Retirement Income Planning and Your Financial Advisor
Many baby boomers plan for retirement by consulting a financial planner or advisor. A key topic in consultations with an advisor is whether your retirement income will last for as long as you need it to. The answer to this question requires a careful analysis of your assets so as to predict with some degree of accuracy if you will outlive your money. This must involve more than a back of the envelope calculation. Unfortunately, some financial advisors oversimplify their analysis of your retirement income. This produces an unrealistic outcome.
There are three fundamental flaws with a straight line projection model. First, it ignores market volatility which can effect portfolio survival. Second, it ignores the order of returns. In other words, a straight line analysis uses an arithmetic mean instead of a geometric mean in applying hypothetical market returns. This is absolutely the wrong thing to do. Third, a straight line analysis does not take into account the possibility that actual market returns will substantially deviate from historical returns.
So what method should your financial advisor use in projecting your retirement income and portfolio survival? One such method is called a Monte Carlo analysis. Using a computer model, a Monte Carlo analysis uses a wide range of projected values for all of your retirement assets. Then, applying historical and theoretical performance data, it projects an overall probability of achieving certain valuation and survival outcomes, at different income withdrawal levels. In other words, your analysis is derived from hundreds or thousands of different scenarios, not a single straight line scenario.
To understand how the different types of analysis can affect the outcome, let’s assume the following: A retiree has a $2 million portfolio in a taxable account. Let’s further assume a 7.8% annual rate of return over 20 years, with a market volatility of 18.3%. From this portfolio, the retiree wants to receive an income of $100,000 annually. A straight line retirement analysis of this data predicts a 100% success rate. Putting this same data through a Monte Carlo analysis predicts an 82% probability of success. Stated another way, the more rigorous and realistic Monte Carlo analysis tells the retiree that 18 times out of 100, his or her retirement income plan will fail. That is important knowledge to have before the plan is actually implemented.
Many financial planners and advisors have access to planning software that will run Monte Carlo simulations of future performance of your portfolio. Make sure yours is one of them. There are also tools that you can use to analyze your own portfolio and calculators for asset allocation strategies. It wouldn’t hurt for you to run the numbers yourself, to be sure that your advisor is not being overly aggressive in an attempt to sell you something you don’t need. Another option is to skip the expense of a financial advisor entirely and use one of the couch potato (“lazy man”) portfolios.
Finally, some experts believe that nothing you can do will sufficiently eliminate stock market risk. They recommend retirement income strategies that exclude the use of stocks and stock mutual funds. I will be writing more about that in the near future.
Photo credit: Tylerdurden1
FREE UPDATES: If you enjoy what you read here, please consider subscribing to receive free updates automatically by RSS feed or by email. (I promise that your email address will not be shared or used for any other purpose.)