Ready For Retirement
Ready For Retirement
The Hidden Flaw in Monte Carlo Analysis That's Ruining Retirement Plans
Many retirees focus on achieving a high Monte Carlo “probability of success” in retirement—but is chasing a 99% success rate always the best move? In this episode, James highlights a real-life story of a man forced to delay retirement after a divorce dropped his probability of success from 99% to 70%. James explores why this single number shouldn't drive such massive decisions. He explains how context—like income sources, spending flexibility, and home equity—matters more than a static success rate. You’ll learn why 100% isn’t always ideal, and how to build a retirement plan that supports a meaningful life, not just a perfect score.
Questions answered?
1. Should I delay retirement if my Monte Carlo probability of success drops?
2. Is a 100% probability of success the best goal for my retirement plan?
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Timestamps:
0:00 - An encounter at the gym
2:37 - What is Monte Carlo analysis?
4:18 - Consider severity of failure
6:19 - Consider other assets, like property
7:35 - Is a 100% probability score really success?
10:55 - Monitor and course correct
14:13 - Margin
15:07 - No universal number
16:13 - Assumptions about spending
18:27 - Retirement spending smile
20:57 - Context matters
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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. I was at the gym the other day and someone came up to me who recognized me from the YouTube channel and he said hey, I watched some of your videos and we got to talking and he was sharing with me how he had saved a whole bunch. He and his wife had saved. They've done really well in their retirement portfolio. They had a paid off home here locally in a very nice part of town.
Speaker 1:He had a pension from work, he had social security and they were planning to retire. And he shared that they had a 99% plus probability of success as they modeled this out with their financial advisor. Then he went on to share with me that he and his wife actually just went through a divorce and after the divorce, after splitting assets, after everything settled, his Monte Carlo probability of success dropped to about 70%. Now this individual he was 60 years old and he was planning to retire very soon until the divorce happened, until this new financial model showed that his probability of success dropped from almost 100% probability of success to 70% probability of success. He then went on to share that because of this change to his financial situation specifically this change to his probability of success, given Monte Carlo simulations his new plan wasn't to retire soon, but was actually to work another 10 years until the age of 70, at which time he would max out social security and his probability of success would be right back up there in the high 90%.
Speaker 1:Now I don't know any of the specifics of this individual situation. I don't know dollar amounts, I don't know desired retirement lifestyle, I don't know what he wants to do in retirement. I know none of that information. I don't even know whether his decision to continue working longer or not was good or bad, because I just don't know enough information. But what struck me about this conversation was how many enormous life decisions were made, at least seemingly, because of this single number, this single probability of success number called a Monte Carlo analysis. So what I don't know is I don't know that him working 10 years longer after this was the right decision or the wrong decision in light of previous circumstances and what he just went through. But what I do know is that there's some deeper questions I would have wanted to unpack if I was his financial advisor, to say how can we be sure the decisions you're making because of this aren't going to cost you long-term? How can we properly look at what that Monte Carlo probability of success number looks like in the context of a bigger plan, in some seemingly small details or nuances that could have dramatic impacts on all of this? So what we're going to do today is we're going to talk about defining what exactly is that Monte Carlo number and then how should we view it? And not just how should we view it, but what are some common things I see that can radically change that number upwards or downwards that you all should be aware of. So, as you're running your planning projections, you're viewing things in the proper context and you're not letting a single number drive the decisions you make or don't make when it comes to something as important as when you retire and what you do in your retirement.
Speaker 1:I'm going to start by defining what exactly a Monte Carlo number is, what that probability of success number means. So when you have this number, this probability of success, it is a randomly generated simulation using various investment returns, inflation returns, life expectancy numbers. All these things we cannot perfectly predict in advance what the market's going to do, what inflation is going to do, how long we're going to live. And so when you randomly generate a whole bunch of different scenarios, saying based upon the return characteristics and the risk characteristics, something called standard deviation of investment returns, for example, we can have a wide outcome in terms of the possible scenarios that we go through when we retire. So it's not enough just to say what if you average a certain rate of return throughout retirement. We need to know the sequence of those returns. How would our probability of success change if we go into retirement and have really poor years the first few years versus having really good years in the market for those first few years? So this is a gauge that helps us understand what is the probability of success, aka what's the probability of me achieving my goals throughout retirement.
