Ready For Retirement
Ready For Retirement
Why You Should Avoid Simplistic Monte Carlo Results and Create a Real Financial Plan Instead
Are you mistaking a Monte Carlo analysis for real financial planning? I'll explain why this common tool, often used by financial advisors, is not a substitute for a true financial plan. A Monte Carlo analysis provides probabilities of success based on investment outcomes, but it doesn’t offer actionable steps, strategies, or a clear path to achieving your goals.
I’ll break down the benefits and limitations of Monte Carlo simulations and show you what real financial planning should deliver: clarity on spending, income strategies, tax-saving opportunities, investment optimization, and a roadmap to living your best life. Don’t settle for vague probabilities—learn how a comprehensive financial plan can give you the confidence and direction you deserve.
Questions answered:
1. Why is a Monte Carlo analysis not the same as a comprehensive financial plan?
2. What should a true financial plan include to ensure success and peace of mind?
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Timestamps:
0:00 - Monte Carlo analysis vs financial plan
1:34 - What is Monte Carlo analysis?
4:02 - Why a MC analysis is not enough
6:08 - Benefits of a MC analysis
7:59 - Downsides of MC analysis
11:18 - Consider of severity of failure
13:23 - Perspective and peace of mind
14:51 - What a financial plan do
17:08 - Summary
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I'm often shocked when I hear clients describe what their financial experience looked like with their previous advisors before they begin to work with our firm, root Financial. And while this episode is not going to be a sales pitch, what it is going to be is it's going to shine the difference between what real financial planning is, in my opinion, and what most people pass off as financial planning. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. So, going back to my conversations with clients, I'll say tell me about your experience working with your previous advisor. And they'll tell me. They'll say you know, our advisor had us fill out a fact finder. When do you want to retire? How much do you want to spend? What are some of the goals that you have? And they come back to us with a sheet of paper and that sheet of paper has a number on it and that number gives us what it's calling a probability of success. It might say 90%, it might say 77%, it might say 100%, but that's measuring the probability of success of our plan, and that's it. And I'll ask if there's anything else, and the clients will say, no, that is our financial plan. Anytime we talk to our financial advisor, we get an updated number, and that updated number gives us an updated probability of success and to them, that's what financial planning is. So in this episode, I'm going to tell you why that is not financial planning and what financial planning should be. What that is is that's a Monte Carlo analysis, and a Monte Carlo analysis can be a helpful tool, but only in specific areas. You should never confuse Monte Carlo analysis for an actual financial plan. This is why A financial plan should show you what's possible. It should give you steps to take to arrive at your goals, specific things you should be doing and, finally, it should uncover the right strategies to optimize everything that you've worked for, and do so in alignment with the way that you want to spend your money and what you want your money to do for you. That's not what a Monte Carlo analysis does. So what is a Monte Carlo analysis?
Speaker 1:A Monte Carlo analysis, or a Monte Carlo simulation, is a model used to predict the probability of different outcomes when there's a random variable present. So what is that random variable? It's investment returns If you're going to retire, you can more or less control how much you spend. You can more or less control how long you're going to work. That is an input that you have control over.
Speaker 1:One thing that we do not have control over is investment returns, and there's two ways in which we don't have control over it. One way is we have no idea what investment returns will actually be. That much is obvious. Is the market going to return 10%, 6%, more or less? Who knows? We have history as our guide that does not tell us exactly what the market will do going forward. Now, most people know that. The second part of investment returns that we have no control over is even if we could predict with certainty what your average return was going to be over the course of your retirement, we would not know the sequence in which you receive those returns or you achieve those returns. So that's what a Monte Carlo analysis helps with.
Speaker 1:If you run a standard retirement projection, you might look at what does your retirement look like, aka, do you have enough money to last the rest of your life If you get some rate of return? Let's assume 6%. So the starting point for many of these financial projections that financial advisors are running. It's using straight line projection of what if you get 6% every single year. What if you get 7% every single year? Are you going to meet your goals? The answer to that could be yes, and even if you were able to guarantee that you could get the average return let's say 6% there is still the possibility that your plan fails. And there's the possibility, because of the sequence in which you receive those returns, you're never going to get exactly 6%. You're never going to get exactly 7% or 8% every single year.
Speaker 1:So what a Monte Carlo analysis does is it looks at the return characteristics of the underlying asset classes large cap stocks, small cap stocks, international stocks, bonds, real estate, whatever it is. It looks at the return in the risk characteristics as measured by something called standard deviation, and it runs 1000 different scenarios. So if you take these return characteristics and run those through good market environments, bad market environments, all these different possibilities, and what percentage of the time are you successful? Aka, you don't run out of money. So that's what a Monte Carlo analysis is, and what I want to tell you is how does that fit into what a good financial plan should be, but, more importantly, why that should not be the entirety of your financial plan, like I see it being for far too many people.
