Unconventional wisdom: Add certainty to your retirement

Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Add certainty to your retirement

"It’s not really gambling when you never lose."

- Jennifer Aniston

Grab your tuxedo. Hit the ATM. We are off to Monte Carlo. Monte Carlo is famous for its’ casino. At a casino games of chance have random outcomes. We may walk out big winners. We may lose our shirt. Gambling provides a dopamine hit which makes us feel great – at least for a while. Gambling is the last thing we want to associate with retirement. All of us desire a more certain outcome.

An intrepid reader was running Monte Carlo simulations on his upcoming retirement. Frustratingly he couldn’t find a way to remove every trace of uncertainty. A Monte Carlo simulation is named after the famous casino and estimates the probabilities of different outcomes. This is useful because the future is the result of a complex interplay between many factors.

When running a retirement Monte Carlo simulation the results are based on investment returns and inflation. The probability spit out by the simulation represents the chances of not running out of money over a specific time frame. That time frame is also unknown since none of us know when we will die.

Returns matter. If they are high enough you will never run out of money. The order or sequencing of returns matter. If you have the misfortune of getting low returns early in retirement you can run out of money faster regardless of the average returns. That is called sequencing risk.

Inflation matters. To maintain a set standard of living the money taken out in the first year of retirement is increased by the rate of inflation each year. The more you spend the faster you run out of money.

These are the stakes at the retirement casino. Spend too much and you will increase the probability of running out of money. Spend too little and you might have a disappointing retirement. Ready to take the challenge?

Our trip to the casino

Our retirement pokie machine can be found at the Portfolio Visualizer website. Our goal is to understand how changes in each factor influences results.

As a baseline scenario I’m using a 4% withdrawal rate for a 30-year retirement with a portfolio allocation of:

35% to Aussie shares (‘Pacific’ in the simulator)
20% to US shares
15% to global ex-US shares
30% to US bonds (Aussie bonds aren’t available)

As I pull the proverbial handle on the pokie and the wheels spin the simulator does its’ magic. The results of every combination of historic returns and inflation rates are simulated based on the inputs I’ve selected. Flashing on the screen is……78.37%.

Is the alarm going off? Do you have a sinking feeling in your stomach? It all depends on how you feel about a 78.37% chance of not running out of money in a 30-year retirement.

I’m going to remove the uncertainty. First the good news. You can give up your gym membership and take up smoking. For a 12-year retirement there is a 99.98% chance you don’t run out of money. It may be a short retirement but it will be fun.

Not your cup of tea? There is another option to remove uncertainty. In this case you don’t have to take up smoking. Not that you could afford cigarettes anyway. Reducing your withdrawal rate from 4% to 1.85% gets you a 99.46% probability of not running out of money in a 30-year retirement.

Beyond the baseline scenario

What happens when things aren’t going your way at the pokie machine? You bet bigger. At least I do. In investing that means dialling up the shares and dialling down the bonds.

I’ve changed the asset allocation to increase the amount invested in shares. It is now:

50% in Aussie shares
20% in US shares
20% in global ex-US shares
10% in US bonds

Much like my attempts at upping my bets on the pokies this has backfired. The probability of not running out of money is now 68.59%

Perhaps this is a surprising result. Afterall shares have higher historic returns than bonds. Shares also have more volatility. A portfolio with more volatility will go down more in the bad years. That is sequencing risk when those bad years occur early in retirement.

Time to hit rock bottom. Going back to the ATM for the third time rock bottom. The Monte Carlo simulator has the option of adjusting the order of returns. This allows you to stress test different scenarios.

For instance, if I select ‘worst 10 years first’ I can see the impact of a terribly unlucky situation. In a 30-year retirement the 10 worst years of returns happen in the first 10 years. Over a 30-year retirement there is a 1.63% probability of not running out of money. This is sequencing risk on steroids.

You might not be feeling great about things. Perhaps you are considering taking your actual retirement savings to the casino. I’ve got good news. There is a glitch in the Monte Carlo simulation.

To get there we are going to return to the original scenario but this time we are switching the 30% allocation from bonds to cash. The probability of not running out of money has increased from 78.37% to 80.24%.

The interplay between volatility and returns strikes again. This time in our favour. Bonds have higher returns than cash. Yet cash does not have volatility. Now we are getting somewhere.

I’m going to lower the cash and increase the allocation to shares. The new asset allocation is:

40% Aussie shares
25% US shares
20% global ex-US
15% cash

The probability of not running out of money slightly increases to 80.37%.

