"Who the hell can see forever?" Thoughts on retirement planning and the Monte Carlo Analysis

Monte Carlo. The words make us think of gambling, yachts, dining….and retirement planning?

It is also the name of a powerful financial planning tool…if used properly. Years ago, financial plans were developed using averages and straight lines calculations. It captured what happened on average….but it removed the variability that is a part of life. Though it is still useful, something was missing.

Enter Monte Carlo; named (perhaps unfortunately) after the odds and probabilities that are present in casino roulette. When we run a Monte Carlo simulation, it runs your spending, income and investments through 1000 different scenarios of investment return and inflation to see how many are successful (i.e., you are able to fund all of your goals through your potential life expectancy).

Monte Carlo simulations model the probability of different outcomes in a process that can’t be easily predicted due to the intervention of random variables. In financial planning, the random variable is market performance.

It provides feedback on plan success, i.e., not running out of money. As well, it shows your success probability at any age/life expectancy. By doing both straight line and Monte Carlo calculations for every planning client, I get and give increased feedback on how to meet goals and what is possible.

By getting this feedback now, you have the ability to make corrections along the way in the smart and proactive way that most humans do. If you are calculated to have an 80% chance of success in a certain financial plan, what do we make of the other 20%? What does it mean? Failure and poverty? No, it just means that you have to make an adjustment. Work a year longer, spend a little less, or other mid-course corrections all along the way. These are adjustments that most can make.

There is a certain hubris in showing a 40 year old a graph projection of their net worth at age 87. The goal of our work is not to accurately predict that exact number, but to get you on the right path or trajectory, identify problem areas and risks, make corrections, etc.

Through ongoing work with a financial planner, you can understand the trajectory you are on and make sure that the trendline is a good one. We work together to make sure that “the trend your friend”.

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Dave Pedersen is an Advice Only Financial Planner. Based in Hermosa Beach California, he shepherds clients (typically age 40+) through “The Complicated Years”, where they have overlapping goals and need insight from a trained professional. Compensated only for his time and work (and not commissions or management fees), Dave provides true independent insight. Interested? Reach out to discuss further.