Surviving The Worst Case

More recently, the declining cost of computing power has permitted the use of Monte Carlo simulations to model the uncertainties of future market returns. Typically, these complex exercises generate two significant numbers: a prescribed dollar withdrawal amount and a percentage expressing the degree of confidence that this will not entirely deplete the asset during the client's lifetime.

Undoubtedly, Monte Carlo is a big improvement over the average return approach. It can examine hundreds of possible portfolios, incorporating the historic correlation of various asset classes as well as hypothetical returns varied over the years across a range suggested by historic experience. Nevertheless, the Monte Carlo approach has some constraints that, I believe, limit its usefulness in advising real people.

One limitation (at least in the versions I have seen so far) is that it presents conclusions such as "invest 55% in stocks and withdraw $1,500 a month" without a graphic presentation that inspires confidence in the client. Remember, there are two issues being addressed: The client wants to withdraw as much as possible, within the constraints of his or her long-term financial security. So, the confidence aspect is extremely important.

Another softness I perceive in Monte Carlo simulations is this business of declaring a percentage of confidence that the withdrawal will be sustainable for "x" years. If an advisor tells her client that there is a 70% chance this will work out, what do you suppose goes through the client's mind? "There's a 30% chance I will run out of money before I stop breathing!" If I told the Stones that they should live on $60,000 a year instead of $90,000 so they could be sure their money would outlast them, would I being doing them a favor or sacrificing their dreams on the altar of academic propriety? We are dealing with the future, the unknown, and I think that assigning mathematical degrees of certainty to the output of a black box may be inappropriate.

My experience convinces me that people who are old enough to retire have seen enough of life to understand that risk goes with the territory. Most of them would rather enjoy the early years of their retirement, when their knees still work pretty well, and take some risk that, if the markets are worse than expected, they will need to cut back on something. We usually suggest modeling a reduction in projected living expenses at some point, perhaps age 75. Sometimes, we do it by simply eliminating the inflation factor at that age, in effect beginning a gradual reduction in "real" spending. When it seems reasonable to our clients, we actually reduce projected spending by 15% at some future age to permit greater spending in the early years; it is just more realistic. In all cases, we counsel our clients that it is important to revisit these long-term projections every year or two for a reality check.

The new retiree's greatest financial risk is that the first so many years of retirement will be terrible years for the investment markets. We wanted to create an easy-to-understand model that stared this risk right in the face. If we could get past it, our clients could have the level of confidence they need to make the withdrawal decision. We call the model our Bear Market Endurance Model©.

Using the Stones' data, we have displayed nearby the spreadsheet model that we used to determine a stock/bond mix capable of providing the $90,000 annual withdrawal that their planned lifestyle requires. One Monte Carlo presentation we looked at would guide them to a first-year withdrawal of about 4.3%, or $64,500, with a 95% certainty. In sharp contrast, our model suggests that the Stones' portfolio can support the 6% ($90,000) beginning withdrawal rate on which our clients have their hearts set.

Our presentation focuses on the annual withdrawal, which is what the client is focused on. It also shows a year-by-year portfolio value in three radically different stock-market scenarios to demonstrate a range of possible outcomes. Our goal is to support their lifestyle even in the worst-case scenario; that way, surprises are more likely to be pleasant ones.

Our worst-case scenario is an entire decade when stock appreciation averages only 2% a year. We purposefully placed the worst-case markets in the first 10 years of retirement, because this is when it would be most disruptive to our clients' plans.