Tuesday, June 10, 2014

What Are the Odds Telling You?

How much is enough?

A big concern when starting retirement is knowing if the income goals are sustainable. This question largely depends on two factors: longevity and the amount of money available for retirement.

Assuming your planning horizon is long enough, say age 95, market returns are then the deciding factor that will determine your odds.

This is because over time the amount of money saved for retirement becomes a smaller piece of lifetime assets. As your assets grow, the amount of investment income becomes greater than the capital invested (your contributions each year toward the retirement nest egg).

Most of the investment returns depend on how capital markets perform, much less from investment manager outperformance. In other words, investment returns are mostly explained by the allocation of funds between the main asset classes.

A lot of sophisticated modelling (including our own) can help determine whether the income goals are affordable and sustainable.

Here are a few thoughts related to modelling in general.

Should we save as much as we can for retirement?

Capital markets are volatile. This means that the range of potential outcomes from any model of future investment returns will be wide.

Any realistic model is going to produce a number of disaster scenarios.  When combining a large range of possible outcomes with a reduced ability to generate more capital during retirement, we can often end up with uncomfortably high odds of running out of money early.

Planning for more savings or a lower lifestyle are foolproof ways to improve our odds.

How can I spend my last dollar on the day I die?

The range of outcomes not only include disastrous possibilities. On the flip side, there is a chance that you will reap spectacular returns over the long run.

If you experience this as you get older, you can revisit income goals and apply windfalls to improve your lifestyle going forward.

It's better to be conservative at first and increase spending later if the money is on the table than the other way around. This way you take advantage of a windfall if it occurs, and keep spending conservatively if it doesn't.

Why not take risk away and invest in GICs?

You can remove the unpredictability of returns by getting guaranteed investments returns. For example, if you invest in GICs, you will know what you can earn and your range of outcomes will be much narrower.

But your retirement plan may no longer be affordable. The magic of investing part of your assets in equities is that the portion of lifetime assets coming from investment returns greatly exceed the capital invested for retirement.

Why trust a model when the future is unpredictable?

A model shows us what might happen. We cannot predict future investment returns, but we know that annual returns will form a pattern of good and bad years.

Outcomes from a model depend on assumptions, in particular those for expected returns and volatility. Volatility is the amount of variability that can occur for each asset class and is used to reproduce the unpredictable swings in equity returns.

With these ingredients, the model will produce a  range of potential outcomes. The range can be frustratingly large, but its value lies in providing insights into the sustainability of the retirement plan.

A model will determine the odds of success and failure.

But for the model to be even more useful, we can monitor results regularly as they unfold by re-evaluating our financial position and recalculating the odds.

Monitoring the trend will give you peace of mind, so update your plan every quarter or six months and make sure the odds remain on your side.

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