Retirement Calculators: Should You Use Monte Carlo or Deterministic?
I'm a fan of using online retirement calculators to help you decide how much money you need to retire and how much to save for retirement. This post drills down on the topic of which type of calculator is best for you.
Some retirement calculators use sophisticated techniques called "Monte Carlo" forecasts, also known as "stochastic" projections. These run 500 or more simulations of the future under a variety of possible future economic scenarios regarding rates of return and inflation, and they calculate the odds of various outcomes.
After you enter such personal information as your account balances, asset allocation, expected living expenses in retirement and expected retirement age, the output might say something like this:
- Optimistic results: There's a 5 percent chance your total annual retirement income will be $75,000 or more.
- Average or median results: There's a 50 percent chance your total annual retirement income will be $55,000 or more.
- Pessimistic results: There's a 5 percent chance your total annual retirement income will be $40,000 or less.
Other calculators use much simpler projections, such as assuming single fixed rates for your asset return and inflation and a fixed number of remaining years of life. Either you input these assumptions or the program makes these assumptions for you. These are called "deterministic forecasts", since the assumptions you make determine a single projected retirement income, and that either your projected income exceeds your projected living expenses or not.
I don't prefer one type or the other. However, I strongly recommend that you fully understand how to use the specific retirement calculator that you choose, whether it's Monte Carlo or deterministic.
If you use a Monte Carlo system, focus on the results for the pessimistic scenarios, for the following reason. Suppose you withdraw from your retirement savings the amounts associated with the median or average forecast. According to the computer program, you have a 50-50 chance of outliving your retirement savings! Not good odds for such an unpleasant outcome. I'd prefer you have much lower odds of outliving your savings -- say, one out of 10. In this case, you'd need to withdraw according to a forecast that had a 90 percent success rate -- often called a 90 percent confidence level.
In addition, I believe that even the most sophisticated Monte Carlo system can't accurately predict the timing and magnitude of "rare" events such as a market meltdown. Is the chance of a future meltdown one percent, five percent, ten percent, or twenty percent? I contend that these systems can't refine the odds this accurately; instead, the best we can reliably say is that these events don't happen very often, but when they do, you-know-what hits the fan, so be prepared.
If you use a deterministic calculator, I recommend you run the projections several times, each time varying such factors as projected investment returns, projected withdrawal rates from your retirement savings, how long you expect to live, and your retirement age. Remember -- a main goal of this effort is to help you survive future downturns. This means you should project what will happen to your financial situation assuming that such downturns will occur in the future, and put strategies in place to protect you. Many smart decision-makers -- such as presidents and generals -- call this scenario-planning, and it deserves your consideration.
Very important decisions you need to make are how much money you need to retire, and how much to withdraw each year from your retirement savings. Online calculators can give you valuable insights about these decisions. However, I strongly advise that you don't make these decisions based exclusively on the median or average scenario produced by a computer forecast, for the reasons stated previously. I'd rather have sources of retirement income and investments that protect me in case we have high inflation or another meltdown, even if a computer model tells me that these events are unlikely to happen.
Have peace of mind by planning for the worst, and then enjoy life if the worst doesn't happen.
More on CBS MoneyWatch:
Saving for Retirement: Are You as Clueless as Your Fellow Americans?
How to Choose the Right Retirement Calculator for You
Why You Need to Diversify Your Retirement Income
Steve Vernon
View all articles by Steve Vernon on CBS MoneyWatch»
Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops
and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.
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