The market’s response to the coronavirus had a stark effect on portfolio values, according to Michael Finke, a professor of wealth management at The American College of Financial Services.
Less apparent, but more important, wrote Finke in a recent Advisor Perspective article, was how it reduced the probability that your financial plans will succeed in reaching your financial goals.
That’s right. You might not be able to enjoy the retirement for which you planned.
At the beginning of retirement, according to Finke, you likely have a plan to withdraw some amount of money, say $40,000 per year, from the various accounts you’ve earmarked for retirement. And on day one of retirement, a Monte Carlo simulation will assign a failure rate—the likelihood of running out of money (or desired lifestyle) in retirement.
But that failure rate, according to Finke, is “only relevant the first day of retirement.”
Monte Carlo simulations run the day after day one, and the day after that, and so on will result in different failure rates, or if you prefer probabilities of success. And if your portfolio declines, as it likely did in March, your probability of success might have fallen from, say, 95% to maybe 65%.
That decline in the probability of success is bad news for your best-laid plans. “The question,” said Finke, “you have to ask yourself is: Do you need to readjust? Is it really the 95% chance of success that matters the most? And if it does, then you're, you're probably going to have to re-adjust your lifestyle downward.”
And the most crucial point of that, said Finke, is that we have to—if we're going to invest in flexible assets like stocks that could go up or could go down—be willing to adjust our spending up and down in retirement if we want to maintain the same level of success, the probability of success in our investment portfolio.
This, Finke said, is something that you probably need to understand. “What does risk mean?” he asked. “Risk means that if you get unlucky, there's going to be a lower probability that you're actually going to be able to successfully achieve your retirement lifestyle.”
Given this, Finke suggested that those planning for or living in retirement should be running Monte Carlo simulations on their portfolios on a quarterly basis. What’s more, he said pre-retirees and retirees ought to consider matching guaranteed sources of retirement income - such as Social Security, pensions, and income annuities -- against essential and fixed expenses, and matching risky assets - like stocks - against variable expenses. “You shouldn't be funding fixed expenses with variable investment categories like stocks,” said Finke.