Are you saving enough for retirement, and will your retirement plan survive a damn good buffeting by an uncertain future? Obviously nobody knows, but you can stress test your strategy with a Monte Carlo simulator.
A Monte Carlo simulator takes your predicted pension pot and pits it against multiple visions of the future. It subjects your portfolio to random return sequences to determine the chances of your money running out before you breathe your last.
Staying in the black until you cark it is a win.
In contrast eating dog food in your eighties is not shown, but is the unsavoury implication of failure.
Retirement roulette
In some return scenarios, the 1980s dream sequence for equities will bubble into the dot.com boom and turn you into a multi-millionaire.
In other possible worlds, you’ll get hit by the Great Depression then World War 2 then the 1970s oil crisis, coming one after the other, like the three buses of the Apocalypse.
The main interest lies in the big % number written on your scorecard at the end. Handed out, as if Death himself was a Strictly judge, this shows the likelihood that you haven’t emptied your pot before you’ve completed the waltz of life.
To run a stress test on your own retirement plan, head to Vanguard, which hosts a free Monte Carlo retirement calculator that’s very simple to use.
The calculator wants to know:
Your total pension pot – I used the figure projected by Hargreaves Lansdown’s calculator based on my existing salary and contributions (as we’ve previously discussed). Ignore the Vanguard calculator’s request for your portfolio’s balance today. Instead insert your projected pot as it will stand on the day you retire (but in today’s terms).
The annual income you require 1 – I used my current budget because I’m already a money-saving maven. I’m not going to spend much less in retirement unless I’m afraid to leave the house. If you’ve never imagined what your retirement income might look like, try this suggest-o-tron.
How long you plan to live – Use the national averages, or try a life expectancy calculator, or accept the 30-year default.
Your asset allocation – Use your current risk tolerance and these rules of thumb to guesstimate your likely asset allocation when you’re retired. Once you start playing with the calculator you’ll discover that there’s much less room for manoeuvre than you might imagine.
Place your bets
Run the simulator, let the digital dice roll, and you’ll end up with something like this:
The green zone represents all the time streams in which I lived happily after. The orange area shows the scenarios in which I bitterly regret not having children. In the worst-case scenario, the money tap runs dry after 16 years.
The important number is 78%. That’s the probability of my portfolio lasting for 30 years based on every scenario in the sim.
That’s not great. I’m not prepared to risk a 1-in-5 chance of hitting the skids.
Options for remedial action
So what am I to do?
Well, I could plan on cashing in my chips earlier.
Hmm.
What else? I can spend less, retire later, save more, and invest more aggressively.
Sticking with the moveable parts of the calculator, I try upping my equity allocation. But I can only hit an 81% success rate even with portfolios of 50 – 75% in shares. Not good enough.
Time to pinch the pennies. I can reach an 88% survival rate by spending only £18,000 a year. 10% less than I planned. This I can live with.
To hit the magic 100%, I either need to exit the stage after 20 years or get austere on my ass and only spend £12K a year.
A kick in the assumptions
For simplicity’s sake, I haven’t taken into account my state pension or the fact tax would reduce my £18K spending money to £16.5K. Do work these factors into your own retirement plan.
UK investors should bear in mind that this is an American calculator that uses historical US asset return data (from 1926 to the present day).
Many commentators argue that this was a golden age for US assets that’s unlikely to be repeated. On top of that you can knock off about a point of growth every year to represent UK returns lagging the US.
As the returns data is based on indices, there’s also every chance that the simulator doesn’t take into account investment fees (although it doesn’t say so in the fine print), which will deplete a pot even faster.
Not including my state pension makes my results conservative enough to allow me to feel comfortable about the above issues, however.
Another thing to keep in mind is you don’t know how often you ran out of money with, say, less than 24-months on the clock. Quality of life may not matter as much near the very end.
Lastly, this kind of calculator assumes you draw down your portfolio until it runs out or you do. In reality, you may want to annuitise a large proportion of your pot and take the guessing out of the game. But that’s a different story.
This is the end, my friend
For all these reasons and more, you shouldn’t treat these numbers as gospel. At best they enable you to circle within the vicinity of your retirement destination. They’re not exact co-ordinates.
Darrow KirkPatrick from the excellent Can I Retire Yet? blog advises using several different retirement calculators. That way you’ll get a range of answers that would make an astrologer sound precise. The process should dispel the notion that there’s one, ‘true’ number to shoot for.
I highly recommend trying Firecalc – it’s an excellent Monte Carlo sim with all kinds of tweakable options. Too much fun.
The vagaries of these calculators become a metaphor for the uncertain future ahead. Because however your retirement plan turns out, for better or worse, it won’t return the same answer as the calculator.
