Case Study Scenario

Imagine a 65 year old couple, Jack and Diane, about to retire. Like so many private healthcare professionals, they have no private pension. Jack worked outside the home for over 40 years in Canada, and Diane worked infrequently outside the home. In concert with their Advisor, they collect the following information and assumptions. Note that Jack and Diane are both 65, and will retire at the end of this year.

Combined RRSP Assets $1,000,000 Expected inflation rate 3%

The Lifespan planning horizon, also called Median Remaining Lifespan or MRL, needs some explanation. A persons MRL is the age at which the person has a 50% chance of mortality. For example, at age 65 Jack has a 50% chance of living to age 82, so his median remaining lifespan is 17 years. In contrast, at 65 Diane can expect to live over 20 more years to age 85.

For simplicity, we will assume that Jack and Diane elect to have a constant, inflation adjusted income until Dianes death, so they assume a time horizon equal to Dianes MRL of 20 years. Couples often elect to model for retirement income to drop upon the death of the first spouse, but our contrary assumption does not materially affect the conclusions of our comparison.

Traditional Approach

The traditional planning model assumes that the couple will experience 7% returns on their portfolio every year throughout retirement, with no ups or downs. This allows us to model a simple pro-forma portfolio value and cash-flow forecast for each year of retirement, as shown in the tables and charts below. These tables and charts should look familiar to those who have worked through a financial plan with one of the major investment or accounting firms.

Expected investment returns

7% per year

Lifespan planning horizon (MRL)

Age 85

Savings Expected Return Inflation Portfolio Income

$1,000,000 7% 3% $70,102

$1,000,000 $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000

$0

$140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0

End of Year Portfolio Value and Inflation Adjusted Income

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

Age

Year Age

1. 1 66

2. 2 67

3. 3 68

4. 4 69

5. 5 70

6. 6 71

7. 7 72

8. 8 73

9. 9 74

10. 10 75

11. 11 76

12. 12 77

13. 13 78

14. 14 79

15. 15 80

16. 16 81

17. 17 82

18. 18 83

19. 19 84

20. 20 85

Starting Value

$1,000,000 $994,991 $987,380 $976,919 $963,339 $946,349 $925,637 $900,866 $871,675 $837,673 $798,439 $753,524 $702,440 $644,665 $579,638 $506,754 $425,365 $334,772 $234,227 $122,925

Income Ending Value

$70,102 $994,991 $72,205 $987,380 $74,371 $976,919 $76,603 $963,339 $78,901 $946,349 $81,268 $925,637 $83,706 $900,866 $86,217 $871,675 $88,803 $837,673 $91,468 $798,439 $94,212 $753,524 $97,038 $702,440 $99,949 $644,665

$102,947 $579,638 $106,036 $506,754 $109,217 $425,365 $112,494 $334,772 $115,868 $234,227 $119,344 $122,925 $122,925 $0

Source: Butler|Philbrick & Associates

Portfolio Value

Inflation Adjusted Income

You can see that a traditional model provides for Jack and Diane to extract $70,104 from their portfolios each year, adjusted for inflation. This equates to an extraction rate of about 7% per year from the portfolio ($70,000 / $1,000,000). We will use this 7% rate in our second analysis below.

It is important to identify the salient features of the traditional plan as illustrated above. Specifically, the solution above assumes:

constant returns to the portfolio of 7% every year with no variability constant inflation of 3% a fixed lifespan of 85 years.

The use of averages in the models without accounting for the variability around the averages implies a great deal of ambiguity about the model's likelihood of success. For example, if expected average returns are to be 7% per year, by definition one must acknowledge a near 50% possibility of experiencing returns below this average, which would result in a failed retirement plan. Further, if we assume an average (median) expected lifespan of another 20 years, there is by definition a 50% chance of living beyond this age, which would again result in a failed retirement.

Actuarial Approach

Next we will contrast the results from the standard planning exercise above with an actuarial approach. Our actuarial approach allows us to tailor the model inputs in ways that account for the random nature of lifespan, inflation, and market returns.

