IT’S HUMAN NATURE to be impressed by things that sound sophisticated or seem complex. In the world of personal finance, this certainly applies to the planning tool known as Monte Carlo analysis.
Its roots go back to the 1940s, when it was developed by Stanislaw Ulam, a physicist working on the Manhattan Project. Today, it’s a popular way to assess the strength of a proposed retirement plan. If you’ve seen presentations indicating that a financial plan has a particular probability of success, that likely came out of a Monte Carlo simulation. Because of its highly mathematical underpinnings, this type of analysis tends to be viewed as rigorous and its results reliable. It’s not perfect, though.
In the past, I’ve discussed some of the shortcomings of Monte Carlo simulations. Chief among them is the issue that retirement can’t be characterized as having a binary outcome. It’s too simplistic to say that someone’s retirement will either be a success or a failure. As researcher David Blanchett noted in a recent article, “Monte Carlo failures aren’t like plane crashes.” Retirement—thankfully—is much more nuanced.
That leaves us with a crucial question: If we don’t use Monte Carlo analysis, how do we assess the robustness of a retirement plan? How can we be sure a particular plan won’t result in a retiree outliving his or her money? Below are nine strategies to consider.
1. Asset allocation. Adherents of Monte Carlo laud its ability to protect investors from sequence-of-return risk. That’s the risk faced during the first years of retirement, when poor investment returns can be especially damaging. Because Monte Carlo analysis looks at thousands of possible sequences of returns, it can help identify this risk. That’s useful, but there’s a simpler and more intuitive way to protect against an unwelcome sequence: through portfolio structure. If you hold sufficient dollars outside of stocks and in more stable assets like bonds or cash, that can help immunize your portfolio against a bear market in stocks, even one that persists for a number of years.
2. Scenario analysis. An appeal of Monte Carlo analysis is that it effectively “rolls the dice” hundreds or thousands of times. That can help investors explore a range of potential outcomes. A downside to this approach: Each time the computer rolls the dice, it only changes one variable—typically just the projected market return. This makes Monte Carlo analyses incomplete. In the real world, many more variables are in play, and it’s important to see how those changes might also impact the sustainability of a plan.
For instance, you might look at the impact of different spending levels or different housing scenarios. What if you purchased a vacation home or you downsized? You might also look at the impact of a large charitable gift. And, of course, you might want to analyze the impact of a change in tax rates. You can’t test everything, but it’s important to look beyond the single variable that Monte Carlo simulations tend to use.
3. Tax diversification. To help shield your portfolio from ever-changing tax rules, try to strike a balance among the four main types of accounts: a cash account, a taxable investment account, traditional tax-deferred retirement accounts and tax-free Roth accounts. This sort of balance is important because it helps retirees better control their tax rate from year to year.
Already have the four types of account? You might also look into a health savings account, though eligibility will depend on the type of health insurance you carry. If you have children or grandchildren, a 529 education savings account is a great idea—especially with the new escape hatch that allows for the partial conversion of leftover 529 dollars to a Roth IRA. Contributing to some of these accounts—such as a Roth—might mean forgoing a tax benefit this year. But remember, it’s the long term that matters. Sometimes, it’s worth paying more tax this year if it means paying less down the road.
4. Guaranteed income. No doubt about it, income annuities have a bad reputation—but don’t dismiss them entirely. What most people fear is that they buy an annuity on Monday and then die on Tuesday. That’s an understandable concern, but it’s also unlikely. Locking in some guaranteed income can provide both financial security and peace of mind. At the very least, remember that Social Security represents probably the best annuity of all—with both inflation protection and a survivor benefit. I suggest doing everything you can to maximize that benefit.
5. Real estate. Rental property seems to be the asset that people either love or hate. That’s understandable. A friend described arriving at a tenant’s door to pick up an overdue rent check and being greeted by a pit bull. That’s every prospective landlord’s worst fear—but it’s also unlikely. Real estate is attractive because it delivers passive income, isn’t highly correlated with the stock market, allows for the use of leverage and provides unique tax benefits. It isn’t for everyone, but it’s worth considering.
6. Tuition. Most parents feel an obligation to provide their children with an education. As one parent put it, “If my kid gets into Harvard, I’ll find a way to pay that bill—no matter what.” It’s a wonderful sentiment. But with tuition so high, it’s important to think more critically about this. One way to manage risk while also supporting your children is to have them take out loans. Then, after they graduate, contribute toward paying them down, but only to the extent that it doesn’t jeopardize your own plan.
7. Mortgage. If at all possible, I recommend paying off mortgage balances before retirement. Even if the numbers indicate that you’d be able to make the payments in retirement, reducing your fixed costs can provide you with valuable flexibility to navigate life’s inevitable curveballs.
8. Estate plan. Along with tuition, another potential budget buster is long-term care. Should you or your spouse require an in-home aide or a long-term-care facility, the costs can easily run to six figures a year. While there’s no way to predict the level of care you might need—if any—you can take steps to protect your portfolio so every last dollar isn’t consumed by a nursing home. It’s worth consulting an elder-care attorney to learn what strategies exist. Those strategies differ from state to state.
9. “Right” answers. Personal finance pundits seem to enjoy beating each other up over retirement strategies. In addition to Monte Carlo analysis and the scenario approach described above, there’s the so-called 4% rule, the RMD method, the guardrails strategy and many others—and everyone has an opinion on which is best. But since none of us can see the future, the best strategy, in my view, is to consider what each of these models has to offer. Don’t let any one model leave you feeling overconfident—or overly worried. Instead, see them all as data points for consideration. Most important: Make sure that, should your plan falter, you have a backup plan.