Speaker 1:Now that's the next thing that's important to know how do we define success versus failure in this? This is really important and while it might seem simple enough, I'm going to show you in just a bit some of the downsides of viewing retirement through this lens. But success simply means you have lived your whole retirement and you still have assets in your portfolio or in the bank when you die. That's success. You don't run out of money. Failure, as defined by these simulations, is you run out of money before you pass away. So, very simple, very binary. Those are the two definitions we're looking at, and the probability of success says what's the probability that you're going to have more money in your portfolio when you pass away, versus the probability of failure is, of course, what's the probability that you're going to run out of money, based upon these simulations.
Speaker 1:So let's now dive into it. And again, I don't know the specific numbers for this individual, so this is not designed to be a specific recommendation, of course, to his plan, as much as pulling out the principles that all of us can be aware of when it comes to our own planning. Number one, and the first thing that I want to point out, is you do not need 99% or even 100% probability of success in order to comfortably retire. So what number is acceptable? Well, this is where it depends, and what it depends upon is it depends upon what is called severity of failure. So, for example, this individual I was talking to I don't know the numbers, but he mentioned he has social security and he has a pension.
Speaker 1:Let me just assume some arbitrary numbers. Let's assume that he wants to spend $10,000 per month in retirement and let's also assume that between social security and his pension he has $9,000 per month coming in, meaning his portfolio is responsible for the extra $1,000 per month. Well, severity of failure here means what happens in some of those instances that he does run out of money. The severity of failure is not that bad. He takes a 10% pay cut. Instead of spending $10,000 per month, he's spending $9,000 per month. Not ideal, but if that's worst case scenario, I'd be willing to venture that most people would be okay with that as their worst case scenario.
Speaker 1:Now let's compare that to another scenario. What if that pension and social security added up to $3,000 per month and he wanted or needed to spend $10,000? Well, now the severity of failure is a whole lot different. He has to take a 70% pay cut, goes from $10,000 per month of living expenses down to $3,000. So that's one thing that you need to know. To put this in proper context, it's not just what's the probability of success, but what's the severity of failure. If your severity of failure is not that bad, you can afford to go into retirement with a lower probability of success because it's not going to be disaster, it's not going to be doom and gloom if you actually were to run out of money, because you have some other income sources there to continue meeting your needs, if your severity of failure is high, meaning you could not continue living if you ran out of money. That's where you're going to want to have a higher probability of success before you go into your retirement decisions.
Speaker 1:Another thing that you want to look at is, in this case I don't know the value of this individual's home, but I know where his home is and I know those homes are quite valuable, quite nice. So when you look at that, typically when you're running a Monte Carlo simulation, you're running a simulation that says can these assets, can these portfolio assets, last forever? Because these portfolio assets are my means of creating income. And when I say last forever, what I should have said is can these last for the rest of my lifetime? Well, if you run out of money in your portfolio but you still have a home, a lot of these Monte Carlo simulations will show that that's a failure, and it very well could be. But you have to ask what are you going to do with that home. Let's assume that you're looking at your plan and you have a $2 million home, so a nice home, well-valued home today, and you don't intend to ever sell your home if you don't have to. But we somehow fast forward 25 years. You're 60 today and at age 85, we know that you ran out of money, because we have the ability to predict the future. Well, that $2 million home, if it's been appreciating by 4% per year, that $2 million home is worth closer to 5.3 million by the time that you're 85. So the Monte Carlo simulation would say that's a failure because it fails to recognize that you've got a significant piece of equity being your home and now, no, you can't spend your home. But could you take a reverse mortgage? Could you downsize? Could you do something else with it that allows you to continue generating income throughout the remainder of your plan? So these are some things to look at. What's the severity of failure if you do in fact fail? What other fallbacks do you have if you do in fact quote, unquote fail, given your portfolio runs out, your home could certainly be something there.
Speaker 1:I'm going to come back to this point in just a little bit, but the next point that I want to make is a 100% probability of success, in my opinion, oftentimes is not actually success. This goes back to defining at the very beginning what I talked about. If success means you have money in your portfolio when you die, failure means you run out of money before you die. It's as simple as that. To have a 100% probability of success in most cases means you have such a significant buffer, you have such a significant margin that no market downturn, no level of inflation, no, anything has a serious chance of derailing your ability to spend what you want to spend. Oftentimes you could translate that to meaning you're only taking a very small amount out of your portfolio. For example, maybe you're only taking half a percent, 1%, 1.5% from your portfolio. That's going to be a very high probability of success because there's very little circumstances where that withdrawal rate in fact maybe no historical circumstances where that level of withdrawal rate would deplete a normal portfolio, a well-diversified portfolio, over a normal retirement horizon. So that might seem comforting to look at that and say I've got a 100% probability of success.
