determining your probability of success in each game.

How A Monte Carlo Simulation Improves Financial Planning

Retirement Portfolio Monte Carlo Simulation in Excel without Macros! – Part 2

Monte Carlo simulations can be beneficial for helping clients to understand the likelihood of reaching their desired financial goals in the future, but they arent predictors of success. Its important that any conversation that includes a Monte Carlo analysis emphasizes that while the calculations may point to success now, time and variables may change.

Over time, investor behavior will have a large impact on the final result. A client who begins to spend more because of overconfidence in their plan only sets themselves up for future failure. A Monte Carlo used to assure clients of success no matter what is clearly the wrong approach.

But that said, this isnt the time to throw out the good with the bad.

A Monte Carlo simulation can improve financial planning by giving advisors an opportunity to demonstrate, with real data, why a plan may or may not be likely to result in what a client wants.

Financial planning is both an art and a science, and Monte Carlo simulations can bring the science part to the forefront for advisors who may need to gently guide investors toward a more realistic goal, or a better set of financial behaviors.

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How This Method Can Improve Retirement Projections

There is no foolproof way to predict the future, but a Monte Carlo simulation that allows for the real possibility of disaster can give a clearer picture of how much money to safely withdraw from retirement savings.

Here’s how the Monte Carlo method works and how to apply it to retirement planning. It’s also important to understand where it can fall short and how to correct for that.

How To Plan Realistically

There are a few basic adjustments that experts suggest to help remedy the shortcomings of Monte Carlo projections. The first is to simply add on a flat increase to the possibility of financial failure that the numbers show, such as 10% or 20%.

Another is to plot out projections that use a percentage of assets each year instead of a set dollar amount, which will greatly reduce the possibility of running out of principal.

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Getting You To And Through Retirement

When were building a financial plan, the whole idea is to not only get you to retirement, but through retirement. Thats what our Guided Retirement System is all about. Were focused on helping you accomplish your personal retirement goals. To do that, we need to know what your goals are, and how you think and feel about money to set up a spending plan for your retirement.

Keep in mind that your spending is going to be much different between your working years and in retirement. It will change throughout retirement as well, just as your goals will continue to change. Thats one of the reasons why we have review meetings with our clients to make sure their plan is current.

Knowing how you think and feel about money will allow us to determine how much risk youre comfortable with taking. This is where the Monte Carlo simulations come into play, as they help determine how much you should be spending.

Deterministic Vs Monte Carlo Planning

Wade Pfau: Does The 4% Rule Work In Todayâs Markets?

If you dont want to trust your financial future to the casino, Income Allocation offers a plan that is much more predictable. An Income Allocation plan will continue to include stocks and bonds. Notably, annuity payments do not eliminate all risk, but they make the risk more manageable. My advice is to depend on income annuities for no more than 30% to 35% of your portfolio.

Income Allocation also makes it easier to prepare.

As you design a plan for income, you select your view of the stock market . Then you test the results, creating the levels of income and legacy to your heirs that works for you. If you dont like the results, you can revise your assumptions.

As you build an income allocation plan for you and your family, you will consider how your retirement income will look under three different results: A market that averages annual growth of 4%, 6% or 8%.

And whatever date your plan takes effect, you can return for adjustments later on.

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