Articles About Retirement Planning

Monte Carlo simulations are an important part of an advisor’s toolbox when constructing a client’s financial plan, as they demonstrate the wide range of potential outcomes that a retiree might experience. These simulations inform the retiree of how much they can spend in the short-term to avoid plan failure in the future, and they also suggest corrective spending levels along the way as plans get updated – an immensely difficult task given that no one knows precisely what will happen. Advisors can assess a number of important variables through Monte Carlo simulations, the most important of which is the frequency of accomplishing the client’s financial goals.

However, when constructing plans that are guided by probability-of-success outcomes, advisors walk a delicate line. Creating a plan with a 100% chance of success, for example, may assume that the retiree has no flexibility in spending and thus will not recommend spending increases… which would present a risk that the retiree may die with too much of their money remaining in the bank, having missed out on experiences, memories, and comforts they could have had. On the opposite side, creating a plan with a higher chance of failure can make clients uncomfortable, given the uncertainty of the future. Accordingly, advisors strive to find the right balance between these two scenarios, and while practices vary in the industry, many advisors tend to target a fixed threshold— say 90% – to determine whether a plan is strong enough to actually implement.

One key assumption of the 90% threshold is that clients should accept a 10% probability that they may need to course-correct at some point in the future to achieve their goals, should investment returns prove unfavorable. While a 90% success threshold might be a suitable threshold for many clients, advisors should recognize that every client has a different willingness and ability to take corrective action when needed, and perhaps a one-size-fits-all approach should be reconsidered. Some clients may prefer a plan that requires course correction 50% of the time, while others may shy away from any chance of failure at all.

Fortunately, advisors can adopt simple processes to identify appropriate (and uniquely customized!) target success thresholds for their clients. Conversations with clients about risk management can evolve, such that advisors shift away from a focus on the unpredictable movements of the market and, instead, move toward more controllable variables within a financial plan (e.g., discretionary spending categories), assessing the corrective actions that a client would be willing to take if needed. By identifying a client’s willingness and ability to modify spending, advisors can utilize a more appropriate and customized Monte Carlo success rate that reflects the client’s true tolerance for risk.

Ultimately, a client’s retirement plan will be more effective when it largely comes down to their comfort with risk, rather than the advisor’s comfort with risk. Because if the scenarios have been discussed and both parties are comfortable with the plan  – along with the adjustments that may be needed to stick to that plan – then clients will feel more confident and willing to take the necessary steps to deal with the market fluctuates in the short-term. And, of course, markets can also exceed expectations… not all adjustments need to be negative!

Read More...

Financial advisors often seek to help clients understand the range of outcomes they might experience when following a given financial plan, and frequently rely on statistical probability outcomes derived from Monte Carlo simulations to report on what outcomes the future may hold. In turn, some researchers and practitioners have suggested extending the analysis even further, by accounting for related statistics, such as Magnitude of Failure and Expected Failure, to shore up the weaknesses of Probability of Failure and further enrich the breadth of information that prospective retirees have when considering the best plan to pursue. However, a focus on ever-deepening statistics alone ignores other important aspects of how retirees perceive risk.

Peter Sandman, in his book Responding to Community Outrage: Strategies for Effective Risk Communication, suggests an updated definition of risk that includes not just an objective component – “Hazard”, which measures probability and magnitude of failure – but also a subjective component, which Sandman calls “Outrage”. In Sandman’s framework, “outrage” accounts for an individual’s emotional reaction to risk. For instance, if a plan’s Magnitude of Failure is relatively low, we may think that this will calm retirees’ fears; however, including statistics based on failure in client communications may highlight low-probability-but-catastrophic and dreaded plan outcomes that are involuntary and uncontrollable. Rather than calming fears, these factors may instead amplify outrage and, therefore, heighten the perception of risk. And because Sandman finds that outrage can weigh just as much on our evaluation of risk as the hazard itself, advisors who frame their planning process and communication to reduce their clients’ negative “outrage” emotions can potentially help clients better understand what their plan’s outcomes really mean, and make better choices.

In practice, this means moving away from outrage-inducing failure-based statistics and language, and instead counseling towards dynamic adjustments over time (e.g., spending more if they can and less if they must) as circumstances change and the risk landscape evolves. This also allows advisors to reframe retirement risk in more adjustment-based and even-less-outrageous terms that emphasize what is voluntary and controllable, with a process to manage a chronic (not catastrophic) risk, focusing more on questions like: “What would need to happen to trigger an increase or decrease in income?”, “If we find ourselves in such a situation, how large would the increase or decrease be?”, and “What would we expect a household to experience in a good/bad financial environment when following this plan?”

