The Complaint against using Monte Carlo Simulation For Retirement Planning   by A J Nelson

in Investment / Retirement Planning    (submitted 2010-11-26)

The Complaint against using Monte Carlo Simulation in a Retirement Calculator

The chief complaint against Monte Carlo simulation is that it does not properly prepare individuals for the actual level of risk that they are undertaking. The main reason for this is known as modeling risk. Basically, modeling risk covers any and all of the reasons that the level of risk determined by the model may not be borne out once retirement begins.

The reason for this can be summed up: there is absolutely no way to predict the future. However, that may be a little trite. There are explanations with a little more meat on the bones.

A Monte Carlo Simulation usually relies on historical investment returns as the basis for making assumptions about future investment returns. Although a long history of returns may seem replete with all of the possible outcomes--it may not be so! There is always the possibility of a one time catastrophic event, or a series of bad years due to a combination of events that just haven't come together in the past, but which remain a distinct future possibility.

Therefore, you may want to modify the statistics generated from the historical returns in order to make the Monte Carlo Analysis produce more extreme results. One consideration would be to use a distribution curve with fatter tails. This would allow for more outliers in the results, and would help raise awareness of the possibility of catastrophic events. Perhaps using a larger standard deviation for the first few years of the income stream would have a similar effect. After all, really poor returns during the first few years of the income stream, are the most detrimental to survivability.

As well, tweaking the income model might reduce risk, and the vulnerability of the model. If you are assuming that withdrawals are coming from a volatile investment portfolio on a monthly basis, consider an annual transfer of funds into cash to cover the year’s budget. By moving the funds in this way, you may eliminate the asset erosion that could occur if the market begins to slip. Asset Cost Averaging (the opposite of dollar cost averaging, which is a popular method for saving for retirement), may also be considered, although this will lead to variations in the income received.

Finally, be conservative. The best way to avoid being overtaken by a catastrophic financial event is to lower your exposure. This may well mean living below your means, and exposing yourself to less investment risk, which also means the potential for lower returns.

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For more information about using Monte Carlo Simulation in a Retirement Income Calculator go to http://www.retirementcalculatorhq.com