3 Engineer-Like Ways to Test Your Retirement Income Plan
Posted in: Retirement Planning
Published: March 30, 2018
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.
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. Yet, when I started in the financial planning business in 1995, providing answers based on data was not the norm. At that time if someone wanted to know if they should pay off the mortgage or invest, the canned answer we were “supposed” to give was that they should invest. The reasoning was that you were likely to earn a much higher return on investments over time than the cost you would pay on the mortgage.
I hated those canned answers. And, most of the answers taught to us financial representatives at that time were canned. That’s because all of us young, well-intentioned (but ignorant) commissioned salespeople 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.
Unfortunately, even today, too many financial advisors provide canned answers. They do not take an engineering-like approach to retirement income planning – but they should.
There’s no time when an engineering-like approach to retirement income planning is more important than the ten years before and after retirement. Retirement is the biggest financial decision you make and you can’t afford to make mistakes. You need answers that are based on reliable data and which have been thoroughly tested.
What Does an Engineer-Like Retirement Income Plan Entail?
Engineers use tests and formulas. Tests and formulas can be applied to retirement too. We use three specific retirement readiness tests to analyze a client’s financial situation. If they pass all three tests then we are confident their retirement income plan will work throughout their projected life expectancy. Let’s take a look at each of these tests.
Many people ask me if “fundedness” is a word. It is certainly a word in the coursework we study to become a Retirement Management Advisor. Fundedness is based on a math concept called present value.
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.
You’ve learned that if you wait and begin Social Security at age 70, you’ll receive $30,000 a year. If you take Social Security earlier, you’ll get less. Can you afford to wait? To retire earlier than 70, from ages 65 to 69 you will need to withdraw $30,000 a year from your savings and investments. You can begin to lay this out in a timeline format.
Year 1 – Age 60 – Withdrawal needed – $0
Year 2 – Age 61 – Withdrawal needed – $0
Year 3 – Age 62 – Withdrawal needed – $0
Year 4 – Age 63 – Withdrawal needed – $0
Year 5 – Age 64 – Withdrawal needed – $0
Year 6 – Age 65 – Withdrawal needed – $30,000
Year 7 – Age 66 – Withdrawal needed – $30,000
Year 8 – Age 67 – Withdrawal needed – $30,000
Year 9 – Age 68 – Withdrawal needed – $30,000
Year 10 – Age 69 – Withdrawal needed – $30,000
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 below.
1% Return – Present value $138,536
2% Return – Present value $128,074
3% Return – Present value $118,515
This shows 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. Safe investments offer lower returns. That is why I use lower rates of return in this example.
The example I used was very simple. In reality, this type of analysis incorporates all aspects of your financial life – your 401(k), IRA, taxes, inflation, health care costs, pension, stock options, deferred comp plans, downsizing later in life, etc. After coordinating all your financial items, a withdrawal plan is created. It shows you how much you need to have, earning what rate of return, for the plan to work over life expectancy. And it incorporates the assumption that funds invested for longer time frames would be earning higher returns than 1 – 3%.
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.
Another retirement readiness test we use is a historical audit.
2. A Historical Audit
With a historical audit your specific withdrawal plan is tested over past markets. For example, if you had retired in the early 70’s right before the market crash and years of high inflation, would your plan have worked? You can find out. It feels really good when you know your plan could have successfully weathered every past recession since the Great Depression.
We work with our investment partner, Asset Dedication to run a historical audit based on your specific plan. Meaning it’s not a simulated example for an academic paper. It’s your numbers tested over the past.
Asset Dedication goes back to 1927 and shows you what results you would have experienced if you had retired that year. Then they see what happened if you retired in 1928, 1929, 1930, and so on. Think of it like this; from 1927 to 2017 there are 90 years. Assume you could clone yourself and go back in history. One of your clones retires in 1927, the next in 1928, and so on. You have sixty clones, each lving for thirty years. That means there are sixty complete thirty-year blocks of time to test. The results show up in what I refer to as the “spaghetti chart” like the one you see below. Each yellow line represents the path of the financial assets of one of your clones. You can see your sixty clones and which ones had financial accounts that grew over their thirty years, and which ones didn’t.
To be confident in the success of your retirement income plan, we want to see 100% success rate when tested back to 1947 – visually, 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.
3. 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. Unlike the historical audit, these returns are randomly generated – so the software can simulate market conditions that are far worse than what we’ve seen in real life. 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.
If the red line results aren’t within the parameters we want to see then we see what adjustment need to be made to keep you out of harm’s way.
- As you near retirement, you can’t afford to make big mistakes. You need an engineering-like approach applied to retirement income planning.
- At Sensible Money, our financial advisors are both Certified Financial Planners and Retirement Management Analysts (RMA). The RMA is an advanced certification that teaches us engineering-like tools that we can use to test retirement income plans.
- After gathering an incredible amount of data, we use three tests, Fundedness, a Historical Audit, and Monte Carlo, to determine if we are confident your plan will work.
If you haven’t rigorously analyzed your retirement income plan, maybe it’s time.
Written by Dana Anspach.