3 Ways to Tell if Your Retirement Income Plan Will Work
My stepfather growing up was an aerospace engineer. Just out of college I was married to a materials engineer. My youngest brother is a mechanical engineer. They are all amazing people, and I’ve always found engineering fascinating, particularly when it comes to building something that will last. After all, when you build a skyscraper, you can’t have it fall. The same thing is true for building a retirement income plan – it needs to last.
Unfortunately, most financial advisors do not take an engineering-like approach to retirement income planning – but they should.
Early in my career, I realized I wanted to find a more engineering-like way to deliver financial planning advice. I wanted answers based on data, not on speculation.
You see, when I started in the financial planning business in 1995, if someone wanted to know if they should pay off the mortgage or invest, the standard answer we were “supposed” to give was that they should invest. The reasoning was that they were likely to earn a much higher return on the investments over time than the cost they were paying on their mortgage.
I hated these standard answers. And most of the ones taught at that time were wrong. That’s because all of us young, well-intentioned (but ignorant) commissioned sales people were trained to provide these answers so that we could sell more products for the company that employed us.
Eventually, I figured that out and made the decision that I would only work in an environment where I could base answers on analysis and give advice that was in the best interest of the client.
There’s no time where this type of advice is more important than the ten years before and after retirement. That’s when you need an engineering-like approach to retirement income planning – you can’t afford to make big mistakes at this point.
What Does Quality Retirement Income Planning Look Like?
We use three ways to analyze a client’s financial situation and determine if we are confident their retirement income plan will work throughout their projected life expectancy. One of those ways is something we call “fundedness”.
Let’s look at a simple example… assume you are retiring in five years at age 65. You need $30,000 a year of income. (Yes, I said a simple example!)
If you start Social Security at age 70, you’ll receive $30,000 a year. To retire earlier than 70, from ages 65 to 69 you will need to withdraw $30,000 a year from your savings and investments. The image below shows how you can begin to lay this out in a timeline format.
How much would you need to have saved right now, earning what rate of return, to have the $30,000 a year withdrawal for five years?
You can calculate the answer using the “present value” math formula. You can do this on a financial calculator or by using the “NPV” formula in Excel. “NPV” takes the net present value of a series of cash flows. Using the NPV Excel formula, you see the answer in the screenshot below.
What this table shows is that if you currently have $118,515 saved, and it is invested safely earning 3% a year, then your withdrawal plan is fully funded. You have enough to deliver the $30,000 a year you’ll need in five years, and you don’t need to add more to your savings. If your savings earn 1% a year, you need $138,536 in the bank today.
Since you need the first withdrawal in six years, your time frame is relatively short, which means you would want the portion of your money assigned to meet these withdrawals invested safely. That is why I used lower rates of return.
Now, imagine this type of analysis incorporated many other things – your 401(k), IRA, taxes, inflation, health care costs, pension, stock options, deferred comp plans, downsizing later in life, etc. The funds invested for longer time frames would be earning higher returns than 1 – 3%. And imagine that you could then lay out a withdrawal plan the encompassed all those things, and see how much you would need to have, earning what rate of return, for that withdrawal plan to work?
That is what we do with our fundedness analysis. It is the same type of analysis used in the Discounted Cash Flow (DCF) method for analyzing stock prices or other investment opportunities. And that is only one of three ways we test your retirement readiness.
A Historical Audit – Back Testing a Retirement Income Plan
Another way we test a retirement income plan is through a historical audit. With this analysis, we work with our investment partner, Asset Dedication.
We send them the value of the financial assets you currently have and the expected cash flows (both deposits and withdrawals) as projected over your entire lifetime. The cash flows include deposits to 401(k)s or IRAs while working, and then withdrawals you’ll need once you retire.
Asset Dedication goes back to 1927 and shows you what results you would have experienced if you retired each year going forward. The results show up in what I refer to as the “spaghetti chart” like the one you see below. Each yellow line represents the value of your financial accounts over time, assuming you had retired in 1927, 1928, 1929, etc.
To be confident in the success of your retirement income plan, we want to see 100% success rate when tested back to 1947 – that means the majority of the yellow lines are well into the green area.
Figure 5-10 used with permission. It is from Chapter 5 of the 2nd edition of Control Your Retirement Destiny.
We are ok if a few yellow lines from the Great Depression era end in the red as we know if such a horrible economic time occurs again there are adjustments that could be made to make sure a minimum lifestyle is secured.
Now, on to one more way to test a retirement income plan.
Probability Testing Through a Monte Carlo Analysis
Monte Carlo is a famous casino in Monaco near the French Riviera. Monte Carlo is also the name for a set of algorithms that generate random results. In retirement income planning a Monte Carlo analysis can be used to stress-test your retirement plan and see how it would hold up under a random pattern of hypothetical investment returns.
This type of simulation is available in several free online retirement calculators. A Monte Carlo simulation is the only analysis provided in most of the retirement income plans that we see generated by other financial advisors.
We use software powered by Finance Logix to run the Monte Carlo simulation. You can see what it looks like below.
- The green line shows the path your financial accounts would take in the best 25% of hypothetical outcomes.
- The purplish colored line illustrates the results if you earned a rate of return of exactly 5% a year.
- The red line shows the results in the worst 25% of hypothetical outcomes.
To be confident in the success of a retirement income plan, we want to see an 85% chance of reaching your target. The software uses the term “chance to run out of money, ” and some may be alarmed if it says there is a 15% chance, but it is best to reword that into a “chance you may need to make an adjustment to your plan.” Small adjustments (that only need to be made if a bad market materializes) can prevent you from running out of money.
- As you near retirement, you can’t afford to make big mistakes.
- You need an engineering-like approach applied to retirement income planning.
- Most financial advisors use one test – a Monte Carlo analysis, which tests the outcome of your plan over a series of random future returns.
- At Sensible Money, our financial advisors are both Certified Financial Planners and Retirement Management Analysts, which is an advanced certification that teaches us engineering-like tools that we can use to make rock-solid retirement income plans.
- After gathering an incredible amount of data, verifying your income and expenses, and projecting those out through life, we then use three tests, Monte Carlo, Fundedness, and a Historical Audit, to determine if we feel confident your plan would work.
If you haven’t rigorously analyzed your retirement income plan, maybe it’s time.
Written by Dana Anspach.