Different portfolios don’t just impact the probability of not running out of money

The Monte Carlo simulator also provides simulated portfolio balances based on the different return and inflation scenarios. We can see the different pathways for a portfolio by examining the baseline scenario. As a reminder that was 70% equities and 30% bonds, a $1 million account balance, a 4% initial withdrawal increased by inflation each year. Here are the results.

Source Portfolio Visualizer

Remember the probability of not running out of money with this scenario is 78.37%. You also have a 10% probability of ending up with more than $8.5 million in 30 years. The middle 50% of scenarios between the 25^th percentile and the 75^th percentile shows an outcome of having between $248k and $4.53m in your portfolio.

We can compare that to the 85% equities and 15% cash scenario using the same assumptions on withdrawals and portfolio size.

At an 80.37% probability of not running out of money you have a 10% probability of ending up with more than $13.1 million in 30 years. The middle 50% of scenarios between the 25^th percentile and the 75^th percentile shows an outcome of having between $349k and $6.6m in your portfolio.

That is a better outcome than the previous scenario with a slightly better chance of not running out of money. The message seems clear. Some cash is better than more bonds.

The range of different levels of wealth at the end of the 30-year period show the cruel hand of fate. There is a 10% chance that everything could go very right which would result in more than $13 million in the second scenario. If everything goes really wrong you have a 20% chance of running out of money.

You are not powerless in the face of bad luck

A devout man is drowning. First one boat, then another, and finally a helicopter arrives. Each time he refuses help citing his faith in God. The Lord will save him.

Meeting God he asks why he was not delivered from the flood waters. In disbelief God asks what more could he do - he sent two boats and a helicopter.

The parable of the drowning man provides a good lesson for retirement. The Monte Carlo simulation is fun. And yes, I am using ‘fun’ loosely. It also isn’t real life. You are not helpless if you retire at the wrong time. There are more ways to thwart vicissitudes of fortune.

The simulation assumes that you are selling equal parts of your portfolio to fund each withdrawal. Simplistically that means if you had a portfolio of 50% shares and 50% cash you would take half your withdrawal from each bucket.

In simulation world this occurs if the shares went up 20% or down 20%. In the real world you could selectively pick how to fund a withdrawal.

In the scenario with 15% cash there was an 80% probability of not running out of money. Yet if the 85% allocation in shares plunged you could not sell. You have cash.

The cash could fund your retirement spending for more than 36 months even if inflation was high. This would give you time for shares to recover.

Since the end of World War II, there have been 13 bear markets. To get back to the market peak – the breakeven point – took an average of 21 months.

In the real-world dividends could fund at least part of your withdrawals. In the real world you could adjust your spending in years when the market fell significantly or in years of high inflation.

Final thoughts

I’ve outlined several steps you can take to improve the probability of having a great retirement.

Yet I would be remiss if I didn’t also say that you can make things a whole lot worse by doing the wrong thing.

The simulation assumes historic market returns. Many investors get returns lower than the market.

The simulation assumes that you only sell what is needed to fund your withdrawals. Many investors panic in bear markets and go to cash.

Making these decisions would make it more likley you run out of money than the model shows.

One thing a Monte Carlo simulation can’t model is human behaviour. My goal was to help you understand how changing circumstances impact your retirement outcomes. My hope is that better decisions will come from greater understanding.

Please share any thoughts or topic suggestions with me at [email protected]

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Previous editions of Unconventional wisdom:

Unconventional wisdom: Are passive ETFs leading to lower returns?
Unconventional wisdom: A controversial income pick
Unconventional wisdom: The not so inevitable investment case for AI
Unconventional wisdom: Don’t play Russian Roulette with your finances
Unconventional wisdom: 3 things you won't find in my portfolio
Unconventional wisdom: A simple way to better returns

What I've been eating

Most people have heard the origin story of the name sandwich. But did you know that a court in Boston ruled on the official definition of a sandwich in 2006. As the court defined it a sandwich “consists of at least two slices of bread and is not commonly understood to include burritos, tacos, and quesadillas, which are typically made with a single tortilla and stuffed with a choice filling of meat, rice, and beans." You might be curious about the court case. A restaurant selling burritos was trying to move into a shopping centre where an existing vendor signed an exclusive agreement to sell sandwiches. Under any definition of a good sandwich the chicken katsu at The Lucky Pickle in Surry Hills qualifies. Shani recommends extra sauce and some chillis.