When you sit down with a traditional financial advisor to plan your retirement you will provide her with the spending budget you have in mind. The advisor will adjust that amount for inflation and after running through a “black box” model, will predict how many years your retirement savings – typically made up of cash, stocks and bonds — will last.
The model to make this prediction is called “stochastic” — a fancy way to describe what is a typical Monte Carlo simulation model.
What you should know about this modelling
The problem is that it provides you with probabilities, not certainties – which means your “planning” is much like playing a roulette wheel or any of the other casino games. The stochastic model will examine many scenarios for the coming years. It will factor in historic stock market returns and volatility, and even the volatility of inflation, to measure your savings balance against your possible lifespans.
The probabilities display on a computer screen as squiggly lines to show the value of your savings. As you test against older ages, the number of lines that hit zero increase, indicating a greater chance that your money will run out before you do. This all translates into a prediction along the lines of, “With your budget and with expected inflation, you have a 90% chance your money will last to age 90 if markets in the future perform like markets in the past.”
It is easy to discern the lack of precision. But if you don’t like the prediction, you don’t have many options. While you can increase the percentage of bonds or cash to the investment mix to reduce volatility, that also lowers your average expected return. Another alternative is to adjust your budget and lower your monthly income – and hope your savings will last longer. You may end up with a spending goal before you walk out of the office, but the process hidden in the black box is complex and you’re still dealing with probabilities.
How to factor in personal circumstances
And the scenario I just described deals only with the income of one person, with no unexpected expenditures, and an average lifespan. Let’s add the questions that arise when “life happens.”
- Will your finances support your spouse after your death?
- How much inheritance do you want to leave to your kids?
- Where will the money come from for late-in-retirement medical and caregiver expenses that Medicare doesn’t cover?
- What if your house needs expensive repairs? Or your kids or grandkids need a loan?
- And what if market volatility means your savings took a hit the same month you had those unexpected expenses?
The alternative is Income Allocation
Income Allocation focuses on providing income that lasts a lifetime, instead of predicting the date your savings will run out.
The addition of annuity payments to the dividends and interest your portfolio generates guarantees income for life and smooths out the volatility that hangs like a dark cloud over other plans. That makes your planning much simpler because you no longer must be totally dependent on the stock and bond markets.
Deterministic vs Monte Carlo planning
If you don’t want to trust your financial future to the casino, a plan for Income Allocation offers a planning that is much more predictable. An Income Allocation plan will continue to include stocks and bonds. Notably, annuity payments do not eliminate all risk, but they make the risk more manageable. My advice is to depend on income annuities for no more than 30% to 35% of your portfolio.
Income Allocation also makes it easier to prepare.
As you design a plan for income, you select your view of the stock market (how much risk are you comfortable with?) Then you test the results, creating the levels of income and legacy to your heirs that works for you. If you don’t like the results, you can revise your assumptions.
As you build an income allocation plan for you and your family, you will consider how your retirement income will look under three different results: A market that averages annual growth of 4%, 6% or 8%.
And whatever date your plan takes effect, you can return for adjustments later on.
Planning for likely circumstances
With Income Allocation, you can create scenarios and make changes until you are satisfied with the results. The calculations are similarly simple when you add the variables of support for spouse, late-in-life health concerns, and financial legacy for kids. Here are a few examples:
- You and your spouse can each have your own annuity payments, or you can ensure that your annuity payments continue to pay out to your spouse if you pass first.
- You can create income that will kick in when you or your spouse reach a certain age – usually 85 – to help pay for medical and other costs not covered by government programs. It’s done with a deferred income annuity.
- You can test what a large planned-for — or even an unexpected expenditure — might do to your income.
Where does the market risk go?
Admittedly the legacy you leave your kids or grand kids might be lower earlier in retirement when you employ an Income Allocation plan. That’s because your plan protects your retirement income – for life – in the form of annuity payments, which reduce your risks against long-term poor market performance. But it comes with a trade-off. In this case it will be the amount you pass along to your heirs early in retirement.
My view is that heirs should welcome that tradeoff. If your Monte Carlo scenario or just poor planning leaves them on the hook for your income when your savings run out, they will appreciate your smarter lifetime planning. Income Allocation allows you to maintain your independence as long as possible, while perhaps passing along a smaller legacy to the kids.