The purpose of an actuarial approach is to tailor plans to accommodate the level of safety needed by each individual retiree. In our experience with retirees, couples are uncomfortable with the 50% chance of failure that is implied by the traditional approach above. In contrast, the actuarial model allows couples to raise their level of confidence to 80% or more.

Assumptions:

100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40%

Total Return Inflation Expected Portfolio Volatility Median Remaining Lifespan

7%

3% 13.25% 20 years

Probability of a Fully Funded Retirement at Various Income Extraction Rates 30% Bonds / 70% Stock Allocation

3.0% 3.5%

4.0% 4.5%

5.0% 5.5%

6.0% 6.5% 7.0%

7.5% 8.0%

Income Extraction Rate (Inflation adjusted)

Source: Moshe Milevsky, A Sustainable Spending Rate without Simulation, Financial Analysts Journal, 2005; Butler|Philbrick & Associates

The red bar on the chart represents the 7% portfolio income rate per the results of the traditional retirement analysis. Note the red line drawn from the red bar to the y-axis which highlights the confidence level that arises from this 7% income extraction rate. The actuarial analysis suggests that a 7% extraction rate, which equates to $70,000 income from Jacks and Dianes $1 million portfolio, has a 66% chance of success. In other words, if they choose to take $70,000 per year in income, adjusted each year for inflation, there is a 1 in 3 chance that Jack and Diane will run out of retirement savings before Diane passes away. This is an unacceptable risk for most retirees.

Probability of a Fully Funded Retirement

When we run this analysis with clients, we generally suggest that they target a confidence level somewhere between 75% and 90%. The green bar on the chart above marks a 4.5% extraction rate, which represents an 85% chance of successful retirement. Many clients feel that a confidence level of 80% to 85% offers the right mix of income for lifestyle, and safety for the future.

On Monte-Carlo Analysis

Some firms have begun to offer retirement plans based on Monte-Carlo analysis. This type of analysis enables Advisors to provide a similar confidence interval to the actuarial approach described above. A Monte-Carlo approach is substantially better than the traditional approach, because it accounts for the wide variety of possible futures by creating alternative histories from historical market data. If used properly, this approach can provide a slightly more accurate confidence interval than the actuarial approach described above.

Unfortunately, this approach is rarely used properly. Before engaging in a planning exercise that incorporates Monte-Carlo simulations, it is imperative to ask your Advisor the time period the model uses to source its data. For example, many Monte-Carlo models often use data just from the past 20 or 30 years. By using data from 1990 or 1980 on, the results will be skewed to higher returns than were experienced over longer time periods. An analysis based on this data will suggest a higher withdrawal rate than might be advisable based on data over longer time periods. This allows the Advisor to provide a more palatable answer for prospective clients, but the answer may not be in the clients long-term interests.

Conclusion and Future Applications

We have examined two different approaches to retirement planning, and demonstrated how a traditional planning model leaves unacceptable ambiguity about the likelihood of retirement success. The vast majority of financial plans delivered to Canadian clients by major wealth management, accounting and legal firms, apply the traditional approach. These plans make it simple to present clients with many pages of detailed pro-forma retirement cash-flow forecasts. Unfortunately, the traditional approach to planning is like playing Monty Halls Lets Make a Deal with your retirement dreams. These plans are very precise, but not very accurate.

We propose that retirees should demand that Advisors apply an actuarial approach to calculate their safe retirement income rate. This technique allows retirees to quantify their likelihood of success, and track their progress. Further, investors should make sure that plans account for after-tax management and/or trading fees, which might easily represent a drag of 2% or more for most investors.

It is important to note that the analysis above is not a prescription, and should not be used for planning purposes. The assumptions used are not necessarily appropriate for many investors, and each retiree will have a different mix of values, goals, risk tolerances, and financial means. Investors should consult their Advisor or contact us to discuss the creation of a customized

plan.

Future articles will discuss how introducing inexpensive simple annuities to cover non- discretionary retirement expenses can substantially enhance overall after-tax retirement income. Other topics will include investment strategies that can substantially improve retirement income potential. More information is available at our website and blog.

Read the following Case Study on a Retirement Plan and explain the various approaches for retirement. Expound on how the Monte Carlo Analysis plays a vital role in retirement planning. Use the General Instructions for Writing the Paper.