Speaker 1:Until you recognize, or until you translate, what does that actually mean? No-transcript, so translate that even further. What does that mean? It means you probably said no to a lot of fun, meaningful, purposeful things that you could have done. If our success is defined as money at the end of the day, then 100% probability of success, that's tremendous success.
Speaker 1:When you're looking at it through the lens of a Monte Carlo analysis, when you're looking at it through the lens of how can we get the most out of life with our money, that might be a definition of failure. In many cases it might mean you sat around doing nothing because you were too afraid to take that trip with your family. You were too afraid to spend on things that were meaningful to you. You didn't get around to giving your money to family or causes that you cared about. There's so many things you could have done, but maybe it was fear-driven, maybe it was being so focused on this probability of success number that you end up letting the things that are actually meaningful pass you by so that you could chase this arbitrary and maybe ill-defined version of success, which is this high probability of never running out of money.
Speaker 1:That's not to say we want to flirt with disaster here. It's not to say you should live life on the edge and spend like crazy and maybe you make it. Maybe you don't. What it is saying is that oftentimes the plans I see where there's 100% probability success either means you have such a large portfolio that you're fully living your life and you're still going to have some leftover, or it means you're too afraid or too cautious to spend money on the things that you care about and you're going to end up looking back on your life filled with regret because you see a really high portfolio balance but when you're in your 80s and 90s and looking back on your life, is that what's going to be bringing you joy? Or instead are you going to look back and say what, if what, could I have done? How do I use this money in a way that was aligned with my values and the things I enjoy doing? So I wanted to take a quick segue and discuss that, because when 100% probability of success looks good, feels comforting, you're going to walk out of your advisor's office feeling really good about what you're doing. But I might ask you to double check that and to really think through the implications of what that's really looking at.
Speaker 1:Now let's go back to the question of what probability of success is acceptable. What number should I be looking for as I go through this, and let's use an arbitrary example. Let's assume you run your projections and you have an 80% probability of success. What we really interpret that as if I'm running my plan and that's my probability of success, I'm looking at that and saying that's telling me I have a 20% probability of failure and, of course, if I'm going to get on an airplane and go to a destination, if there's a 20% chance that plane fails, I'm not going to get on an airplane. Those just aren't odds. That's not a risk that in any way I'd be willing, or any of us would be willing, to take, and that's how we interpret this.
Speaker 1:Here's the difference, though. If you create a plan at the very beginning of your retirement and if it says, for example, you have an 80% probability of success and if you never change your spending patterns, you never revisit your plan, you never change anything about this for the rest of your retirement, then you truly do have a 20% chance of failing, of running out of money before you run out of life. However, most people, I hope, aren't doing it that way. Most people aren't creating a one-time plan and then never looking at it again. The reality is, you're not going to go from an 80% probability of success today and then tomorrow you wake up and find that you've run out of money. What's going to happen is that 80% is going to turn to 75. It's going to turn to 72. It's going to turn to 71, to 70, to 65. It's going to be a gradual, slow burn and what you can do is, if you're looking at this and monitoring this regularly, you can make course corrections along the way.
Speaker 1:So, assuming you're willing to make some of those adjustments a 20% probability of failure or an 80% probability of success the way you should really interpret that is there's a good chance, there's a 20% chance you're going to need to make some adjustment along the way. For example, the market drops 35% in your six of retirement. Well, in your six of retirement, you're planning to buy a new car and you're planning to take a great trip with your family. Do you, for example, say I'm going to push this off? I'm not going to buy the new car until the market's recovered. I'm going to take a little trip this year and push this bigger trip off a year or two once things have recovered. That's a great example of how you can make some changes that immediately will help to increase the confidence of your plan, the confidence level and the probability of success.
Speaker 1:Or maybe you're early on in retirement, you retire and you retire, let's say, at 62. In one year, in two years, in the market's been horrible, inflation's been horrible. Inflation's been horrible and you say you know I'm going to get a part-time job for a couple of years because that part-time job is going to create more income that alleviates some of the pressure on my portfolio. Or maybe start social security early. This is something not enough people think about. Sometimes people think I'm going to do social security at 70 and I'm going to retire at 65, for example, and their debt set on. Well, that could be a great thing when you just look at it in the grand scheme of things. But one thing about social security you can view that in a more dynamic way, where maybe you retire at 65, but by 67, you've had two really bad years in the market in a row.
