Should You use a Dynamic Process with Guardrails to Keep Spending on Track in Retirement? Yes, But Not with a Monte Carlo Model Typically Used by Financial Advisors

This post is a follow-up to our post of March 7, 2021
and several other of our posts and articles noting that a model like
the Actuarial Financial Planner (AFP) is a better model to use when
employing a dynamic process to keep spending on track during
retirement. In his December 11, 2024 Kitces.com article, Justin Fitzpatrick of Income Lab, says“CMAs
[Capital Market Assumptions], even perfectly accurate ones, can’t
predict exactly how much someone will be able to spend in retirement.
But clients still want answers to the basic question, “How much can I afford to spend?”
The key to addressing this dilemma is to recognize that retirement
income planning doesn’t require a one-time-only ‘set it and forget it’
decision. Instead, the ongoing process of guiding someone through
retirement involves revisiting this question as the years – and even
decades – progress.When we structure retirement planning as
ongoing guidance, assuming that clients are willing and able to make
adjustments, the predictive weakness of CMAs becomes less problematic.
Structuring retirement income planning in this way involves the
following steps [Process]:Build a full picture of client resources, needs, and preferences.Using
a reasonable model of the world, including CMAs, estimate a range of
spending levels that may be possible for the client(s) today.Find
an optimal spending level within this range that aligns with client
risk preferences, balancing their ability and willingness to take on the
risk of future cuts in income with their desire to spend and live life
well. This becomes the answer to the question, “How much can I spend?”
Advisors who are especially concerned that their return assumptions may
be too high can target a spending level with a lower risk of
overspending.Set ‘guardrails’ to signal when clients can spend more (because their risk of underspendingis too high) or less (because their risk of overspending is too high). These guardrails will address the question, “Should I adjust my plan?”Update
and monitor the plan regularly and adjust spending or other parts of
the plan as needed to keep risk in a reasonable range.”https://www.kitces.com/blog/retirement-planning-right-capital-market-assumptions-cma-spending-limit-variables-advisor-behavior-client-needs/We
agree with Mr. Fitzpatrick that good financial planning in retirement
typically doesn’t involve a one-time only set-it-and-forget it decision,
and it is important to establish an ongoing planning process to keep
household spending on track. We note that Mr. Fitpatrick’s suggested
ongoing planning process steps outlined above are essentially the same
as the seven-step process we advocate in our website. Simple “3M” Process for planning in retirement. The gist of our recommended process can more simply be described using the following 3Ms:Measure
your funded status (ratio of the present value of household assets to
the present value of household spending liabilities) using reasonable
static assumptions about the future and granular expectations of future
spending (recurring and non-recurring)Monitor your funded status from year to year to observe the trend, andMake
adjustments in your household assets or spending liabilities whenever
your Funded Status falls outside a reasonable range (guardrails)Why
the Actuarial Approach is superior to Monte Carlo models typically used
by financial advisors for ongoing planning in retirementMost
Monte Carlo models in use today determine the probability that a
household can spend $X per year (real dollars) for the expected lifetime
of the household based on stochastic assumptions about the future
(including assumptions about returns and standard deviations associated
with certain asset classes). Unfortunately, most households don’t spend X
real dollars every year. Most households have many non-recurring
expenses that they will incur over their retirement period. Unlike
typical Monte Carlo models, the Actuarial Financial Planner (AFP) can
accommodate most of the granular aspects of retirement spending
including:non-recurring expenses like cars, home-remodeling
projects, long-term care expenses, temporary support payments for
children, vacations for a limited period of years, etc.classification of essential expenses vs. discretionary expensesdifferent rates of future increases for different types of expenses, andreduction in expenses upon the first death within the householdIt
is this granularity that makes the AFP a superior tool for use in the
dynamic process anticipated by Mr. Fitzpatrick and the process we
advocate. The ability of Monte Carlo modeling to provide probabilities
of success through the use of stochastic assumptions has more value for
clients and households who prefer the static set-it-and-forget it
approach or who are looking to select a desired asset mix. It does not
provide as much value when used as part of a dynamic process. This is
why most actuaries (like Social Security actuaries and pension plan
actuaries) use models employing static assumptions like the AFP model in
their dynamic processes. ConclusionIf
you think it is important to make adjustments in retirement to avoid
underspending or overspending, then we advocate the “3M” process
outlined above using the Actuarial Financial Planner (AFP) model
available for free in our website.