A Monte Carlo simulation is like a stress test for your financial future. Using financial planning software and retirement calculators, you can leverage these powerful forecasting models in your retirement planning.
Learn to understand the terms, use the simulators, and interpret their results.
- Monte Carlo simulations use standard deviations on historical market data to calculate potential passive income.
- Monte Carlo simulations must include at least five variables about the portfolio: size, allocation, annual income withdrawn, annual deposits until you retire, expected inflation, and time horizon.
- Several professional calculators rely on Monte Carlo simulations.
What Is a Monte Carlo Simulation?
A Monte Carlo simulation ("sim") differs from older models that make estimates based on static variables. This model offers a means to test a process using a wide range of factors that can affect the outcome, taking into account the inherent risk and uncertainty in the process.
The model has been used in fields that range from economics to finance. You can use it to help you plan the outcome of an investment. If you know the paths that a plan can take, you can make better choices with your money.
The model tests whether your nest egg will last enough years by using several factors. Monte Carlo sims involve five variables at a minimum:
- Portfolio size: This is the amount you have saved in an account.
- Portfolio allocation: This is the percentage of stocks, bonds, and cash that make up your portfolio.
- Annual income to be withdrawn: This is the amount you plan to take out of your accounts to fund your living costs.
- Annual deposits: These are the amounts you plan to add to savings until you retire.
- Inflation: This is the rate of inflation applied to the income withdrawn.
- Time horizon: This is the number of years you have until you retire.
When you run one of these sims, you can modify any of the above factors. You can change more than one to see how it affects the income you have planned.
How Monte Carlo Simulations Aid in Retirement Planning
Many investors assume that they can predict how big their nest egg will be by using an average rate of return, but the reality is that you don't know what your future returns will be. Looking at past data, returns for stocks and bonds can vary widely over 20-year return periods.
If you assume a constant rate of return, your nest egg may fall short of your needs if the market contracts, and you do not have enough time to recoup any losses. In contrast, if the market performs much better than you hoped during certain periods, you may put too much into your nest egg. You may get to the point, in that case, where you can't live comfortably.
Given the variations in the factors used in the sim, you can follow the same allocation approach as another retiree who plans to stop working at the same time as you. You could still have a different outcome, even though you make the same choices. This is called "sequence risk."
When you use a Monte Carlo sim, run simulations with both likely scenarios and "what-if" scenarios, such as a stock market crash, to get a more accurate sense of the portfolio you might have.
The Monte Carlo sim uses past data and standard deviations to factor in likely market changes. It tests your income outcomes over a wide combination of possible market returns. It typically delivers your chances of success based on the total number of simulations that are run. You can have tens of thousands of runs, depending on the simulator. If your income survives in 4,000 of 5,000 scenarios, you'd have an 80% chance of success. The goal is to get the highest rate you can.
Most financial planning software used by professionals has some type of Monte Carlo sim. There are also Monte Carlo financial planning software and calculators available for consumers. Some examples are Retirement Simulation and Vanguard's Retirement Calculator. This software relies on Monte Carlo sims to provide you a better sense of your chances than using only the average annual rates of return.
Using the Simulations to Calculate Your Retirement Nest Egg
The free financial planning app Retirement Simulation lets you get your feet wet. You can also use it to learn how to read the results of simulations. It uses past rates of return and inflation along with other hypothetical factors like a stock market collapse to help you see your chances of success when you retire.
Assume the following factors:
- Current age: 40
- Retirement age: 67
- Current savings: $300,000
- Annual deposits: $5,000
- Annual withdrawals: $40,000
- Stock market crash: None
- Portfolio: 60% stocks, 40% bonds
The results indicate that this person has an 89% chance that an inflation-adjusted nest egg will last until age 102. They also have a 99% chance of success sustaining their income until age 78.
However, let's assume that the stock market declines by 40% when this person is age 55. Run the simulation with the crash, and the chances reduce to 80% and 98% at ages 102 and 78, respectively.
What about the 20% of the time where the plan fails at age 102? The simulation assumes that this individual makes no lifestyle changes and keeps spending the same amount of money.
You might begin to notice that the chances of failure increase with age. You can try to control the age at which you start withdrawals or deposits. You could also change other life factors to reduce the number of failed scenarios and the overall failure rate. Play around, and look for chances to boost your odds of success and reduce the odds of an income shortfall.
Final Thoughts on Monte Carlo Simulations
You can use average annual rates of returns alone. You can also use financial planning software and planners that use this model to provide a better picture of your financial future. Used together, you can build a decently accurate picture of how a situation may play out.
For all their strengths, Monte Carlo simulations are still based on assumptions that might not bear out in the future.
Everything is an assumption, and there is no guarantee of success. No one can predict whether the market will perform as it did in any of the simulations. A divorce, the onset of a disability, the death of the primary income provider, or another financial impact can also greatly reduce your chances of success.
One way to offset overly favorable assumptions is to factor in multiple what-if scenarios. You could use stock market collapses or below-average returns. Above- and below-average rates of inflation can are not unheard of. It helps to look through past downturns and use them as guides to toss in some factors that might affect your outcome.
If you encounter a poor set of economic circumstances in your early retirement years, adjust the factors that are in your control to help ensure that a failed scenario does not occur. Much like in many financial situations, identifying any problems early gives you time to remedy them and stretch your nest egg further.