Financial advisors who use Monte Carlo simulations to develop retirement income plans must be careful with the language they use to present such plans, as the same financial plan can feel very different to clients based on its framing.
This was among the takeaways of a mainstage presentation given by financial planning experts Michael Kitces and Michael Finke during the American College of Financial Services’ inaugural Horizons retirement conference in San Diego.
According to the duo, advisors should not present the simulation results to their clients without providing substantial contextualization about what the commensurate probabilities of success and failure really represent. Providing such insight might not be easy, Kitces and Finke agreed, but is well worth the effort.
People have a natural fear of destitution in retirement, so even retirement income strategies with a small probability of “failure” are often seen as unacceptable — despite being perfectly reasonable from a financial planning perspective. Clients without a working knowledge of statistical modeling may demand a plan with a 0% probability of failure, although this will likely require an unnecessarily restrictive lifestyle. In many cases, it might not actually be possible.
“I actually have completely stopped using the term ‘probability of failure’ in my client meetings,” Kitces said. “Failure in a Monte Carlo simulation does not mean what many people think it does, and it also ignores the fact that people in the real world can and do make adjustments along the way.”
The essential piece of wisdom to pass along to clients is that Monte Carlo failures aren’t plane crashes. “Failure” in this context merely means running just one dollar short of the stated income goal, and there is a big difference between going broke in retirement and having to skip out on a third or fourth overseas luxury trip during a 30-year retirement. Yet, both situations are dubbed “failures” in Monte Carlo modeling.
A better approach, according to Kitces and Finke, is to present Monte Carlo “probabilities of failure” as “chances of adjustment.”
Small Change With Big Planning Implications
It's a better framework for financial planning, Kitces explained, "because it puts the focus on what we can control. When you present a ‘chance of adjustment,’ it also opens up space for deeper planning discussions, because people naturally ask the question, ‘What kind of adjustments are we talking about?”
Here, advisors can introduce building the retirement income plan not according to strict and potentially inefficient rules of thumb but with a focus on retirement income guardrails, which allow clients to enjoy their wealth while responding to either over- or underperformance in the markets. An emphasis on adjustment is also much more true to real life, according to the duo, because people don't spend the same amount year over year adjusted for inflation.
Instead, people generally follow the retirement spending smile: They spend more early in retirement before cutting back due to aging factors and eventually spending more on end-of-life health care. As people spend more or less than anticipated, their guardrails will kick in, helping them to adjust their forward-looking spending assumptions in a way that allows them to prosper while avoiding late-in-life bankruptcy.
Using modern income planning software, advisors can go so far as to provide exact dollar figures that speak to when spending changes would have to happen — and how large they would have to be. This is much different than what a traditional Monte Carlo simulation provides, the experts noted.
Surprising Role of Optimism
During the presentation, Finke also previewed research he is preparing to publish examining the role of optimism in saving for retirement. The findings both impressed and surprised the researcher.
“We were doing a bigger survey, and I decided to include what I thought would be a throw-away question on how optimistic people felt about the future,” Finke explained. “Well, as it turns out, the respondents’ general level of optimism about the future correlated highly with their willingness to engage in positive retirement planning tasks.”
Upon further reflection, Finke said, this makes sense. Regardless of wealth level, people who believe that the future will be positive have a greater incentive to prepare financially for a longer and more fulfilling life. This makes them more willing to sacrifice today for a better tomorrow, and they are also more willing to consider purchasing things like life insurance and annuities.
“I’m looking forward to sharing our full findings, but in the meantime, I would suggest that advisors could benefit from asking their clients about their level of optimism,” Finke said. "This could help them understand their clients income planning style and product preferences."
Pictured: Michael Finke and Michael Kitces
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