My letter to the editor on Retirement Planning Distributions

October 11, 2006

Dear Editors of the FPA Journal,

I respect the stochastic (Monte Carlo) approach as a tool in financial planning and respect the many fine contributions over the past 13 plus years of Mr. Bengen and as the author of the article entitled “Baking a Withdrawal Plan ‘Layered Cake’ for Your Retirement Clients”. Here comes the “but” though and I mean this respectfully. Mr. William P. Bengen’s approach to a client’s retirement portfolio withdrawal rates is not like “baking a layered cake” but rather like “reaching for a pie in the sky”.

Even, Mr. Bengen, admits this when he states in one of his examples that “…an advisor who actively managed portfolios and exceeded the returns…by two full percentage points” and this over a 30-year time horizon is, in his own words in the article “…a hypothetical construct of-course.” And, again, in his conclusions states that “…any attempt to project a high degree of precision in these calculations promises more than any professional can reasonably expect to deliver”.

I agree with those statements. What is the point then of illustrating bar charts and ‘layered cakes’ with withdrawal rates to two (2) decimals? Is there a difference between a 4.15% withdrawal rate and a 4.42% withdrawal rate? Really? No, I disagree here. It is dangerous to use Monte Carlo simulations for anything more than a tool to approach a concept and very misleading to use this stochastic method as a practical solution to the problem of withdrawal rates in retirement.

Monte Carlo has several limitations that I rarely see mentioned and more so when applied to the distribution phase than to the accumulation phase of one’s life. If, for example, a client has been given an 80-95% success rate for reaching a particular number to start retirement, then overshooting the mark may not necessarily be so bad if there is balance in one’s life (lifestyle spending choices versus savings/investing). Besides, there is still retirement to enjoy some of those over-savings. However, in the distribution phase of retirement, an 80-95% success rate may mean that the client ends up with the same amount of money or even more money than they started with after the retirement period of 25-30 years. If the client wanted to be close to zero, then this is an 80-95% success rate for the planner who is managing the money but may have meant serious cutbacks in lifestyle for the retiree. This success rate is misleading at best.

Another point for all planners to keep in mind who use Monte Carlo simulations is that the input variables are themselves suspect. Returns, correlations, standard deviations, beta, interest rates and all of the other inputs are based on historical data and cannot, at this point in its development (and maybe never), be able to project how these variables will change in the future. 10,000 iterations is meaningless, too, because many of those iterations are going to provide back-to-back years of returns that are highly improbable. For example, who would expect that a client would retire and then suffer through a 1929 depression-like return, followed by a 1973-1974 recession, followed by 1982 double-digit inflation rates and another recession, followed by the 1991 recession returns and finally the wonderful 2000-2002 market experience? If the first eight years of retirement follow that iteration (and I am sure that one of the 10,000 follows something similar), then the only approach that makes practical sense is one like Mr. Evensky and his firm that recommend years of safety.

I have listened and read and studied many of these theories on how to manage a retirement portfolio during the distribution phase and am convinced that Mr. Ray Lucia, CFP® in his book, “Buckets of Money”, provides the most clear-cut, practical solution. More importantly, the client would be able to understand his concept, believe in it and therefore be more likely to implement it successfully. Rather than go into the details here I encourage FPA to research his theory and possibly present his approach in a future edition of the FPA Journal.

Following Mr. Ray Lucia’s advice rather than Mr. William Bengen’s, the planner/advisor would never have to, in Mr. Bengen’s own words in his August 2006 article, “…explain to the client that in the event of a major bear market early in retirement, Draconian measures may be required to salvage his withdrawal plan…”. No, instead, the client would be able to sleep easier at night knowing that the stock/bond portions of the portfolio had time horizons that were reasonable and appropriate and that the cash and short-term portions of the portfolio were sufficient to meet the client’s immediate income needs.

It is time to return to the needs of our clients and truly help them with a financial planning process that is not found in a “pie in the sky” but where the “rubber meets the road”.

Sincerely and respectfully
submitted,

Phil Bour, CFP®
South Riding, VA
BourGroup