Ultimately, the language we use to describe risky outcomes – and the potential “outrage” it can induce – plays an essential role in the conversation around retirement risk, as much as discussing the hazards (objective risks) of retirement itself. By moving away from the concepts and language of Failure and Success, the financial advisor can lessen the emotional reaction clients may have in response to their financial plan. Similarly, when advisors present adjustments as a natural and necessary part of the plan, clients will be more likely to accept and proactively implement the changes that may be required for a successful plan outcome. By adopting Sandman’s updated definition of risk, and accounting for both objective Hazard and the more subjective Outrage components of risk, advisors may find that clients are not only more open to having conversations about their financial plans but also more willing to listen to their advisors, follow their financial plans, and make changes when action is needed!

Read More...

From time to time, individuals (typically high-income) can make after-tax contributions to traditional retirement accounts that are usually designated for pre-tax funds. No deduction is received for these contributions because the contributions have already been taxed and should not be taxed again. To avoid such double taxation, however, the after-tax contributions must be recorded properly, and those records must be adequately maintained. This is particularly important when after-tax amounts end up in Traditional IRAs.

After-tax contributions can make their way into Traditional IRAs via two separate routes, either via direct contributions of after-tax amounts or through rollovers of after-tax dollars previously held in an employer-sponsored retirement plan. Critically, while many taxpayers think that their IRA custodian is keeping track of the after-tax amounts they have in their Traditional IRA, it is, in fact, the taxpayer who is responsible for doing so. Specifically, taxpayers are required to file Form 8606, Nondeductible IRAs, to keep track of such amounts. Sometimes, for numerous reasons, taxpayers may fail to file Form 8606, which can result in basis being ‘lost’. Yet filing Form 8606 does not always capture IRA basis, as it is only required either when after-tax amounts go into the Traditional IRA (via a nondeductible contribution or a rollover of after-tax funds from employer-sponsored retirement plans) or when after-tax money is distributed from a Traditional IRA (including a Roth conversion).

Accordingly, there can be gaps between these actions with long periods of time during which Form 8606 is not required to be filed. In the interim, various events, such as changing CPAs or the death of the client, can lead to a previously filed Form 8606 being ‘forgotten’, resulting in a similar outcome to having never filed the form in the first place! One way to dramatically reduce the likelihood of properly reported basis being forgotten is by filing Form 8606 every year regardless of whether it is required. This way, a taxpayer can be sure that their cumulative IRA basis will always be available on their most recent income tax return.

In the event Form 8606 was not properly filed to begin with, basis can be reconstructed from scratch. To reconstruct nondeductible Traditional IRA contributions, taxpayers can find old Traditional IRA account statements showing contributions, past years’ Form 5498 (Individual Retirement Arrangement Contribution Information), or Form 1099-R (Quantifying And Proving Prior Years’ Nondeductible IRA Contributions) that report such amounts. Alternatively, they can also request a Wage and Income Transcript from the IRS. All of these could be used to prove that a contribution to a Traditional IRA was made. And if a contribution to a Traditional IRA was made with no deduction taken, which can be verified with copies of the relevant tax returns or by requesting Return Transcripts to the extent that such returns were otherwise unavailable, the amount is a verified nondeductible contribution!

Ultimately, the key point is that taxpayers may still be able to deduct tax-free distributions, even if they have ‘lost track’ of the basis in their Traditional IRA accounts. By turning to a multitude of resources to help identify the nature of their retirement account contributions and rollovers, financial advisors can help prevent the double taxation of after-tax contributions made to clients’ retirement accounts!

Read More...

When it comes to navigating the world and understanding our surroundings, abstraction (i.e., the process of extracting the higher-level essence of something to formulate general ideas of concepts) is very important. We are constantly formulating and updating mental maps of our world for the purpose of carrying out goals. Abstraction is particularly relevant in a field like financial planning, where we deal with abstractions that are not only more complex than simple, physical objects (e.g., a tangible concept like a chair), but also that represent concepts that are complex and abstract themselves (e.g., the concept of preparedness for retirement).

