Often the best part of Super Bowls are the commercials, especially when there is a blowout (and, I must admit, when Tom Brady isn’t the one blowing out). I must say I was underwhelmed by most of this year’s commercials, even though I found the game itself one of the most satisfying blowouts I can remember!
The primary exception to that this year were the Rocket Mortgage commercials with Tracy Morgan. It turns out that “certain is better” in situations other than procuring a mortgage. For example, I believe it would be undisputed that certain is better than “pretty sure” when dealing with retirement planning as well.
Why, then, is retirement planning almost always focused on “pretty sure”? Perhaps it was designed that way?
For example, the primary income planning approach used by the vast majority of “financialplanners” (read: asset managers), is the quintessential “pretty sure” approach, Monte Carlo planning. Monte Carlo Planning was developed in the 1940s during the Manhattan Project. It consists of setting up a series of conditions, running a thousand iterations of an experiment (all exactly the same), and kicking out a probability from which, under whatever circumstances are being tested, various different outcomes can be measured and predicted.
This method is extraordinarily accurate when all the inputs can be controlled and measured, for example in nuclear physics. In this arena, it’s possible to precisely measure all of the inputs and controls to determine how each impacts the outcome by changing each one individually. It really is a precise way to measure and predict the behavior of various substances under specific conditions.
Now, imagine trying to do the same thing but without tracking the inputs and controls for each iteration. One experiment might contain certain gases and other materials; another may not; yet another might be performed under different temperatures, while another could be bombarded by different types of radiation.
I am sure you see the problem: Without knowing exactly how conditions for each experiment are changed, you will never be able to determine what caused any changes, nor predict what theoutcomes will be.
So why would you use this method to try to predict a financial outcome when you have no idea at allwhat the various inputs will be? How can you possibly predict an outcome if you don’t know whatinterest rates or the rate of inflation are? Or whether the stock market is up or down, and the timing of each? Or whether you will need to pay for long-term care or not? Or when you will die, or when your spouse will die?
It’s simple. You can’t.
For years now, Monte Carlo Planning has been predicting a 90% chance of success, meaning not running out of money over a 30-year retirement lifetime if you limited your annual spend to 4% plus an annual inflation adjustment of 3%. Over the years, billions of Monte Carlo runs have borne this out. Until they didn’t, that is.
That occurred during the first decade of the 2000s, when the stock market crashed by over 40%twice in a single decade. T. Rowe Price and Morningstar, both Wall Street stalwarts, ran studies that determined that utilizing the 4% Rule during that period would have resulted in failure more than 90% of the time. In fact, both studies concluded that to achieve a 90% confidence level, you must limit beginning withdrawals to under 3%. And even then. you can’t be certain. Even then, you can only be “pretty sure.”
The reason is, you never know what the landscape is going to be. Will we have another meltdown? You can be certain of it. But when? How frequently? And how severe? You can’t possibly know. How long will it take to recover? Again, no way to tell. And even if the market does recover within a reasonable amount of time, how do you know if you will have the discipline to stay invested? Again, no way to tell.
Are there ways to move from pretty sure to certain? I am quite certain there are. You begin by focusing on the desired outcomes rather than the inputs. For example, let’s assume you want to kick up your annual contributions by 10% because your adviser recommended it. Did she also give you an idea of what your potential outcome would be? Probably not, because it’s unknown.
For example, you could bump your contributions by 10%, and then Congress could raise taxes by 10%. How would that play out? Or you could find the market declining by 50% and taking years to recover, as it did in the Great Depression and again in the 2000s. How will that impact future income?
Here’s a simple calculation. Assume you have projected you will have $600,000 socked away in 10 years when you retire, but you already know you will need about $22,000 in retirement income overyour Social Security to make ends meet. If you go by the 3% Rule, you can determine the amount you are likely to need by dividing $22,000 by .03 = $733,333. So, you decide to bump your contributions by 10% and hope for a favorable rate of return.
Is there a better way? Here’s an idea. Instead of working with increased contributions and hoping for favorable rates of return, which are iffy at best, why not start paying the taxes when you put the money away rather than when you take it out? After a quick calculation, I estimated that, based on an annual growth rate of around 6%, every dollar saved over a 30-year working lifetime will generate around $15 in lifetime income over a 30-year retirement.
If you take a tax deferral when you initially contribute, such as in a 401(k) or IRA, every one of those $15 will be taxed. However, if you pay the taxes when you contribute, every one of those dollars will be tax-free, thereby increasing your net income by 10% to 20% in retirement. So if you are in the 10% to 15% effective tax rate, which most people are, paying your taxes now would require anincrease of around 10%, but the outcome would be far more likely what you are looking for than simply bumping your contributions by that amount.
Of that, I am certain.
Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, N.H., he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die and I’ll Tell You How Well You Can Live,” which deals with the problem that unknown life spans create for retirement planning. It and his other books are available on Amazon.com. His radio program, “The Free Money Guys,” can be heard every Sunday at noon on WCAP. He also conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach him at 603-881-8811 or at www.FreeToRetireRadio.com.