Speaker 1:But before we get right into that, let's go back to what clients typically say they have with their previous advisor. I'll say what did the advisor say when you had your Monte Carlo analysis run? And they'll typically say something along the lines of you know, if I had an 85% probability of success or higher, that was what my advisor was calling the confidence zone. If it was between 70% and 85%, it was a little iffy. You know, the software projection showed yellow as opposed to a green light or a red light, and if it was under 70%, you need to change your plan. That's red light. You need to make some serious changes.
Speaker 1:And here's the problem with that. If an advisor came to me and said hey, james, you have a 90% probability of success, well, I look at that. There's a little green light next to it. I might think that's a positive thing, but what does it actually tell me? It's not telling me what things I should be doing. It's not telling me how I can optimize that in light of my overall financial plan. And on top of that, if I tell you you're going to get on an airplane, you have a 90% chance of reaching your destination safely. Are you going to feel pretty confident about that? Of course not. So we're going to talk about how you should interpret that and what you should be doing instead.
Speaker 1:And here's the other thing getting a Monte Carlo analysis and having that be the entirety of your financial plan. It's kind of like going on a hike and you have a tour guide and you ask your tour guide how to get to where you're going and they say you know what, james, if you start walking down this path, you'll have an 87% chance of reaching your destination. What does that really do for you? Well, not a whole lot other than keep you pretty stressed out the entirety of your hike, thinking about that 13% of the time that you're going to get totally lost and not make it to your destination. That's why a true financial plan should tell you what you should be doing along the way. Are there better paths to take along the way? Are there little shortcuts to avoid the treacherous areas? Are there times you should actually stop and enjoy the view instead of just pushing, pushing, pushing?
Speaker 1:A financial plan tells you what to do. It gives you actions. A Monte Carlo analysis gives you a vague probability of success. That can complement a financial plan, but it should never be the plan by itself. So, with that in mind, let's talk about the benefits of Monte Carlo analysis and then let's talk about the downsides, so that you don't fall into the trap of thinking that the Monte Carlo analysis maybe you've run for yourself or an advisor's run for you should in any way or can in any way replace a true financial plan.
Speaker 1:So what are the benefits? Well, number one, there's the old saying that I'd rather be approximately right than precisely wrong. So what does it do? It, directionally, gives you a sense of are you somewhat on track or somewhat off track? That is a benefit. It gives you a temperature check or a gut check of when you're looking at your goals. Assuming that the assumptions are right, that you're planning for when you're going to retire, what you're going to spend, what return you might get all the various things along the way. This is going to give you a general sense of are you on track or not? You know.
Speaker 1:If you look at this and you have a 10% probability of success, you probably know it's time to go back to the drawing board, probably time to take an updated look at your plan to see what can you do to improve your odds of success Versus if you have 100% probability of success, to me in many cases that's actually the sign of a bad financial plan. It means you're probably going to leave a whole bunch of money behind, which may be your goal, or maybe it's not. 100% probability of success more often than not means clients are being too conservative with what they're spending on or how they're giving or how they're really living in retirement, because they're under spending. They're under utilizing what they otherwise could have been doing. And then the final benefit of a Monte Carlo analysis in my mind is it does help you to understand the uncertainty of investing. You know it's kind of nice to walk through a plan and say, look, if I get this straight line rate of return, I'm going to be okay. But then you contrast that to the Monte Carlo analysis saying same plan but all of a sudden Monte Carlo analysis is saying there's a 75% probability of success. What that highlights is the variability of investment returns and how various investment returns can completely change the outcome of what we might be planning for. So it does help to imprint that upon us of helping us to get out of the mindset of thinking, okay, I can count on 5%, 6%, 8%, whatever percent rate of return, and understand there's going to be inherent volatility, inherent uncertainty with investing, and it highlights the importance of continuing to revisit that. So those are some positives.
Speaker 1:Here are some downsides, though, of Monte Carlo analysis. Number one just because you're at 100% does not mean you're doing everything right. I've had people come to me before and they show me their plan from their previous advisor and it says 100% probability of success. James, I don't know how you can help us and I'll point out to them and say, hey, just because you have a 100% probability of success does not mean you're doing anything right. It probably gives that impression that you're good, you're dialed, you can go ahead and do this and there's nothing that you need to change. But that couldn't be further from the truth.
