So how can you realistically determine whether your investments will be enough to meet your retirement needs? The best way to estimate future investment outcomes is through the use of a Monte Carlo simulator — a computer simulation that is able to estimate the likelihood of achieving your goals by accounting for the variability in the factors that contribute to success of your financial plan. The factors include rates of return, inflation rates, interest rates, portfolio allocation and spending levels.
Because the program will randomly produce thousands of independent iterations, it provides a range of possible outcomes. It can help clarify issues such as how much you can reasonably expect to spend once you retire or how much you can expect to have saved by the time you are ready to retire. With this knowledge, you can then make reasonable adjustments to your current lifestyle as needed.
The expected outcomes are expressed in terms of probability. For example, a possible expected outcome could be that you have a 93 percent chance you will not run out of retirement funds if you structure your portfolio in “this manner”. Conversely, you have a 7 percent chance you will run out of retirement funds. Another expected outcome could be that there is a 50 percent chance you will accumulate at least $2.8 million, a 25 percent chance that you will have $5.0 million or more, but a 10 percent chance that you will have $350,000 or less.
In addition, Monte Carlo can provide sensitivity analyses by adjusting your portfolio allocation and/or changing your level of spending. For example, the analysis could be based on an anticipated portfolio allocation of 70/30 (70 percent in equities and 30 percent in fixed income) with a possible expected outcome that you have a 93 percent chance that you will accumulate $3 million. Conceivably, you could change to a less risky allocation of 50/50 and still have a 93 percent chance to accumulate $3 million. In addition, you may increase your spending by 5 percent and have a 92 percent chance that you will accumulate $3 million.
As you can see, Monte Carlo can be a very useful tool in planning for your retirement. However, it should neither be the only tool you use to plan your investment objectives, nor should it be a onetime exercise.