One difficulty with developing abstractions is that ‘ideal’ levels of abstraction are simply not self-evident. In one context, a ‘high-resolution’ abstraction (e.g., one with very specific information, like the scientific name for a certain species of rattlesnake, 'Crotalus atrox') may be ideal, whereas in another context a ‘low-resolution’ abstraction (e.g., a broader, less detailed description, such as ‘living organism’) may be best. Yet, in other circumstances, some middle-ground abstraction (e.g., ‘rattlesnake’) may be most useful. The level of abstraction that is ideal depends on many factors such as one’s environment, the knowledge level of those we are communicating with, and the need to convey certain pieces of information. This is why a group of advisors can communicate just fine using industry jargon, while that same industry jargon could be a barrier to communicating with a client.

Perhaps one of the best abstractions ever developed within financial planning is the Morningstar Style Box. By capturing two of the most crucial dimensions of equity returns within a single, easy-to-read graphic, the Morningstar Style Box conveys a tremendous amount of important information about a stock portfolio in a highly efficient manner. The Morningstar Style Box also has the advantage of reporting two primary dimensions, which lends itself to presentation in a two-dimensional graphic that remains easy for our brains to interpret. However, once we get out to three dimensions (and particularly four or more dimensions), the added complexity can actually diminish our understanding rather than enhance it.

Despite the success of abstractions such as the Morningstar Style Box, however, abstractions used for many other key concepts within financial planning are severely lacking. For instance, ‘probability of success’ – the primary metric used for conveying preparedness for retirement within most modern planning software – is known to have a number of issues. In particular, ‘probability of success/failure’ entirely misses the dimension of ‘magnitude of success/failure’, which is highly important for developing a rich qualitative understanding of a retiree’s plan dynamics. For instance, a plan with a high probability of failure and a low magnitude of failure is qualitatively different than a plan with a high probability of failure and a high magnitude of failure, but in a world where only ‘probability of success’ is reported, then these two plans will look identical.

Notably, the problem with many Monte Carlo-based retirement analyses is not necessarily with Monte Carlo itself, but with trying to find a better abstraction for communicating Monte Carlo results. At a minimum, an ideal abstraction likely needs to cover both relevant likelihood and magnitude of success/failure. Furthermore, an ideal abstraction should convey that success/failure themselves can be a bit inaccurate in a world where ‘adjustment’ can avoid the most extreme outcomes. And finally, we also want to consider what may even be most important to report to a client in the first place, as it is possible that Monte Carlo metrics can largely live behind the scenes while planning results can be reported in a manner that is more directly relevant to clients (e.g., How much can my portfolio go up/down before I have to make a change? How big of a change would I need to make?).

Ultimately, the key point is to simply acknowledge how financial advisors abstract results that are reported to clients matters. The ideal level of abstraction is not self-evident and varies by context, but it is quite clear that ‘probability of success’ leaves a lot to be desired. We’re still at an early stage of figuring out what those abstractions may be, and most dominant platforms currently have quite limited ability to report anything other than the focal point of ‘probability of success’. We, as advisors, should be thinking about developing better ways to communicate with clients and, if the current tools don’t provide ideal levels of abstraction, letting software providers know that we want more than ‘just’ probability of success!

Read More...

Retirement income guardrails strategies – i.e., planning strategies that predefine thresholds that would trigger an increase or decrease in retirement spending – have been noted to have some significant communication advantages for managing retirement spending expectations. For instance, an approach like Guyton-Klinger’s guardrails – perhaps the most popular guardrails strategy of all – can be presented in a manner that not only tells a client when a spending change would occur, but also how much of a spending increase or decrease would result from ‘hitting’ a guardrail. The caveat to such approaches, however, is that guardrails strategies are generally based on portfolio withdrawal rates, which can be rather crude metrics that may not capture a lot of retiree-specific nuances that could warrant the use of higher or lower guardrails in a given retiree’s situation.

By contrast, one of the most significant strengths of Monte Carlo simulations is their ability to incorporate retiree-specific nuance into a simulation. From capturing unique cash flows and goals to varying longevity assumptions and portfolio composition, Monte Carlo simulations shine in their ability to model scenarios that better reflect a given retiree’s goals and preferences in retirement. The caveat to Monte Carlo simulations, however, is that there are a number of weaknesses regarding the communication and presentation of the results these simulations provide. The common focal point for reporting Monte Carlo simulation results is the ‘probability of success’ of a plan, which is not only often misunderstood by retirees (e.g., by assuming ‘failure’ is more devastating than the ‘adjustment’ that failure scenarios actually imply), but also ignores entire dimensions of planning results (such as the magnitude of spending change) that are crucially important to setting both good short- and long-term retiree expectations regarding retirement income planning.

