Wednesday, November 18, 2015

Actuary Discovers Chinks in Monte Carlo Modeling Armor

In his recent article in Advisor Perspectives, fellow actuary Joe Tomlinson raises serious credibility concerns about Monte Carlo simulations that use historical data to calculate the expected equity premium for stocks when such simulations are used to determine how much wealth to spend down during retirement.    Mr. Tomlinson points out that out limited statistical evidence regarding equity premiums produces levels of uncertainty that are unacceptable to most clients. 

As I have indicated in prior posts (see for example my posts of July 15 of last year and January 24th and 25th of this year), I am not a buyer of the supposed superiority of Monte Carlo modeling as a tool for developing reasonable spending budgets for retirees.  These Monte Carlo models are also frequently used to develop static withdrawal strategies (see my last post for discussion of the superiority of dynamic over static approaches).  Mr. Tomlinson article confirms some of my major concerns about using Monte Carlo simulations and static approaches.

While the simple spreadsheets provided in this website can accommodate higher equity premium investment return assumptions, I recommend (at least for determining essential expense budgets) that retirees use an investment return assumption that is approximately equivalent to interest rates baked into single premium immediate life annuities at the time of determination.  For example, an immediate monthly life annuity of $582 ( yesterday from Income for a 65-year old male with a life expectancy of 274 months under the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality projection translates into approximately a 4.5% annual interest rate.  As I have previously indicated, including riskier assets in your portfolio (such as equities) can increase your expected rate of return, but it will also generally increase variability and therefore may not increase your annual spending budget over the long-run. 

The Actuarial Approach is a dynamic approach that involves periodic (usually annually) remeasurement of the retiree’s assets and liabilities and possible periodic adjustments to the spending budget, not a one-and-done static approach developed using Monte Carlo modelling.  I caution you to question the data used in Monte Carlo simulations producing a spending budget for you that significantly differs from the budget you (or your financial advisor) develop using the Actuarial Approach.  

Budget Pun of the Day (My first and probably my last one):  You’ll feel Stuck with your debt if you don’t properly Budge it.