Adieu Monte Carlo

The time has come to put Monte Carlo analysis on the shelf as a retirement planning tool alongside privatizing Social Security, 8% load funds and horoscopes.  As a former advocate of stochastic modeling this is hard to admit. But when black swans become as prevalent as pigeons in Saint Mark's Square the whole notion of probability analysis as a planning tool should raise an eye brow. 

Before his conversion, a certain blogger would explain Monte Carlo by piously quoting Aristotle who allegedly said when an outcome is in doubt it makes sense to do what is most probable.  Who could argue with Alexander the Great's personal tutor?   The logic makes sense but the question to ask is what is most probable? (This assumes there is an answer.   Nassim Taleb, author of  the "The Black Swan", would scoff at the notion.)    

Whatever your philosophy, dramatic swings in portfolio values are not the low probability tail risk depicted by Monte Carlo analysis.  In fact, an objective observer might say the white-knuckle markets we've experienced going back to 1987 seem to occur with great frequency.   Accordingly, using  stochastic modeling to develop an asset allocation strategy is like using the metric system to plan a cross-country road trip. Intuitively it makes sense but it's the wrong standard to use at least when traveling in the United States.  This can lead to confusing outcomes that provide a false indication of where you actually are.  In fairness, relying on linear return projections is equally  specious.  Assuming a retirement portfolio will achieve consistent positive performance year after year is like waiting for Godot - it's not happening.  So how does this affect retirement planning?

The first step is to acknowledge that volatility is here to stay.  This can lead to the great temptation of buying several mattresses (which doesn't mean you're diversified) and learning to sleep with one eye open.   As with anything, there's risk in extremes and being fully invested in a particular asset class (or fully uninvested if there's such a thing) is imprudent for most. The key is to be honest with the amount of risk / volatility you're willing to accept.  This will help determine an allocation that's unique to your particular needs and if that includes a little mattress stuffing so be it. 

That's the easy part. The challenge is then sticking with it through regimented rebalancing, dollar cost averaging and periodic reassessment of your risk tolerance.  There are a number of quality planning tools that can help quantify your risk tolerance (just ignore the probability analysis most of them use.)   And an experienced advisor can be helpful in taking the emotion out of this process.

Retirement planning is more challenging today than it's ever been.  That's why using the right tools and measurements is imperative. Reconsidering the relevance of stochastic modeling as a retirement planning tool can be a catalyst in assessing your overall strategy. Doing so may one day get you to the real Monte Carlo.  Just remember they use the metric system in France.

Jack Daniels, Coke and Retirement

Taxes have been imbued in the American consciousness since the founding of the Republic.  In fact, taxes caused the founding of the Republic.  Ironically, many investors (and their advisors) seem unaware of how taxes are a major retirement risk along the lines of inflation and healthcare. Actually, for those in the highest brackets, taxes will be the greatest expense they have in retirement.  And with rates inevitably rising at the federal, state and local levels taxes will become problematic for virtually every retiree.

As an early advocate of Roth conversion, a certain blogger was surprised by how little of the conversion discussion focused on how to invest those assets once they were safe from the clutches of Congress.  Roth conversion presents a brave new world to retirees previously confined to municipal bonds as their sole source of tax free income.  So as a public service announcement please be advised the remainder of this post contains references to annuities that have been known to cause drowsiness due to the guarantees they provide.

On the surface, a single premium immediate annuity (SPIA) in a Roth IRA may seem as horrifying as drinking Jack Daniels with coke. But after a few sips it just might grow on you so consider the following.  Allocating a portion of a Roth IRA to an immediate annuity is a way to generate tax-free income that can't be outlived.  Add an inflation rider which most SPIAs have and you've addressed three of the biggest risks faced by any retiree: longevity, taxes and inflation.

It gets better.  Unlike a municipal bond, SPIAs are not callable and several of the insurance companies that issue them have AAA ratings (if you still believe in that sort of thing) - a nice way to diversify and upgrade the credit quality of your tax-free sources of income. This strategy should be particularly compelling if your state and city have the temerity to tax your income.  As the old Lebenthal ads used to say about municipal bonds, "It's not what you make, it's what you keep."  This is especially wise advice in an environment where low interest rates are rewarding borrowers while punishing retirees stretching for yield.  A back of the envelop example helps make the case.

A 65 year old male can generate about $600 a month by investing $100,000 in a SPIA.  That's $7,200 a year in tax-free income if the annuity is purchased with Roth assets.  For someone in a combined 50% bracket (federal, state and local) that's a taxable equivalent yield of over 14% - an intoxicating number that hasn't been seen since the Reagan administration.   It's important to note this isn't an apples to apples comparison because a portion of the SPIA payments represent a return of principal which wouldn't be taxable regardless of the source of funds. This is called the exclusion ratio.  However, upon reaching your life expectancy, all of the annuity payments would be fully taxable unless purchased with Roth assets.

Of course drinking Jack Daniels has consequences as does annuitizing Roth assets.  First, annuitization has to be right for you regardless of the type of account where the assets are held.  SPIAs also mean you hand your money over to the insurance company in return for the guaranteed paycheck.  However, many do provide some degree of flexibility in terms of returning a percentage of your investment or guaranteeing payments for a certain period of time should your demise come earlier than expected.  Naturally all this comes with a cost in the form of reduced payments.

Then there are the killjoy pundits who rail at the idea of tapping Roth assets until the apocalypse and maybe not even then. Understood, but surely the sanctity of Roth assets should be reconsidered  based on the unique needs and circumstances of the individual.  And with the inevitability of higher taxes this concept shouldn't be dismissed out of hand.  In fact, the retiree who annuitizes their Roth will have more than enough to buy a JD or two.  Just be sure to do both responsibly.

The Big Shift

It's hard to imagine but a mere ten years ago there was little discussion about retirement income planning.  The Baby Boomers were ten years younger and the stock market was rising to the point where there was serious talk about privatizing Social Security.  Home values would always increase - it was only a matter of how much - and those steady gains could be counted on to fund a secure retirement.  The focus was on making money, not making it last.

Of course those sure things proved otherwise, The Boomers aged and today it's impossible to have a conversation about retirement without addressing income.  Consider some of the newest additions to the planning lexicon; annuitization, longevity and Monte Carlo (which was once a place you might visit in retirement).  Ultimately, dream books have been replaced by a stoicism that suggests it's not going to be a walk in the park, let alone on the Riviera, for most.

Income, not age, will trigger retirement.  But in spite of the focus on income planning, many advisors and Boomers remain at a loss. That's because transitioning a nest egg into an income stream is one of the least intuitive, but most important planning steps that we must get right.  Yet this is a generation that's been admonished since childhood not to touch the piggy bank.  In addition, product solutions are complex and  in many cases advisor / client objectives are not aligned.

Adding to the challenge is the fact that retirement income planning has no clearly defined process or end point. Accumulation planning has relative structure in the form of Modern Portfolio Theory, salary deferral, contribution limits and a point in time when you will at least stop working full time.  Income planning is more like a Picasso; abstract, open to interpretation and with no clearly defined end-point.  The goal for financial services providers is to help clients make sense of what they are looking at as they gaze at the distribution phase of retirement.

Future posts will do just.