Speaker 1:Let's look at a simple example. Let's assume that you want to spend $60,000 per year in retirement and let's also assume that you have social security for you and a spouse and you have a pension and between those three income sources, you have $70,000 per year coming in after tax. Well, regardless of what you're doing with your investments, you're going to have a 100% probability of success when you look at a Monte Carlo analysis. The reason for that is you don't need your investments, your pension, your social security. They're covering everything. You could be invested in a horrible portfolio for you and the probability of success is still going to read 100% because the projection is going to say you're going to meet your needs for the rest of your life without running out of money. What it's not going to show you is you're invested wrong. There's tax strategies that you could implement to improve what you're doing. There's better ways of spending or withdrawing your money, or whatever it might be. Those are things that a real financial plan shows you. Those are things that real financial planning does, where it doesn't just say what's your probability of success and then ends there. It says what can you do to improve this? What can you do to optimize, either from a financial standpoint or an overall quality of life standpoint? The second downside of just looking at a Monte Carlo analysis is that it doesn't show you the path from where you are to where you want to be and what could be improved along the way.
Speaker 1:So what should a real financial plan look like? If you're just considering retirement. Let's use that as an example. Well, I should show you what's the cost of your retirement. How is that changing over time with inflation? How is that changing over time with taxes? So give a sense of what's your annual cost gonna be, not just year one, but year two, year three, year five, 10, 15, and beyond.
Speaker 1:Now, once you know what the cost of your retirement is going to be, what non-portfolio income sources will you have coming in? Is it social security? Is it pension? Is it an annuity? So what income sources do you have coming in to help meet those expenses? And then, number three what's the gap? What's the gap between the income sources you have coming in and the expenses that you're going to have every single year throughout retirement. From there, a real financial plan should help you to understand how do you fill that gap. That gap is going to come from your portfolio, most likely. So what does that represent as a withdrawal rate? How should you be invested in your portfolio to support that withdrawal rate? What accounts should you be withdrawing from?
Speaker 1:Start looking at this stuff to make sure that you're on track for retirement, and then from there you get a very clear sense of what can be adjusted. What can be improved? Is it your spending that can be enhanced? Is your tax strategy that can be improved? Is your investment allocation that needs to be tweaked? Do we need to factor in things like long-term care, healthcare, life insurance, other protections to your plan? What about estate planning and beneficiary designations? How can you pass this on? Well, after your time here is done. So those are just some simple examples of things that a Monte Carlo analysis is never going to look at. A Monte Carlo analysis is a very high level gauge of how are you doing, given the assumptions of your plan, but it's never going to tell you, step by step, what you should do. That is what a good financial plan, a real financial, should be doing.
Speaker 1:The third downside of just looking at a Monte Carlo analysis is it doesn't show you the magnitude of failure. Now, this is a big one. Let's assume that you have a probability of success of 25%. Is there any case where that's okay? Now, my guess is many of you are probably thinking no. Who on earth would retire with only a one in four probability of success? Well, here's my thoughts on this.
Speaker 1:Well, let's assume that you're retiring and you wanna spend $6,000 per month and you have your portfolio to help meet some of those needs. But you also have two social security benefits and a pension, and those total $5,800 per month, and you only have a very small portfolio. Well, what happens if your portfolio runs out? What that's going to trigger is your Monte Carlo analysis saying hey, that was failure. You ran out of money, so we're counting that as a failure.
Speaker 1:But what we have to look at is what's the severity of failure? In that instance, you wanted to spend $6,000 per month. Your portfolio is now gone, but that doesn't mean you can't spend anything. It just means now you're limited to $5,800 between your social security and pension benefits. Is that that bad all things considered? Well, it's bad if social security or your pension get impacted, but otherwise, assuming you have $200 of discretionary expenses that you could cut out, it's not that bad in the grand scheme of things.
Speaker 1:Now let's compare that to another individual who also wants to spend $6,000 per month. But, for whatever reason, this individual has no social security or outside income streams. They're relying on their portfolio for the entirety of their retirement needs. If that couple or that individual runs out of money, that truly is a pretty severe failure. They don't have anything else to fall back on. So in that case, the severity of failure is enormous.
Speaker 1:That is one thing that Monte Carlo analysis by itself does not take into account. It just says what's the probability of failure Failure very narrowly defined as you run out of money. You run out of money from your portfolio, but what about income sources? What about real estate assets? What about other things that you can do? Those aren't taken into account. So this isn't a knock on Monte Carlo analysis. That can be very helpful in the proper context, but if this is all you're using, if this is the entirety of your financial plan, you can start to see how limited this is when determining what you should be doing throughout retirement. And then, finally, the fourth limitation of a Monte Carlo analysis is it doesn't give you peace of mind. Let's assume you have a 90% probability of success. What you're really thinking is 10% probability of failure, and you're going to feel really nervous about that. Here's how you should be interpreting that.
