RETIREMENT INCOME PLANNING
Retirement income planning is one of the primary reasons people engage in financial planning. In most cases, retirement income planning is a two-step process: a long period of gradual asset accumulation leading up to retirement, followed by a long (hopefully) period of distribution during retirement.
There are numerous strategies that can be implemented and products that can be purchased in order to accumulate retirement assets as effectively as possible. In almost all cases, however, it is impossible to know what long-term rate of return will be realized and, therefore, the amount of savings necessary to accumulate adequate resources to retire comfortably.
Projecting asset growth based on fixed return assumptions is a common approach to determining the amount that should be saved in order to reach a retirement savings goal, and how much can be withdrawn during retirement. However, since long-term rates of return are the result of a series of shorter-term (monthly, quarterly, annual, etc.) variable returns, the sequence of returns realized plays a significant role in determining how much is accumulated at retirement and the sustainability of a given level of distributions.
For example, a period of negative returns just prior to retirement can push one’s planned retirement date well into the future. Likewise, a period of weak returns during the first part of retirement can have a significant impact on the sustainability of the desired distributions. These scenarios are not captured using fixed return assumptions.
In order to account for the impact of variable and unknown returns both pre- and post-retirement, we are now using software that projects the likelihood of a financially successful retirement by modeling a range of potential outcomes. By simulating thousands of return sequences using expected returns, volatilities and asset class correlations, we are able to more accurately calculate the probability of success for various savings and distribution scenarios (chart 1 below). The software also integrates social security benefits, health care costs and inflation expectations into the calculations. This allows us to explore a wide range of possible outcomes with our clients and describes the results in terms of probability of success (chart 2 below).
The results bring a new perspective to retirement income planning and help illustrate the likely impact of changes in savings rates and asset allocation strategies.