Fortunately, however, bringing these two approaches together can provide the best of both worlds, as ‘probability-of-success-driven guardrails’ capture both the communication advantages of the guardrails approach and the analytical advantages of Monte Carlo simulation. Essentially, an advisor would define an initial probability of success target (e.g., 95%), an upper probability of success guardrail (e.g., 99%), a lower probability of success guardrail (e.g., 70%), and some spending adjustment rule in the event that a guardrail is hit (e.g., reset to the initial target 95% probability of success). With these parameters in place, an advisor could then solve for dollar values (both portfolio levels and spending levels) that would summarize the guardrails and the changes that would occur in the event that they are hit, and then communicate that to a client, which provides information that is far more insightful to the client than merely telling them what spending level is associated with an X% probability of success.

Furthermore, while software could ideally help speed up the process for advisors and provide some more relevant long-term metrics, the most fundamental advantages of the probability-of-success-driven guardrails approach involve managing shorter-term expectations, which can be captured using even the most basic Monte Carlo simulation software and without ever needing to utter ‘probability of success’ to a client (unless the client wants the detail, of course). Additionally, advisors could easily substitute historical simulation, regime-based Monte Carlo, or other more advanced modeling methods for traditional Monte Carlo simulation at the modeling level, and still carry out the process of communicating results in a simpler and more effective manner to clients.

Ultimately, the key point is simply to acknowledge that probability-of-success-driven guardrails can bring together both the analytical advantages of Monte Carlo simulation and the communication advantages of guardrails approaches, providing advisors with an opportunity to have better conversations with clients regarding their Monte Carlo results!

Read More...

In 1999, the Social Security Administration began mailing paper copies of Social Security statements to most American workers that summarized their personalized retirement and disability benefits. While these statements were a valuable source of information for workers to understand their future benefits, budget cuts in 2011 ultimately precluded the Administration from continuing to mail paper statements to all workers. However, the Social Security Administration did make online statements available for workers who went through a simple process to establish an account. Whatever the means of access, though, the annual Social Security statement remains the most straightforward way to both know what Social Security benefits are anticipated to be in the future (at least on the worker’s current earnings trajectory), and to spot discrepancies that could be corrected to increase future benefits as well!

Given the likelihood that the Social Security Administration will continue its current practice of not mailing statements to most workers for the foreseeable future, the primary way financial advisors can help clients access their annual Social Security statements is online via a “my Social Security” account.

Once clients establish their my Social Security account and access their Social Security statements, advisors can review these statements with their clients and use them to verify the client’s reported work history, review current estimates of anticipated Social Security benefits, and explore how the benefits align to the client’s retirement income needs. (Though it is important to note that while advisors can help guide clients through the process of creating a my Social Security account (if their clients don’t have one already), they cannot create such an account for their clients, even with the client’s consent!).

Page 1 of the Social Security statement indicates that Social Security benefits are meant to be a supplementary source of income in retirement. This can be an opportune time to discuss a client’s overall sources of income, reviewing anticipated income to be provided by Social Security benefits, current retirement savings, other retirement income sources like a pension, and the potential need for guaranteed income products such as annuities.

Page 2 of the Social Security statement includes a summary of the worker’s estimated retirement, disability, family survivors, and Medicare benefits. Notably, these benefits do not adjust for inflation (i.e., they are reported in current dollars, not future dollars with projected inflation adjustments). Retirement benefit projections also generally assume that the income a worker earned last year will be how much they will continue to earn, in inflation-adjusting dollars, each year until they reach their retirement age. If there are no reported earnings from the prior year, but there are earnings from the prior-prior year, the earnings from the prior-prior year will be assumed through retirement age. Though if a worker has no earnings from either the prior year or the prior-prior year, the Social Security Administration will assume that there will be no future earnings when projecting future benefits.

Page 3 of an individual’s Social Security statement details the earnings that the Administration has on file for each year since an individual began working. Advisors should encourage clients, especially those who are long-term self-employed individuals, to carefully review the earnings history on their statements. If an error or omission is identified, the mistake should be corrected as soon as possible by providing evidence (e.g., old Form W-2s or pay stubs, and/or tax) of the under-reported income to the Social Security Administration.