Speaker 1:Do you take social security early? Because what that's doing is it's alleviating the pressure in your portfolio, so you're not simultaneously drawing down your portfolio while also the market is dropping your portfolio value year after year. So obviously, look at these things in context, look at these things unique to your plan, but these are the examples of types of things that you can do so that that 20% probability of failure what that really should mean is there's a 20% chance you need to be ready to make some change like this in order to preserve your portfolio for the rest of your retirement years. So, as you're thinking about this for your plan, a big part of this is going to come down to how much margin do you have. If you're in retirement and your bare minimum essentials are $4,000 per month and you have income of exactly $4,000 per month, you don't really have much room to cut. You don't have much margin to cut. So you're going to need to have a higher probability of success here, because it's not as simple as saying I'll push off the new car purchase, I'll push off the big vacation, I'll push off some of the discretionary expenses. You don't have those to start with in your plans. There's nothing you can cut. Versus those of you who you look at your retirement budget and you say, yeah, we don't want to make cuts here, but we're certainly willing to, because making cuts for a year or so is way better than running out of money before you run out of life. Those of you that do have margin, it would be easier to make these cuts. Therefore, you don't need as high of a probability of success going into retirement because you have the flexibility to make some of those tweaks and adjustments along the way.
Speaker 1:So I hope that one of the themes so far here is there's not an exact number, there's not a universal number of. You need an 85% probability of success or you need a 70% probability of success. A lot of softwares kind of use those numbers Anything below 70, they look at that number and it's in red. Anything between 70 and 85, they look at that number, it's in yellow. Anything 85 and above and it's in green. That's not true. Maybe it's a great starting point. It's really just something because we want to grasp to certainty. We want to have some level of control or certainty over what's to come.
Speaker 1:The unfortunate reality is we just can't but understanding how these things and how this context should help you interpret that probability of success. That is the best thing that you can do from this is what level are we comfortable with and do we have a contingency plan? Do we have a contingency plan of what we can do to cut expenses, of what we can do to create more income, what we can do if and when the market drops, to prevent that 10% probability of failure, that 20%, that 30%, whatever it is, do we have a plan in place so that, when those types of things happen we've thought about it ahead of time we can simply make the changes that are needed to make sure that our portfolio value is being preserved over the duration of our retirement? Then the last thing that I want to point out is sometimes these Monte Carlo simulations are based upon assumptions about spending and simply extrapolate that spending out into the future. Not a bad place to start. But, for example, if I'm going to illustrate $100,000 per year of living expenses today and if I'm going to assume an inflation rate of 3%, what that means is I'm going to model out $100,000 this year of living expenses, next year it's going to be $103,000. The following year it's going to be $106,000 and some change and so on and so forth, as we continue to increase spending to keep up with inflation. Now, at first glance, we should be doing that. We want to preserve our purchasing power, not just that strict $100,000 every single year, because if we never give ourselves raises, inflation is going to go up, but our spending is not and therefore our standard of living is actually going to slowly decline. Well, here's the thing about spending in retirement it doesn't tend to actually keep up with inflation.
Speaker 1:There's a lot of great research around this and you've maybe heard people talk about or me talk about the retirement spending smile and talks about spending patterns of retirees. But before I go, imagine you retire at 60. What are you doing? Imagine your lifestyle, the trips you're going to take, the activities you're going to do, the people you're going to spend time with. Just get a picture of what that might look like for you. Now imagine what life looks like for you at age 85, 25 years into retirement. Does it look the same? Are you taking the same trips? Are you involved in the same activities? Are you as active? Are you doing the same things?
Speaker 1:The answer for most of you probably is no, and I think when you look at the research, it confirms that. Whereas if you look at retirees and if you look at a number like $100,000 as a starting value not saying that's going to be your number your number is probably going to be different than that, but if we use $100,000 as a standard research shows the average real expenditures. So meaning what you spend but adjusted for inflation, drops by about 25% by the time that you are 84 years old. That doesn't mean that you're taking pay cuts because you have to. It simply means you start slowing down. It simply means all those trips you're taking earlier on in retirement you're not taking later in retirement.
