Retiring without sufficient assets to maintain a minimally acceptable lifestyle (which each person defines in their unique way) is an unthinkable outcome. That’s why, when investors are planning for retirement, the most important question is usually something like: How much can I plan on withdrawing from my portfolio without having a significant chance of outliving my savings?
The answer is generally expressed in terms of what is referred to as a safe withdrawal rate—the percentage of the portfolio you can withdraw the first year, with future withdrawals adjusted for inflation.
A Simulation Solution
While historical returns can provide insights, it’s critical that investors not make the mistake of simply projecting the past into the future. Current valuation metrics should be used. Additionally, investors must address the issues involving our limited ability to estimate future returns and the fact that the order of returns matters a great deal. The way to do that is to use what is called a Monte Carlo simulator.
Monte Carlo simulations require a set of assumptions regarding time horizon, initial investment, asset allocation, withdrawals, rate of inflation and, very importantly, the distribution of annual returns for the different asset classes.
The expected final wealth distributions in Monte Carlo simulation programs are determined by two numbers: average annual return (which should be based on current valuations/yields, not historic ones), and the standard deviation of the average annual return. The Monte Carlo simulator randomly selects a return for each year and calculates the wealth values over the expected retirement period. This process is repeated thousands of times in order to calculate the likelihood of possible outcomes.
The Monte Carlo simulation output is typically presented showing the odds of success. For example, the simulation result might be that there is a 90% chance of you not outliving your assets.
Said another way, the failure rate, in this case, is an estimated 10%. However, while the failure rate has become an essential tool when evaluating withdrawal, as Javier Estrada, author of the October 2016 paper “Refining the Failure Rate,” points out: “This variable is silent about how long into the retirement period a strategy failed.” He continues: “Two strategies that sustained withdrawals for 10 and 25 years of a 30‐year retirement period have both failed, but a retiree would be far from indifferent between them.”