Ultimately, the key point is that a client’s Social Security statement can provide an advisor with valuable information, help clients to better understand their future potential Social Security Retirement Benefits (or fix their projected benefits if historical earnings are missing!), and serve as a launching point for deeper conversations with the client to explore how they can meet their financial planning goals!

Read More...

With the rise of Monte Carlo analysis as the most commonly used method of conducting retirement projections for clients, 'probability of success' has become the focal point for communicating retirement preparedness to clients. While a number of issues with framing results around probability of success have been noted – from not accounting for the magnitude of failure, to not acknowledging that small 'adjustments' can often save a 'failing' plan, and even some biases related to how we think about 'wrong' probabilistic forecasts – there is an additional issue with the current usage of Monte Carlo analyses that has gone largely unnoticed: If you are doing ongoing planning for a client who is willing to adjust their spending, then the norms that have emerged – particularly strong negative perceptions of planning results below 70% probability of success – may not be as problematic as most advisors (and clients!) think. In fact, a 50% probability of success (or lower!) may be reasonable for retirees who are willing to make spending adjustments.

One concern when reporting Monte Carlo results to a client framed around ‘probability of success’ is that anything less than 100% can sound scary. Consider a 50% probability of success: ‘Failing’ one-out-of-two times when failure implies running out of money in retirement simply does not sound acceptable. Such a result can make clients feel that they are unprepared for retirement and that they must save even more or retire even later so that they can achieve a higher probability of success. It is important, however, to think carefully about what a 50% result actually implies. First, this metric alone actually tells us nothing about how severe 'failure' is. If 90% of a client's desired income comes from guaranteed income sources, then 'failure' is capped at a relatively modest 10% cut in a client's income, which is not ideal but far from devastating. Moreover, adjustments can often save a 'failing' plan, so simply shifting a 50% probability of success framing to a 50% probability of adjustment can take a lot of sting out of that result.

Additionally, the difference between setting spending based on a one-time projection versus ongoing projections should be acknowledged, as these two approaches are fundamentally very different. If you only had one opportunity to select a spending level and you were forced to stick with that no matter what happened in the future, then selecting a spending level with a 95% (or higher) probability of success may make a lot of sense. But the reality is that planners generally provide ongoing projections for clients, and even those who provide one-time plans will recommend periodic updates. And if a retiree is going to keep their plan up to date (which allows for opportunities to identify when a plan is veering off course and adjust as needed), then planning to a 50% probability of success (i.e., a plan that needs to be adjusted one-out-of-two times) is not nearly as scary. Furthermore, it should be noted that a 50% probability of success means adjustment at any point in time in the future, and not necessarily even an adjustment in the near future.

To examine what planning using lower probability of success levels actually looks like, we compare planning outcomes using spending levels continually adjusted to maintain a constant 95%, 70%, 50%, and 20% probability of success throughout retirement using actual historical outcomes going back to 1871. What may be surprising is that we find that median, minimum, and maximum spending levels throughout 30-year retirement periods are actually quite consistent regardless of the probability of success used! In other words, if you are going to adjust spending on an ongoing basis, then returns experienced end out being the largest factor in determining how much can be spent, with income shaded either slightly higher (lower probability of success) or lower (higher probability of success) based on the success level targeted. Where we do see larger differences (although still smaller than many might anticipate) is with respect to terminal wealth levels, which suggests that when using Monte Carlo analyses for ongoing clients, the probability of success level targeted is actually more about a trade-off between income and legacy than any genuine difference in the risk that a portfolio will be depleted.

Since our intuitions generally tell us that a 50% probability of success is insufficient, advisors may wish to further consider how Monte Carlo results are framed to clients. Presenting clients with a range of potential strategy considerations may be beneficial in helping explore what best fits a client's preferences. Furthermore, advisors should give thought specifically to what probability of success level best balances the trade-off between income and legacy for a client. Unfortunately, current planning tools do not make illustrating these types of dynamic strategies easy, but ultimately, the key point is that choosing a probability of success level to use is not as simple as being able to apply a one-size-fits-all rule or a natural tilt toward being 'conservative' for the sake of not running out of money. For those retirees who are willing and able to make needed adjustments along the way, a 50% (or lower!) probability of success may provide a better result than most advisors (and clients) realize!

Read More...