Take it steady,
The Accumulator
- Again, enter your desired income in today’s money. [↩]
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I’ve never heard of this kind of exercise, but it sure seems like everyone should attempt to put in best guesses in the different fields and see what the system comes up with. It also forces you to look at what you think is realistic for living expenses far out into the future (hopefully). It’s never easy to sit down and actually do this kind of work, but it’s always very rewarding and informative when you do. Great post!
Thanks for the kind words Accumulator. You did an excellent job capturing the vicissitudes of the retirement calculation. I also like your leading infographic! (Note there are issues with unrealistic probability distributions being used in many Monte Carlo simulations — yet another reason those results should not be taken as gospel.) Thanks again for the perceptive post!
Doesn’t a Monte Carlo simulator pit your predicted pension pot against multiple visions of the *past*?
A useful exercise, but what if the future is worse? Another world war in the next 50 years – unlikely – but stranger things have happened! I can’t see how predicted global population growth will lead to less conflict (without wearing a tinfoil hat).
I think your choice to discount the effects of any state pension is probably a very sensible way of keeping your range of outcomes realistic.
One of the key objectives of your financial life and good to ‘stress test’ your plans! The reality is that most do not plan at all, unfortunately. Lots of good advice on this blog but I would just summarise my key steps to reduce the potential uncertainty in retirement income:
1) Pay into an occupational final salary pension if available
2) Buy your own well-insulated accommodation
3) Annuitise a portion of your savings (this will already be built into your money purchase pension arrangements)
4) Build up half of your portfolio to include long-dated high-yield bonds – timing in the economic cycle is important here (now is not the time)
5) Practice being retired, by living on the equivalent of your passive income (and pruning living costs accordingly)
Having noticed that the simulator ‘rolls the dice’ each time, I decided, just for fun, to roll them several times with same values plugged in. Result? A variation from 79% to 85%. Even with 5000 dice-rolls the distribution can vary. Pinch of salt/margin of error…
Nice comments all. Mary I think you’re right that most of the value in a Monte Carlo sim is that it makes you think long and hard about the factors that will ultimately determine the quality of your retirement. It is fun to play dice with the future (based on a remixed version of the past, you’re spot on Luke), but the real pay off is you’ll end up with a well chiselled plan like Moneyman. Love the one about well insulated accommodation. I’ve just been thinking about that myself. My house has all the insulating properties of a paper bag.
@ Darrow – thanks very much for your comments! Darrow has written a great post here about retirement calculator flaws: http://www.caniretireyet.com/blog/why-most-retirement-calculators-dont-work.html
@ Oliver – I tried that too and it’s a good point. I only found a range of 3% on the Vanguard calc but a much wilder spread when I compared it to Firecalc.
The goal of Monte Carlo simulation shouldn’t be a plan with 100% success. It’s not actually measuring the odds of you actually running out of money because you would more than likely adjust your spending well before spending your last coin. You’re actually measuring the probability that you are over-planning. So at 78% there is about a 4-in-5 chance your over doing it and a 1-in-5 chance your not doing enough. But the real value of using Monte Carlo simulation is the ability to maintain plan. By repeating a process regularly (annually should be sufficient), you can monitor your drift from that 4:1 ratio, making minor course corrections to get back to your target probability. Being around the 80th percentile (4:1) is actually quite manageable, even when we experience “non-standard” deviations.
Bottom line, Monte Carlo simulation isn’t a map; it’s a compass. You need to check it against your map (your retirement plans) in regular intervals and make adjustments (tweak spending/saving) to your course.
The problem with all of these calculators is that they assume a pro-rata distribution from a diversified portfolio. If the cash, bond and stock buckets are used strategically then the odds can change considerably. I have yet to see this type of simulation put into a usable calculator. Having done the math long hand I can tell you I would not rely on the pro-rata distribution.
@ Dylan – wish I’d thought of the compass metaphor when writing the post! One of the interesting sensations that the calculator spurred in me was that I’d rather overcompensate now while I’m some distance from the finishing post in the hope that I can canter in later.
The picture looks a lot less rosy when you factor in the FSA’s new projected growth rates: http://www.guardian.co.uk/business/2012/nov/02/fsa-cut-pension-projection-rates
@ Mike – interesting. I’m guessing that the strategic use of buckets means the calculator’s results are on the conservative side? i.e. you use buckets to avoid selling down stocks when valuations are low.
You can get an idea of how often you ran out of money with only 24 months of cash left. Just rerun the simulation with a two years greater life expectancy and see how much it reduces your chances of having enough cash to last to the end.