Many people build their financial plan using the 50% probability method. That’s the value you get when you assume all the variables are fixed. One major problem that may happen is that if you assume an average rate of return, you are not taking into account the natural variability (called standard deviation) of different asset classes that happens in the real world. Some years you get higher returns and some years it’s lower, even negative. For example, if you withdraw 8% in year one and also experience an overall market downturn of 12%, you’re down 20% in total in year one. You then need a 25% return in year two just to get even, not taking into account your planned withdrawal. It’s possible but not highly probable. In practice, a Monte Carlo simulation takes into account the variability of returns by running numerous “what-if” scenarios and statistically varying the return of each asset class in your portfolio.
Below is the output of a Monte Carlo simulation whereby 50% of the tests passed and 50% failed to have sufficient assets to last until age 90. (Note: the black line represents the 50% probability simulation). The goal is to have greater than 70% confidence that the simulations pass.
One method to improve this plan is to lower the withdrawal rate. The new Monte Carlo simulation results are shown below.
The results of the second simulation exceeded the goal of 70% confidence that assets would last until age 90.
While we cannot predict the future with certainty, we can plan using methods that can lead to a more successful retirement and lessen the surprises. I believe Monte Carlo simulation is one of those methods.
For more information, please contact me at 613-966-8289 or email: dmaycock@a-q.com. Visit www.donmaycock.com and subscribe to “The MAYCOCK Letter” for valuable financial planning information.