Speaker 1:So this is really important to know because on average, your spending is actually decreasing for the first several years and a couple of decades. Even retirement beyond mid 80s and beyond it actually starts to tick up. That's simply due to medical expenses on average increasing at that point. So when you look at this research again, we even have to put this in proper context. This is average spending. Not all of us are average. What this means is some of us are going to spend more, some of us are going to spend less, but on average, real expenditures do tend to drop for most retirees over the first couple of decades or so of their retirement. This is called the retirement spending smile because, if you can envision it, spending starts relatively high, it then starts to dip in the middle and it starts to increase again on the back end, largely driven by medical expenses One relatively simple way to think about it, and this isn't precisely right, but it's directionally correct. If inflation increases by 3%, on average, retirees expenditures are going to increase by 2%. So you're not taking dramatic cuts any given year, but on average you're just not giving yourself a full cost of living adjustment because you tend to slow down slowly but surely over time. Now this might not seem like a huge deal.
Speaker 1:While I was prepping for this episode, I went into our planning software and I chose a few clients at random and I simply looked at what is their probability of success as things stand today, and then I compared that to what would their probability of success do if, instead of illustrating or instead of modeling inflation, adjusted spending meaning they're spending in retirement every single year keeps up with inflation? What if we modeled out this retirement spending smile, meaning spending actually declines a little bit over time, based upon research done to see how do retirees as a whole spend, and on average, that increased their probability of success anywhere between 5% and 14% when I did this. So that's in no way an indication that will do the same for everyone. I chose three people just out of curiosity, to say, if I just toggle this on what's the change for these specific clients. But what does that mean? It means those of you who are at 70% might not be unrealistic to think if you actually spent the way that most retirees spend, that 70% turns to 78% or 79%. That's a pretty dramatic increase. It might mean that if you're at 85%, you're now in the low 90s when you actually model out the way that real people spend their real dollars in retirement.
Speaker 1:So big, big, big disclosure here this is not me doing research with thousands of different households. That was literally picking three clients at random here at Root Financial and just toggling something on for the sake of this research that I was doing for this episode, just to see for those three what was the impact. Now, it might not be as high. It probably won't be as high for many of you. For others it might be even higher. So in no way take this as a definitive, research-based thing where you're going to get 5%, 10%, 15% extra to your probability of success. That's not going to be the case. All I do in saying this is I want to illustrate the fact that you need context when you see that Monte Carlo number. That can either be really reassuring, sometimes in the wrong ways or it can be really intimidating many times in the wrong ways.
Speaker 1:I'll go back to the individual I was talking to at the gym. He made a dramatic, radical life decision to say I'm going to be working another 10 years because my Monte Carlo probability of success dropped from almost 100% to 70. I don't know all the details, like I said, of his plan, but I'd be willing to guess that, if you factor some of these things in of, what if you looked at using your home as a plan B if things didn't go according to plan? What if you looked at spending like this, retirement spending, smile. What if you looked at other things? Maybe it's a part-time work for a number of years? What if you looked at the fact that you don't need a 99% 100% probability of success? But what is that number that we're comfortable with? When we look at severity of failure, when we look at other options that you have, it might seem like, oh, james, this is just splitting hairs, but it's not, because when I go back to this individual, it's not splitting hairs to say that this was the difference between 10 more years of work when this individual is ready to retire and start doing what he wanted to do in retirement.
Speaker 1:So, as we wrap up, I do want to reaffirm the fact that Monte Carlo simulations can be incredibly helpful, but only when viewed in the proper context. What you need to understand is the way that those define success and failure is not necessarily the way I would define success and failure. One is looking at a very binary decision of pass or fail. The other is looking at what does a life well-lived look like? How can we use your resources to do what you want to do? And, as planners, instead of modeling something out today and saying we're never going to change anything for the next 30 years, what are the things we can do along the way? Maybe your probability of success isn't 100% In fact, I hope it's not but what are the things that we can do? So we have contingencies in place so that when things don't go according to plan, when there's bad markets, when inflation is out of control, when these things happen that we don't want to happen, it's not going to derail our retirement, because we've planned for this in advance and we have things that we can do. So use the Monte Carlo simulation simulation absolutely use it as part of your planning process, but understand how that fits.
Speaker 1:In the grand scheme of things, root Financial has not provided any compensation for and has not influenced the content of any testimonials and endorsements shown. Any testimonials and endorsements shown have been invited, have been shared with each individual's permission and are not necessarily representative of the experience of other clients. To our knowledge, no other conflicts of interest exist regarding these testimonials and endorsements. Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner.
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.
