Avoid basing your retirement planning solely on a 'Monte Carlo' approach.
How's your retirement savings plan shaping up? It's quite possible that you're in the dark about it – approximately a quarter of Americans saving for retirement don't have a clue about their savings balance, and more than half of the workforce who aren't contributing to a 401(k) believe they are.
Retirement planning is a complex and often scary process. Will you have sufficient funds to live comfortably? Will you be able to manage medical expenses, and sometimes, opt for surgery as the most financially viable choice? And the most daunting question of all, will you outlive your savings, leading to a life of poverty in your golden years?
Many people turn to financial advisors for guidance and reassurance. Professionals utilize various tools to provide some insight into our savings and potential retirement scenarios. However, there are numerous variables to consider, most of which are beyond our control. Consequently, if you've sought advice from a retirement expert, you've likely encountered something known as a Monte Carlo simulation. These tools can be beneficial, but they should not be overly relied upon.
What is a "Monte Carlo simulation"?
Monte Carlo simulations are advanced software programs that use various assumptions and variables, feed them into a model, and run numerous simulations to assess how changing variables affect outcomes. The results are then averaged to give an idea of the likelihood of various outcomes.
In retirement planning, variables such as inflation or market returns are given random values for each simulation. By running enough simulations, you can get a general idea of how likely your strategy is to last until a certain age. Results are usually displayed as a graph with a bell curve, with middle scenarios being the most likely and outliers at the extremes. You'll also often receive a probability score, which summarizes everything. An 80% Monte Carlo score means your current plan has an 80% chance of lasting.
Monte Carlo simulations are useful. They can help test assumptions and identify potential issues in your plans or validate that your strategy is sound. However, the Monte Carlo score is often oversimplified, and you should not rely solely on it to confirm a retirement savings strategy. Here are four reasons why.
Monte Carlo simulations can't predict the unpredictable
Monte Carlo simulations can only analyze the data provided to them – they cannot anticipate unexpected events or factors in their calculations. For example, financial theorist William J. Bernstein pointed out that if you retired in January 1966, the first 17 years of your retirement occurred during a period known as "The Great Inflation," where market returns for the S&P 500 were almost perfectly matched by the inflation rate, effectively making investment returns zero.
Monte Carlo simulations cannot account for such unusual events – they focus on estimating probability, not accounting for one-time or once-in-a-century financial anomalies or market crashes. Even if it gives you a score of 100%, the chances of success are always lower if you account for the chance of the unexpected.
Different models exist
Another factor to consider when interpreting your financial advisor's Monte Carlo score is the software itself. There are free Monte Carlo simulators available online. You might not know if your financial advisor is using a sophisticated, AI-assisted tool or a simple Excel spreadsheet created in 1999. Methodology is also a concern – if you trust your advisor, it makes sense to trust their simulation. But keep in mind that if the software itself is flawed, so will its results.
Human error is a factor
Monte Carlo simulations need to make numerous assumptions to function properly, and one of the most unreliable is your ability to consistently follow through on your plans. You might promise to save a certain amount in your retirement accounts, cut down your spending after retirement, and live a modest life in a paid-off home – only to indulge during your retirement years, experiencing a kind of "You Only Live Once" fever. In other words, these simulations often assume you will follow your plan religiously, despite human history demonstrating that many people are not reliable long-term.
The opposite is true as well. If your Monte Carlo score is low, the simulation might not account for your ability to adapt and change your habits to save more and spend less at the first sign of financial trouble.
Monte Carlo scores can be misleading
Finally, Monte Carlo scores can be deceptive if taken at face value. A score of 80% means that your current plan has an 80% chance of lasting, but it also means the plan fails 20% of the time – if you were told you had a 20% chance of dying from a particular activity, you probably wouldn't be overly confident about it.
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In addition, Monte Carlo scores can be manipulated by adjusting the variables. Alter the presumption regarding inflation rates, or believe you'll contribute an additional 5% of your earnings to your IRA, and that 80% might transform into 90%—but it's not really significant. It just allows you to explore various scenarios and get a vague notion of whether you're close or far off the mark.
And that's not insignificant—Monte Carlo simulations have their purpose. If nothing else, they provide a rough estimate of how your existing retirement plan will operate if conditions remain stable and you stick to your planned actions (including, you understand, surviving long enough for these plans to matter). However, avoid the fallacy of interpreting a high Monte Carlo score as a guarantee of financial security in the future.
In the context of retirement planning, using a retirement monte carlo simulation can provide insights into the potential outcomes of various scenarios based on different assumptions and variables, such as inflation rates and market returns. However, it's important to remember that money is a crucial factor in retirement, and these simulations should not be relied upon as the sole source of financial security.
Additionally, although a high Monte Carlo simulation score may suggest a strong likelihood of reaching retirement goals, it does not guarantee that unexpected events will not impact your financial situation. It's essential to keep saving and adjusting your retirement plan as needed to account for human error, market fluctuations, and unforeseen circumstances, ensuring a more secure financial future.
