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Determining Retirement Needs - Straight-Line Returns Vs. Probability Analysis

IV. Straight-line returns vs. probability analysis
Most financial plans rely upon a straight-line return that represents a flat, average annual rate of return. This method works for simplicity sake, but it does not represent the reality of investment performance or how financial markets operate.

Returns are volatile, and that volatility can have a severe impact on investment returns. The sequence of returns will make a big difference in the final results. A downturn in investment performance at an inopportune time relative to retirement can devastate a retirement plan, even if the long-term plan in maintained.

Probability analysis
An advanced method of illustrating investment scenarios. Probability analysis takes into account various return scenarios and the likelihood of achieving one's investment objectives given the reality of volatile returns.

  • Monte Carlo simulation - A problem solving technique used to approximate the probability of certain investment return by running multiple trial runs, called simulations, using random variables. Monte Carlo simulation helps to reduce the uncertainty involved in estimating future outcomes. A Monte Carlo simulation typically is performed using a computer.
V. Pure annuity vs. capital preservation
These are two methods of calculating retirement income from accumulated retirement savings.
  • Pure annuity - This method uses the assumption that the accumulated savings will be depleted at the end of an individual's lifetime after a series of annuity payments over the course of retirement. Using a financial calculator, annuity payments are calculated with an assumption that the future value will equal zero.
  • Capital preservation - This method assumes that all or part of accumulated savings will remain at the end of the retirement period. In this case, the individual would seek to live off the earnings produced by a portfolio while maintaining the capital. Such a calculation would be performed on behalf of somebody who may to leave a bequest to one's heirs. Using a financial calculator, annuity payments are calculated with the future value set to the lump sum an individual wishes to exist at the end of the retirement period.
Projected Cash-Flow shortfalls

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