3 Problems with Your Retirement Plan

Ahh, retirement. A permanent vacation. Just the thought of the warm ocean breeze, nature’s own white noise of waves crashing on the beach. A hint of piña colada on your tongue as you relax into reading a good book.

I don’t know about you, but this description makes me want to hop on a plane right now. Let’s leave aside for a moment the fact that I don’t plan to ever retire in a conventional sense. While that idyllic scene sounds amazing, I know from experience that it wears out its welcome in two weeks tops. It’s just the way I’m wired.

That being said, even though I never want to completely stop working, planning for the future is an important part of being comfortable in the present, so it’s something we owe it to ourselves to do. And to do in the right way. Lucky for me (and for you), part of the work that I like to do is to think way too hard about my version of “retirement.”

So let’s dive in.

Monte Carlo

There’s an established tendency within mainstream retirement planning to appeal to something called “Monte Carlo Simulation.” For the uninitiated, Monte Carlo Simulation refers to a technique of forecasting the future by running, say, a million possible futures and then looking at how those futures stack up against your goals.

As much as I’d love to crack into a lecture on how a binomial tree works, we don’t need it for our purposes. Suffice it to say that there is a fair bit of sensible math that goes into Monte Carlo Simulation. We’ll leave it at that.

Let’s go over a simple example. Suppose that you are 65, and you’re on your way to your retirement party. You’re optimistic, and want to plan for having enough money to live to 100. You plug your net worth and your expenses into a retirement calculator and wait for the results.

The program then dutifully applies your numbers and its assumptions, and simulates a million “possible futures”. In 830,000 of them, your net worth has not gone negative at age 100. The program tells you that you have an 83% chance of your plan working out.

Problem #1: Artificiality

Did you notice how I smuggled the word “assumptions” into the last paragraph? If that doesn’t scare you, it should. What are the assumptions?

Well, in a model like this, they’re going to be things like drift (how much the stock market goes up on average every year), volatility (how much returns vary), and possibly others depending on how complex the model is.

If you’re 65 and you’re looking at lasting until 100, that means you’re concerned with the future. But the future is inherently unpredictable. So what gives?

Look Behind You

Well, there’s no data about the future (yet), but we can look to the past to inform our assumptions. And many models do. Unless they’re willing to go purely finger-in-the-air, they’re probably going to base at least part of their prediction of the future on what has happened in the past.

Ever read an entire mutual fund prospectus? Me neither. But if you had, you’d probably see one of the finance world’s most oft-repeated phrases. Say it with me: “Past performance is no guarantee of future results.” You may be seated.

So if everybody and their grandmother knows that past performance doesn’t tell us what the future will be like, why do we rely on the past when making assumptions about the future? Because it’s all we’ve got.

Sham

So do we throw up our hands and admit defeat in the face of a future that is inherently uncertain? Of course not. We do the best we can.

But neither should we let ourselves be blinded with pseudoscience. When someone tells us there is an 83% chance that our retirement plan will work, it is an artificial estimate pretending to be data. The full sentence would be “Based on our assumptions and our model, in 830 thousand of the 1 million lives you could live from this point forward, you’ll be fine.” Or in plain English, “your plan will probably work.”

It’s an opinion masquerading as a fact, hiding behind a number to give it a veneer of officiality. Nothing more.

Problem #2: YOLO

Let’s take a closer look at that sentence above: “Based on our assumptions and our model, in 830 thousand of the 1 million lives you could live from this point forward, you’ll be fine.”

Notice any funny business? Well, unless you’re a cutting-edge physicist and a fan of the Many Worlds Hypothesis, you’re likely to react with something along the lines of, “But wait a minute, I’m only going to live one life…”

Law of Large Numbers

Be not afraid – we’ll keep the math to a minimum. But this concept is important. In basic terms, the Law of Large Numbers states that in any random process, as the number of trials approaches infinity, the sample mean converges to the expected result.

In layman’s terms, if you roll a die one time, you will get any of 6 results, and none of them will be 3.5. But if you roll it a zillion times, the average result will be within a hair’s breadth of 3.5.

When we apply this to our retirement success “probability” above, we see that this might be a meaningful conclusion if we actually had a million lives to live and we got to average them out. But we don’t. YOLO.

Russian Roulette

To drive the point home, if someone offers you to play Russian Roulette with one bullet in any of 6 chambers, you won’t. While on average you’ll wind up alive, somehow the average just doesn’t cut it. Same goes for your retirement.

So does this mean that because the future is uncertain, we never have enough money to guarantee a safe retirement against all possible outcomes? Yes, it does.

Does that mean we should never stop striving for more and more money as we pursue an “enough” that will never come? No, it does not.

