Ongoing retirement planning involves making best estimate (or conservative) assumptions about the future and making necessary adjustments to your retirement plan when those assumptions inevitably turn out to be incorrect. At How Much Can I Afford to Spend, we believe using our Actuarial Financial Planner (AFP) model annually to calculate your funded status can best help you with ongoing (or dynamic) retirement planning.
On the other hand, some financial advisors and academics encourage use of “safe” alternatives (like the 4% Rule or Monte Carlo model results with 90% or greater probability of success) where future retirement plan adjustments are generally not anticipated. This type of planning is referred to as “one-and-done” (or static) retirement planning. We also refer to this second type of retirement planning as “head-in-sand” retirement planning as it is very difficult to predict the future accurately and, as a result, it is very easy to either overspend or underspend relative to your spending goals when using these static approaches. For more discussion of ongoing vs. static planning, see our post of January 15, 2023.
Since financial advisors frequently make financial recommendations to their clients on the basis of Monte Carlo projections, it is important that the projections be reasonably accurate, especially if they are intended by the financial advisor (and/or interpreted by the client) to be “safe.” In their Kitces.com post of April 12, 2023, the authors attempt to measure the accuracy of four different Monte Carlo models using different sets of assumptions and historical experience. According to the authors, they “…examined the accuracy of probabilistic forecasts of retirement income risk from models of investment returns and inflation. Specifically, we asked how well 4 different approaches to the creation of Capital Market Assumptions (CMAs), return sequences, and inflation sequences perform in the real world.”
Note that the authors’ “real world” analysis assumed:
- Households would spend exactly their plan spending budget each year (in real dollars),
- Household portfolios would be invested 60% in equities and 40% in bonds,
- 20-year plans,
- Future experience would exactly follow past experience since 1951 (consistent with modifications in the four approaches), and
- Other possible simplifications
The authors concluded that none of the four models was particularly accurate and the Traditional Approach most commonly used by financial advisors was probably the worst. They said,
“This is not to say that any of the models we’ve discussed approach perfection. On the contrary, another takeaway is that all models’ predictions are rife with errors. Brier scores were never 0 or even close to 0 for any approach. This should humble any forecaster. Advisors should be aware of both the likelihood of error in general and the nature of these errors specifically.
The authors conclude by strongly suggesting that instead of relying on static safe approaches, financial advisors and their clients should plan on making adjustments in their retirement plans when necessary. They said,
“Since errors in forecasts are a near certainty, these results also provide an additional reason to plan for adjustments to retirement income. As time goes on, advisors and clients learn more about the world they are living in and can make adjustments to counteract some of the errors that crept into their initial analyses.”
Summary
In our “real world,” lots of things can happen in the future that can affect the ratio of household assets to household spending liabilities, including variations in:
- Annual investment returns (i.e., past performance is not a guarantee of future results),
- Longevity,
- Annual inflation (or other rates of expense increases or decreases),
- Spending (this is a huge source of potential variability) and spending goals,
- Sources of income (i.e., Social Security or rental income)
- Assumptions about the future
All these things make it very difficult to predict the future with any degree of accuracy. In light of this uncertainty, we agree with the Kitces’ authors that retirees should plan for future adjustments. To do this, we believe it is easier to focus on the Funded Status developed in the AFP from year to year rather than some Monte Carlo model probability of success.
