Adjusting Monte Carlo Success Thresholds By Tolerance For Spending Volatility

Adjusting Monte Carlo Success Thresholds By Tolerance For Spending Volatility

Monte Carlo simulations are an important part of an advisor’s toolbox when constructing a client’s financial plan, as they demonstrate the wide range of potential outcomes that a retiree might experience. These simulations inform the retiree of how much they can spend in the short-term to avoid plan failure in the future, and they also suggest corrective spending levels along the way as plans get updated – an immensely difficult task given that no one knows precisely what will happen. Advisors can assess a number of important variables through Monte Carlo simulations, the most important of which is the frequency of accomplishing the client’s financial goals.

However, when constructing plans that are guided by probability-of-success outcomes, advisors walk a delicate line. Creating a plan with a 100% chance of success, for example, may assume that the retiree has no flexibility in spending and thus will not recommend spending increases… which would present a risk that the retiree may die with too much of their money remaining in the bank, having missed out on experiences, memories, and comforts they could have had. On the opposite side, creating a plan with a higher chance of failure can make clients uncomfortable, given the uncertainty of the future. Accordingly, advisors strive to find the right balance between these two scenarios, and while practices vary in the industry, many advisors tend to target a fixed threshold— say 90% – to determine whether a plan is strong enough to actually implement.

One key assumption of the 90% threshold is that clients should accept a 10% probability that they may need to course-correct at some point in the future to achieve their goals, should investment returns prove unfavorable. While a 90% success threshold might be a suitable threshold for many clients, advisors should recognize that every client has a different willingness and ability to take corrective action when needed, and perhaps a one-size-fits-all approach should be reconsidered. Some clients may prefer a plan that requires course correction 50% of the time, while others may shy away from any chance of failure at all.

Fortunately, advisors can adopt simple processes to identify appropriate (and uniquely customized!) target success thresholds for their clients. Conversations with clients about risk management can evolve, such that advisors shift away from a focus on the unpredictable movements of the market and, instead, move toward more controllable variables within a financial plan (e.g., discretionary spending categories), assessing the corrective actions that a client would be willing to take if needed. By identifying a client’s willingness and ability to modify spending, advisors can utilize a more appropriate and customized Monte Carlo success rate that reflects the client’s true tolerance for risk.

Ultimately, a client’s retirement plan will be more effective when it largely comes down to their comfort with risk, rather than the advisor’s comfort with risk. Because if the scenarios have been discussed and both parties are comfortable with the plan  – along with the adjustments that may be needed to stick to that plan – then clients will feel more confident and willing to take the necessary steps to deal with the market fluctuates in the short-term. And, of course, markets can also exceed expectations… not all adjustments need to be negative!

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