Sunday, January 25, 2015

Forecasting Future Investment Experience--Please Use Monte Carlo Simulations Responsibly

Just after I finished yesterday's post, I received a question from a reader asking if I would consider doing a post on the latest article from Messrs.  Blanchett, Finke and Pfau, "Retiring in a Low-Return Environment", and how the results of their latest research might affect use of the Actuarial Approach.

Since these three gentlemen consistently produce very good retirement research, I was more than happy to read their article.  As it happens,  I was pleased to see that their article generally reinforced the concerns I was expressing  yesterday about the Monte Carlo simulations used in the "Perfect Withdrawal" post.  They said,

"The generous capital market returns of the prior century bolstered a comfortable and long-lasting retirement portfolio. But they will give 21st-century clients a false sense of security and prejudice products and strategies that would do a better job of meeting retirement income goals."

This is not the first time these gentlemen have sounded the alarm about using historical rates of return and Monte Carlo modeling to develop safe withdrawal rates (SWRs) in the current economic environment.  See my post of January 19, 2013 about their January 15, 2013 article, "The 4% Rule is Not Safe in a Low-Yield World."  This new article supplements the older article with information supporting  their assertion that future equity returns may also be lower than historical equity returns.

So, after depressing us all with their view of future investment returns, what do the authors recommend we retirees do other than use lower SWRs?

  1. Rather than plan on living until age 95, plan on living your life expectancy and hedge longevity risk by purchasing a deferred income annuity.
  2. Plan on decreased levels of spending as you age and be more flexible in terms of accepting decreased spending levels if investment experience is not as favorable as expected. 
Item 1 is not so easily accomplished when a retiree is using a SWR approach unless the retiree knows exactly how to adjust the SWR for shorter expected payout periods.   On the other hand, both items can be easily accomplished when using the Actuarial Approach, which just supports my general recommendation to ditch SWRs and use the Actuarial Approach instead. 

In terms of the question of what a low-return environment means if one is using the Actuarial Approach, my response is if you are using the recommended assumptions for 2015 (5% investment return, 3% inflation and a payout period of 95-current age, or life expectancy if greater) then you are already using assumptions that are consistent with a low-return environment and you don't necessarily need to change anything.  The recommended assumptions are also consistent with the 2% real investment return assumption advocated by Dr. Pfau for deterministic projections.   As I have indicated in previous posts, if you desire a more-front loaded spending budget pattern consistent with item 2 suggested above, you can use a lower assumption for inflation.  For more discussion of the 2015 recommended assumptions, see our post of December 3 of last year.

If you are using the Actuarial Approach with assumptions that are significantly more aggressive than the recommended assumptions (or an approach that produces significantly higher current withdrawal rates), you either need to believe that these researchers are being unduly pessimistic about future investment returns or you need to be prepared to reduce your future spending.