Using Monte Carlo For Retirement Planning

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If you’re not sure you have the right retirement plan or worry about your financial future, there’s a way to check. Monte Carlo simulations, which test retirement planning results using a broad range of possible variables, will help you determine if you’ve planned well or you need to make changes.

With this unique method, you can actually predict the amount of retirement income you’ll have throughout the remainder of your life. When it comes to retirement planning, most of the top experts rely on retirement planning Monte Carlo simulations because they’re accurate. Typically, this method consists of five distinct variables:

  1. Size of your portfolio
  2. Allocation of your portfolio
  3. Annual income you need to withdraw
  4. Increases due to inflation applied to the withdrawn income
  5. Time horizon

Using a combination of portfolio returns while keeping these five variables in mind is how the Monto Carlo simulation tests the outcome. What makes this method great is that by modifying different elements like inflation, spending, annual withdrawals, and time horizon, you have the opportunity to see the effect they have on what you want to achieve for retirement. That allows you to refine your plan, thereby helping you succeed.

The Value of Monte Carlo Simulations for Retirement

Although you can use historical data to see how widely stocks and bonds vary over a 20-year period, the challenge with future portfolio returns is there’s no way to determine what they’ll be. Even if you chose the same allocation model as someone you know who retired five, 10, or 15 years earlier, you’d experience what’s known as sequence risk, meaning you’ll end up with a completely different outcome.

Unlike someone from a younger generation driven to accumulate wealth, the goal with retirement is to achieve the highest level of success possible for securing a financial future. Using Monto Carlo simulations, you can test the outcome of your retirement plan to see if it will deliver the level of success you want. Remember, by making changes, you can use this method to test multiple variables.

Today, the majority of retirement planning software programs that experts rely on to help clients prepare for a secure future incorporate some type or degree of Monto Carlo simulation. This includes many of the free tools available online.

Deciphering Testing Outcomes

For example, consider someone with the following:

  • Investments of $700,000 (in retirement accounts)
  • Investments of $300,000 (in non-retirement accounts)
  • Living expenses of $80,000 annually (without taxes) that increase by 3 percent a year for inflation
  • Time horizon between 2015 and 2047
  • Allocation of investments (45 percent for stock index funds, 55 percent in bonds, and 5 percent in cash)
  • Anticipated $24,000 a year pension
  • Roughly $100,000 a year in Social Security benefits

Using that as a test case with the Monte Carlo simulation method, that individual has a 95 percent chance of making a minimum of $80,000 a year (adjusted for inflation) through 2047. While that percentage is impressive, what about the remaining 5 percent? The simulation assumes this individual didn’t change lifestyles and continued spending as usual.

An important note is that even after retiring, it is essential that you keep testing to make sure your failure rate doesn’t increase. If the person in the test case retested and found that instead of 5 percent, failure reached 10 percent, he or she would need to use the Monte Carlo simulation to make the appropriate adjustments to bring it down.

Tax Implications

Monte Carlo simulations should also let you know if you need to withdraw money early from retirement accounts. Depending on the amount that you withdraw, the federal government could penalize you heavily in taxes. For instance, if you want $50,000 out of the $80,000 you put in a retirement account, and you fall within the 25 percent tax bracket, you would have to withdraw a gross amount of $66,667 to cover $16,667 in federal taxes.

Summary

Even with the best retirement plan, fluctuations in the economy could negatively affect when you can retire comfortably. However, by utilizing Monte Carlo simulations, you can make the necessary changes to ensure a secure financial future. Instead of taking a risk, it is worth buying an accurate financial planning software application that utilizes Monte Carlo. If you do not want to do it yourself, hiring a professional financial planner who uses a software program incorporating this method is the responsible thing to do.

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