Ditch Monte Carlo Modeling and Embrace the Actuarial Approach

Thanks
to Kitces.com and Justin Fitzpatrick for once again informing financial
advisors and retired DIYers that there are better metrics and processes
for managing spending in retirement than the probability of
success/failure metric typically used in Monte Carlo modeling. Mr.
Fitzpatrick’s thoughts are summarized in the section of the August 23-24 Weekend Reading For Financial Advisors titled, Reframing
“Risk In Retirement As ‘Over- And Under-Spending’ To Better Communicate
Decisions To Clients, And Finding A “Best Guess” Spending Level.”

Monte
Carlo models touted by financial advisors are good one-and-done
projection models that can show ranges and probabilities of future
results based on assumptions about the future. However, these stochastic
models don’t predict the future any better than deterministic models
and, more importantly, they generally don’t provide a process for
changing your plan when the future turns out to be different than
assumed. 

The Actuarial Approach recommended in this website uses a
simple, easy-to-understand Funded Status metric that measures when you
may be over-spending or under-spending. It also provides a robust
process for managing your assets and spending liabilities in retirement
to help you adjust your plan over time to better accomplish your goals.
We have previously recommended the following easy-to-follow guardrails
be used to manage your assets and spending liabilities in retirement. 

Asset Management Guardrails

Spending Management Guardrails

Self-Correcting Process

The
Actuarial Approach is a self-correcting process in that if actual
future experience (including actual future spending vs. budgeted future
spending) is less favorable than assumed future experience in the
aggregate, the retired household’s Funded Status will decrease over
time. If actual experience is more favorable than assumed, the
household’s Funded Status will increase over time. If you want to be
more conservative (i.e., have a higher probability of not having to
decrease spending in retirement, you can simply use more conservative
assumptions to determine your Funded Status and/or you can choose a
higher “spend-more” guardrail.

Don’t like the Default Assumptions in the Actuarial Financial Planner?

Some
advisors or DIYers believe that the default assumptions in the
Actuarial Financial Planner are too conservative. They believe they can
increase client spending by using more aggressive assumptions from their
Monte Carlo models. This line of thinking is irrational. Assumptions
don’t determine how much a household can afford to spend in retirement.
They only determine the timing of such spending.

It is a
relatively easy process to change one or more of the assumptions used to
determine a household’s Funded Status to make the asset/liability
comparison less conservative (or more in line with assumptions the
advisor may be using for Monte Carlo modeling). Of course, using more
aggressive assumptions simply increases the probability than downward
spending adjustments may be required in the future.

Summary

The
Actuarial Approach is a simpler, easier to understand, more flexible
and more robust approach than typical Monte Carlo approaches used today
by financial advisors. Isn’t it time to ditch Monte Carlo modeling with
its probabilities of success/failure and embrace the more robust
Actuarial Approach? At a minimum, you should give it a serious try.