The city of Monte Carlo in the country of Monaco has long served as a playground for the jet set, where rich gamblers who can afford to lose huge sums of money come to play for big stakes in games of random chance where strategy and experience can provide little or no benefit. But those who are trying to plan for a secure retirement and can't afford to lose their savings don't want to take big chances with their money.

How It Works
Although naming this type of calculation after a gambling mecca may seem a bit ironic, it has come to be used in the financial arena to signify a planning technique used to calculate the percentage probability of specific scenarios that are based upon a set group of assumptions and standard deviations. This method of calculation has often been used in investment and retirement planning to project the likelihood of achieving one's financial or retirement goals and whether or not a retiree will have enough income to live on for life, given a wide range of possible outcomes in the markets. While there are no absolute parameters for this type of projection, the underlying assumptions for these calculations typically include such factors as interest rates, the client's age and projected time to retirement, the amount of the investment portfolio that is spent or withdrawn each year and the portfolio allocation. The computer model then runs hundreds or thousands of possible outcomes using actual historical financial data. The results of this analysis usually come in the form of a bell curve, where the middle part of the curve delineates the scenarios that are statistically and historically the most likely to happen while the ends, or tails measure the diminishing likelihood of the more extreme scenarios that could also occur.

Limitations
Despite its apparently thorough mathematical breakdown of possible future outcomes, recent market turbulence has served to expose a major weakness that seems to afflict this method of financial projections. While its supporters are quick to point out that Monte Carlo simulations generally provide much more realistic scenarios than simple projections that assume a given rate of return on capital, critics contend that Monte Carlo analysis cannot accurately factor infrequent but radical events, such as market crashes, into its probability analysis. Many investors and professionals who used this methodology were not shown a real possibility of market performance such as we have had over the past few years.

In his paper, The Retirement Calculator from Hell, William Bernstein clearly illustrates this shortcoming. He uses an example of a series of coin tosses to prove his point, where heads equals a market gain of 30% and tails represents a loss of 10%. If you start with a $1,000,000 portfolio and toss the coin once a year for 30 years, you will end up with an average annual total return of 8.17% over that time. That means that you could withdraw $81,700 per year for 30 years before exhausting your principal. If you were to flip tails every year for the first 15 years, however, you would only be able to withdraw $18,600 per year, while if you were lucky enough to flip heads the first 15 times you could take out a whopping $248,600. And while the odds of flipping either heads or tails 15 times in a row seems statistically remote, Bernstein further proves his point using a hypothetical illustration based on a portfolio of one million dollars that was invested in five different combinations of large and small cap stocks and five-year treasuries back in 1966. That year marked the beginning of a 17-year stretch of zero market gains when you factor in inflation. History shows that the money would have been exhausted in less than 15 years at the mathematically-based average withdrawal rate of $81,700. In fact, withdrawals had to be cut in half before the money lasted for the full 30 years.

How Can I Plan Realistically Instead?
There are a few basic adjustments that experts suggest can help remedy the shortcomings of the Monte Carlo projections. The first is to simply add on a flat increase to the possibility of financial failure that the numbers show, such as 10 or 20 percent. Another is to plot out projections that use a percentage of assets each year instead of a set dollar amount, which will greatly reduce the possibility of running out of principal.

The Bottom Line
There is no absolutely foolproof way to predict what will happen in the future. But running a Monte Carlo analysis that allows for the real possibility of disaster can give you a clearer picture of how much money you can safely withdraw from your retirement savings. For more information on Monte Carlo simulations, visit http://www.moneychimp.com/articles/volatility/retirement.htm or http://www.flexibleretirementplanner.com/wp/ or consult your financial advisor.

Related Articles
  1. Retirement

    Infographic: How Much Money Do You Need to Retire in Hawaii?

    In this infographic we break down cost of living in Honolulu, Hawaii in terms of taxes, rent, food and other expenses and offer comparison to the cost of living in New York, Los Angeles, San ...
  2. Term

    What are Pension Funds?

    A pension fund is a company-sponsored fund that provides income for employees in retirement.
  3. Retirement

    Overhaul Social Security to Fix Retirement Shortfall

    There are several theories and ideas about how we can make up for the $6.6 trillion retirement savings shortfall in America. Adjustments to Social Security and our retirement savings plans are ...
  4. Investing News

    How Does US Social Security Measure Up Abroad?

    Social Security is a hotly debated topic. After examining the retirement plans of three different countries, the U.S.'s does not come out the winner.
  5. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  6. Retirement

    The World's Most Luxurious Retirement Destinations

    If money is no object (or if you would just like to dream), these five spots are the crème de la crème.
  7. Professionals

    How to Protect Elderly Clients from Predators

    Advisors dealing with older clients face a specific set of difficulties. Here's how to help protect them.
  8. Professionals

    Social Security 'Start, Stop, Start' Explained

    The start, stop, start Social Security strategy is complicated. Here's what retirees considering it need to consider.
  9. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
  10. Professionals

    Your 401(k): How to Handle Market Volatility

    An in-depth look at how manage to 401(k) assets during times of market volatility.
RELATED TERMS
  1. Dynamic Updating

    A method of determining how much to withdraw from retirement ...
  2. Possibility Of Failure (POF) Rates

    The likelihood that a retiree will run out of money prematurely ...
  3. Safe Withdrawal Rate (SWR) Method

    A method to determine how much retirees can withdraw from their ...
  4. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  5. Mandatory Distribution

    The amount an individual must withdraw from certain types of ...
  6. Auto Enrollment Plan

    An employer’s decision to sign employees up to have a percentage ...
RELATED FAQS
  1. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  2. Are spousal Social Security benefits retroactive?

    Spousal Social Security benefits are retroactive. These benefits are quite complicated, and anyone in this type of situation ... Read Full Answer >>
  3. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  4. How do you calculate penalties on an IRA or Roth IRA early withdrawal?

    With a few exceptions, early withdrawals from traditional or Roth IRAs generally incur a tax penalty equal to 10% of the ... Read Full Answer >>
  5. What is the Social Security administration responsible for?

    The main responsibility of the U.S. Social Security Administration, or SSA, is overseeing the country's Social Security program. ... Read Full Answer >>
  6. What are Social Security spousal benefits?

    Social Security spousal benefits are partial retirement or disability benefits granted to the spouses of qualifying taxpayers.  Qualifying ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!