You're smarter than your Monte Carlo

CIO Global Blog

21 May 2019

There are two important, but sometimes misunderstood, concepts we use for decision-making in implementing the Liquidity. Longevity. Legacy. strategies: "percent funded" and "probability of success." Both are useful, particularly when it comes to choosing the right Longevity strategy.

  • Percent funded refers to the ratio of your assets relative to the cost of your future liabilities. For example, if you have USD 1.5mn in the bank and your future retirement goals will cost USD 2mn, you are (1.5/2 = 0.75) 75% funded. Percent funded is used extensively by pensions and other institutions that have specific future liabilities they need to meet.
  • Probability of success measures how successful a proposed plan of action will be over time and is typically quoted as a percentage (e.g. you have an 80% probability of success). This is calculated by running a Monte Carlo simulation: running hundreds or thousands of "trials" that simulate your financial plan through various market conditions.

What does success look like?

Once you get to retirement, your percent funded needs to be 100%. If it's not 100%, your spending goals are too high relative to your assets, and that needs to be solved one way or another (work longer to save more, lower spending goals, etc.). It's simply a budget constraint we all face that can't be broken without bad things happening down the road.

Probability of success is also an important tool for making decisions (read Modern retirement monthly: Understanding "probability of success" for full details), but it's important to understand the nuances of interpreting the results. Generally speaking, an 85% probability of success is usually explained as an 85% chance of not running out of money and a 15% chance of running out of money. The problem with this straightforward interpretation is that the Monte Carlo simulation has a very dim view of human behavior. It assumes that you, the investor, will react and behave the same regardless of how your life progresses.

Realistically, however, financial plans are not a one-time affair. As you meet with your financial advisor year after year, you will make tweaks to the plan, pulling the many levers at your disposal (save more/less, retire sooner/later, spend more/less) to react to changing circumstances. In short, you are not stupid. You're smart. Unlike your Monte Carlo counterpart, you won't naively keep spending at the same pace when it's clear you can't do so. With this in mind, we need to change our understanding of that "15% failure" outcome.

What does failure mean?

It's much better to consider failure as the percentage of the time you'll need to reduce spending relative to what's shown in the plan. In a fully funded plan, these failures come from a mismatch between portfolio volatility and willingness to cut spending. Many investors don't want their spending to fluctuate as much as their portfolios, and that's what leads to some failures, but small tweaks along the way will mitigate most of those failures and make them much more manageable.

Many investors will actually find that a lower-risk portfolio leads to a higher probability of success. For instance, a moderate-risk portfolio might indicate a 95% probability of success versus a 75% probability for an aggressive portfolio. Neither scenario indicates a real chance of running out of money, but there's a 20% greater likelihood of needed to reduce spending at some point in the future with the aggressive portfolio.

On the other hand, the aggressive portfolio also almost certainly leads to a larger Legacy transfer, on average. That is the trade-off we all have to think about when choosing a Longevity portfolio. An investor who favors stability of spending over maximizing Legacy would prefer a lower-risk Longevity portfolio, whereas an investor who is comfortable with reducing spending if necessary in exchange for a bigger Legacy impact would prefer a riskier Longevity portfolio.

Liquidity. Longevity. Legacy. disclaimer: Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

Author:

Michael Crook, Head Americas Investment Strategy, UBS Financial Services Inc. (UBS FS)