Speaker 1:Don't think of 10% probability of failure, as you're going to run out of money in one out of 10 cases. View that as in one in 10 cases, or in 10% of the time. You're going to have to make some strategic adjustment to your plan along the way. Do you temporarily cut back? Do you do something in terms of working longer? Are there things that you can do? Do you give up a vacation? Do you sell a property? Do you downsize? Are there things that you can do to eliminate that 10% of the outcome or to at least significantly reduce that 10% of the time that you're going to, or you're projected to have, failure? So don't think of it, as you have no control over this. You're going into retirement with a 90% probability of success, a 10% probability of failure. It's not static. What that should be telling you, should be informing you of, is that 10% of the time you're going to need to do something to change the base assumptions, your spending, your strategy, whatever it is, in order to be able to reach your goals. What that highlights is the importance of ongoing planning. But if you're just looking at your probability of success and that's it, you're not gonna have a whole lot of peace of mind knowing that there's some probability of failure if you're not properly understanding Monte Carlo analysis and putting it into its proper context. So those are some downsides of Monte Carlo analysis by itself.
Speaker 1:Let's now highlight specifically what your financial plan should tell you. It should tell you. It should tell you how much can you confidently spend. In many cases, we're having to encourage clients to spend more. They've got more than enough to meet their needs because they've been frugal, they've saved, they've done well by putting money aside. Now the encouragement is go live. Let us help you, show you how much you can spend while still preparing well and being prudent about the future, so that you don't overspend and run out of money.
Speaker 1:Your financial plan should show you where should income come from. It's not enough to say you can spend $6,000 per month or $10,000 per month or $20,000 per month. You need a plan that says here's what's coming from Social Security, here's what's coming from pension, here's what's coming from your brokerage account, here's what's coming from your IRA, and showing you how that might change over time. A financial plan should show you how to protect against risks of healthcare, long-term care, death, disability all those different things. What can you do to protect against the unforeseen events, to ensure that they don't derail your plan for either you or a spouse, if you're married?
Speaker 1:A good financial plan should show you how you can save the most amount of money in your lifetime tax liability by understanding the impact of things like Roth conversions, tax loss harvesting, tax gain harvesting, avoiding IRMA surcharges, qualifying for health insurance subsidies and so much more. So, understanding the landscape that you're retiring into, the moves you can make strategically, can help to save tens or hundreds of thousands of dollars or more in taxes. If implemented correctly, a financial plan should show you how to best allocate your assets to support your goals. Not saying that you're retired therefore, you should have a 60-40 portfolio like every other retiree, but instead saying what is the goal of your portfolio, what's the role of your portfolio in terms of your need to create income Based upon your income needs and your cash flow needs from your portfolio, how do we strategically design an asset allocation that's going to meet your needs today, whether the market's doing wonderful or whether we hit a 30 to 40% bear market, as well as how do we support your income needs in the future after inflation has driven the cost of everything higher? And then, finally, a good financial plan should show you how you can live your best life possible. It's not about growing your portfolio forever, working forever, saving forever just to get bigger and bigger portfolio balances, but understanding what your ideal life looks like and how can we utilize your portfolio resources and your overall financial strategy to close the gap between where you are today and what you want your life to look like.
Speaker 1:So when you speak to your financial planner, when you run your analysis, it shouldn't just be to see how you can get your Monte Carlo analysis to go from 97% chance of success to 98%. That's what you're doing. You're just spinning your wheels. It's not going to actually move the needle for you in terms of what actually matters. The actual sign of a great financial plan is a life well lived. So how can you implement the right financial plan that shows you what things you should be doing to move you closer to your desired outcome? A Monte Carlo analysis won't ever tell you how to live a great life. It will tell you the probability of you running out of money, given a series of data inputs that you don't ever adjust over the course of in many cases, a 30 plus year assumed retirement. So know what a Monte Carlo analysis is, understand how it can properly fit into the context of a well-designed financial plan, but never confuse it for an actual financial plan itself. So that's it for today. I hope that conversation was helpful. If you're enjoying the show, I'd really appreciate if you leave a review.
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Speaker 1:Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast If you want to see how Root Financial can help you implement the techniques I discussed in this podcast. Then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions. We'll see you next time.
