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The Method Is Called “Monte Carlo” for a Reason

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You’ve finally made it to retirement.  You are happily sitting on a million dollars at age 65.  You are healthy and looking forward to spending your golden years relaxing and doing some of the things you’ve always wanted to do but just didn’t have the time.  You do have some concerns though and your biggest is how much money you can spend per year without running out.  A million dollars seems like plenty of money but what kind of income streams does it really translate into?

There are 2 important variables that we need to consider.  The first variable is how long you will live and the second is market volatility.  Of course, we have no idea how long we are going to live but what we do know, on average, people are living longer than ever.  With that said, we may need to consider income streams till 90 years and up to be safe.

When it comes to the risks of market volatility, many advisors will turn to Monte Carlo simulations.  Named after the city of Monte Carlo that is known for casinos, this simulation works much like a slot machine.

It will consider the 5 pieces of fixed data; portfolio size, portfolio allocation, annual income to be withdrawn, inflation and time horizon.  It will then take these fixed pieces of data and run them through thousands of simulations from historical data to give a probability of success.

Related: The Power of Investing Young

Let’s take a deeper look at what some of these simulations look like with the following example.

Let’s say we are age 65, we have $1M in retirement assets and we are healthy, so we plan to live for another 30 years.  We will also assume a 50/50 bond to equities portfolio allocation.  With these fixed points we can expect to have about a 97% success rate if we spend 3.5% of our portfolio per year.  When we increase the spending to 4%, we will see a success rate of under 90% and when increase to spending 5% per year we see less than 50% of success.

That’s right.

Just $50K of spending per year will give you a 50% percent success rate of income streams for 30 years.  It can be surprising, but it doesn’t need to be.  With proper planning, you can position yourself to safely have higher distribution rates but keep in mind that the best strategies are achieved many years prior to retirement.  If you wait till retirement to plan these distribution rates it may be too late to make some improvements.

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