The point is that there are certain situations in life for which the expected value is not enough information about whether to take the gamble. If the worst case scenario is unacceptable, we should be willing to walk away from the table regardless of the expected value of taking the bet.

Problem #3: Longevity

There are a lot of retirement planning tools out there that base their conclusions on an assumed age at death. Now, not many people like to think of their own mortality, but in this context it is understandable at least. If you’re saving up all this money, why wouldn’t you plan on burning it all down before the lights go out? What’s the point of dying with a pile of cash?

I’m sure plenty of you are perfectly willing to respond immediately. “What about my kids? What about the causes in which I believe?” Perfectly valid questions. Let’s leave them aside for now and return to them shortly.

Let’s assume you’re purely self-interested, with no heirs or causes about which to care. How would you feel if you planned on living until 95 and wound up living until 105?

If you planned on dying with $0 and living accordingly, this would be frankly terrifying. Ten years of being broke and bodily unable to do most productive labor are not the conditions under which I would want to ring in a new century.

Outliving Your Money

This is a real problem. As medical technology continues to advance, there is every reason to think that outliving one’s money will be an increasingly likely phenomenon as time goes on. So if we have no idea how long we will live, how can we know how much money we need to save?

Well, what if we plan on living forever?

Sounds ridiculous, right? But there is a mathematical bailout that makes this far less daunting. To live indefinitely on a certain amount of cash, you just need to ensure that your investments’ real return after taxes exceeds your expenses. So if you expect 4% real return after taxes and you have $1 million, you can spend $40k per year and be fine.

The good news is, with this plan, your favorite kids and causes will likely have the principal left over when you expire, so even by looking after yourself, you can look out for others at the same time.

Objection, Your Honor

What about sequence of returns risk? If the return is not guaranteed, then how your investments do on average might not tell the whole story of how you wind up in the long term. This is particularly true if you retire and then are immediately hit with a market crash.

“The Four Percent Rule” has gotten plenty of attention over the years, and many are quick to point out that (if it is even still valid) it’s based on a 30-year retirement, not an indefinite retirement.

Good news: the years that put you at the most significant risk of getting smoked by sequence of returns risk are exactly the same years when you’d be most willing and able to re-enter the workforce if the proverbial feces hits the fan.

What about the fact that in the long run every stock in history is likely to go to zero? Not as much of a problem if you invest in the right assets. Consider the self-cleansing aspect of index funds, for example. Stocks generally drop out of the S&P500 long before they go bankrupt.

What if we get invaded? Hit by an asteroid? Devastated by a plague? If any of these happen, you’ve got bigger problems than your 401k balance. So let’s focus on the stuff we can control, and then let the chips fall where they may.

Conclusions

It is entirely understandable that meticulous planners would want to put numbers on their plans to give them more heft and seriousness. But there are some places numbers don’t belong.

This is not a reason to give up on the exercise of retirement planning. It is a reason to be willing to think differently. As a former options trader, I love a good Monte Carlo Simulation in the right context, but using it in the context of retirement planning for an individual is like bringing a tennis racquet to a hockey game. It’s just not the tool for the job.

Yes, the future is uncertain, but that is not a reason to take your eye off the ball. The best you can do is to make assumptions about your future with a layer of conservatism to them and then read and react as you let the chips fall where they may.

4% Rule too aggressive for you? Try the 2% Rule. Either way, it’s worth considering hatching your plans in the context of living forever. No, nobody has ever lived forever (yet), but if you make it a part of your plan, living to 120 won’t put you at significant risk of outliving your money.

Accept the uncertainty in life. Embrace it. And then go back to doing the best you can with the information you’ve got. There’s no need to seek a false sense of security. Build a plan that’s sound based on the data at hand, and then be prepared for when things go off track.

When it comes to predicting the future exactly, the only thing you can know for certain is that your prediction is wrong. Don’t blind yourself with pseudoscience, just build in some conservative assumptions and then roll with the punches.

Here are three examples of things you can do to conservatize your future plans:

1. Plan on living forever – When you don’t, you’ll have money left over.

2. Plan on a lower real investment return after taxes than you think you’ll actually achieve. That will increase the likelihood of being positively surprised by what actually happens.

3. Exclude Social Security benefits when planning your financial future. This is especially important and especially doable if you’re under 40. I’m not saying you won’t in fact receive those benefits, but if they do end up in your mailbox, let them be the icing on your home-baked cake.

And while you’re at it, find a way to make saving up money something that’s fulfilling. Most of us are going to be at this for a while, we may as well enjoy the journey.

Ben Miller

Founder of ChroniFI

January 2022

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The foregoing are the opinions of the author and are for educational purposes only. They do not represent professional financial or investment advice. For financial advice, please consult a licensed financial professional.