Perhaps the most common tool used to discuss retirement planning, and especially planning withdrawals from a retirement account is the use of Monte Carlo Simulation. In fact, you can find a classic example of its usage in my own paper here (LIBRARY – Chester Chambers PhD). The basic idea is that you create thousands of “virtual scenarios” by randomizing key variables based on historical data or some set of assumptions and then look at how things play out in each case. If the virtual account balance hits 0 at any time in 10 out of every 1000 scenarios created, we write that “there is a 1% chance that you will run out of money” or a 99% chance of success, if we want to sound optimistic. This is typically done using a 30 year planning horizon with some extra scary language that “you could live longer than that, so you should really spend less!!!”
The scary language works really well. In fact, even when the model shows a 99% “success rate” what the investor hears is “there is still a chance of failure”, and they are likely to respond accordingly. Since the most extreme scenarios ever conceived cannot be ruled out, there is never a 100% chance of success, and there is always some ammunition for the doom and gloom message. I have written elsewhere how a lot of this dates back to the inventor of the infamous “4% RULE”. A fellow named William Bengan was looking for a way to organize his discussions with clients about their finances and came up with a way to use historical data to seed that discussion. He never thought that anyone would be dumb enough to ever jump from that to something like, “You have a 25% chance of running out of money unless you pay me an annual fee to fix that for you,” but here we are.
There are a multitude of things wrong with this approach, but let’s just talk about 1 of them in a way that is not so doom and gloom. If I were to say to you, “if you continue to do what you currently do, making no adjustments due to reality, there is a good chance things will not work out so well,” your response would almost certainly be – “well, I guess I won’t do that.” Its like the old joke where a guy walks into a doctor’s office and says “it hurts when I do this” and the doctor responds, “well don’t do that!”
If we use historical data as a proxy for the distribution of future outcomes AND assume you take out 4% of what you start with, AND assume that you never make any adjustments, AND assume you will always increase your expenditures with inflation, AND assume that you live for 30 years, AND assume that you are a complete idiot, you have a 20% chance of running out of money.
In other words, we have to assume that as you see the account balance fall you never have enough sense to do something different – anything. You never figure out how to cut discretionary spending, you never figure out how to move to a smaller space, you never figure out how to sell another asset, you never figure out how to make another dollar, and you never figure out how to create a backup plan. This conveniently ignores the fact that if you were really that stupid, you probably wouldn’t have money in a retirement account to begin with.
Fortunately, some of us have a better way to discuss this. Instead of saying “You have a 1% chance of running out of money,” I would rather say, “There is a 1% chance that you will have to make an adjustment.” Doesn’t that make a lot more sense, and isn’t that what you would really do? Of course, I am willing to say it this way because I am not charging you a fee based on how much money you leave in your account. If I got 1% of whatever nest egg you have annually, I would have a permanent incentive to tell you to never take the money out wouldn’t I?
Speaking of adjustments you can make, here is a list of 10 possible actions you can always consider:
- Use part of the money that is not in your retirement account to allow you to reduce your withdrawal amount in years when the market goes down,
- Sell something that is not really that important anymore, like jewelry, an extra car, etc.,
- Don’t take that big trip this year – look at the numbers next January and see if you can do it then,
- Don’t donate as much money this year as you did last year,
- Move to a smaller house,
- Figure out how to make money on that blog you started (Maybe I should consider that at some point!),
- Move to a state with a lower cost of living,
- Plant a garden to grow something you used to buy,
- Figure out how to make something that you used to buy,
- Get over the fact that the account balance goes down over time. That’s what it is supposed to do because your planning horizon is shorter now than it was when you started this.
I could go on for a while, but you probably get the idea. Here is a framework to keep in mind as you work through this.
- Plan to live off of what you expect to have under reasonable assumptions,
- Choose key values or “guardrails” such that if the account balance falls below them you make a decision to do something about it,
- Create a list of options like the one shown above and if an adjustment has to be made, be prepared to make it.
I know that wasn’t exactly rocket surgery but that doesn’t mean it won’t work. You had a plan for what to do if the house caught on fire, or if the hurricane came too close, or if the car broke down. This is the same thing. Develop a plan for what you will do if markets fall for a while and go back to the golf course/grandkids/hobbies, etc. You are going to be fine.
