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Forecast or Folly? Diving into The 4 Retirement Planning Models

Last updated 01/24/2024 • By Jason Siperstein, CFA, CFP®, RMA®

Understanding Retirement Planning

Do you ever wonder how weather forecasters predict whether it’ll be sunny or rainy tomorrow?

They use complicated models to make their best-educated guesses. And yes, sometimes they totally miss the mark, but believe or not, they actually get it right about 80% of the time. Who knew, right?!

Retirement planning can feel a lot like this. We have our own set of models to forecast the future. While no model is a crystal ball, some definitely come closer than others.

Most financial planners will lean on one of these four models, listed here in order of their popularity:

In case you are wondering…these are the non-technical terms. The actual terms are listed within each model’s explanation. Without further ado, first up, and by far the most widely adopted model, the Dice Roller.

1. The Dice Roller

Here, we consider all future possibilities and their likelihoods. Imagine forecasting weather based on every possible condition, even those we’ve never experienced before. Sounds thorough, right? However, there’s a catch…

We are not imaginative enough! Studies show that this method can heavily underestimate risk. It is like being told it’s going to be sunny out, only for it to end up pouring.

Or in terms of retirement, it might lead you to believe that your financial situation is stronger than it actually is, and no one likes negative surprises. This is the most widely used, but out of the four methods we’ll discuss, ranks as one of the least accurate.

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OUR TAKE: The proper name of this method is Traditional Monte Carlo Analysis, but ‘Dice Roller’ captures its essence, right?

2. The Always Prepared-for-Rain Pessimist

Imagine a person who always cancels outings at the slightest chance of rain. Being prepared is prudent, isn’t it?

Yet, in our overzealous quest for caution, we might forgo some delightful sunny moments.

Applied to retirement planning, this method often dampens expectations (i.e. lowers expected returns, increases future inflation, etc.), potentially causing us to overlook fulfilling experiences (because we think we can’t afford them).

However, it’s important to remember that both extreme risk-taking and excessive caution can result in unpleasant outcomes. The secret is to strike the perfect balance.

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OUR TAKE: Still not sold on exploring other strategies? Bear in mind, this seemingly safe model is widely regarded as the least reliable among the four…just when you thought you were playing it safe!

–> This method is called the Reduced Capital Market Assumptions Monte Carlo Analysis — quite a tongue twister, isn’t it? Hence, the more digestible alias, the ‘Always Prepared-for-Rain Pessimist.’

3. The History Book

It’s like predicting the weather based solely on what it was like on the same date in the past. We look back at investment performance over the decades and project that the future might behave similarly.

However, just as last year’s weather won’t guarantee tomorrow’s, this model is limited. It assumes that past trends will continue into the future, but the economic landscape is ever-changing. Just as unexpected weather events make us revise our forecasts, novel economic events compel us to reevaluate our projections.

That being said, this model still comes out ahead in terms of accuracy when compared to the previous two we’ve discussed.

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OUR TAKE: A recent case that shows the cracks in this model? Look no further than the COVID-19 pandemic. What it did to the world was something we’d never seen before – a true game changer.

–> The formal name for this approach is Historical Analysis.

4. The Weather Whisperer

When you check your weather app, the forecast for tomorrow is usually spot-on, right? But the further out we go, the fuzzier it gets. Now, imagine applying that same principle to your retirement plan.

This model, which is surprisingly underused, does exactly that. It doesn’t just gaze into the rearview mirror at what has been, or squint into the future at what could be. It also takes a good hard look at the here and now, at the current market conditions.

Just like a seasoned meteorologist who expects the temperatures to drop after a heatwave, this model knows that following periods of sky-high returns, the odds are we’re due for some lower returns. And the reverse is also true. After all, with each day that passes, we’re gathering more data. And this model believes in putting that data to work. It’s not about having a crystal ball. It’s about using all the data at our disposal to make a well-informed forecast.

This model respects the value of current information and doesn’t simply toss it aside like some of its peers might. So when it comes to retirement planning, it’s about using every bit of information we’ve got to create the most informed forecast we can. And despite its uncommon usage in practice, this model truly shines (no pun intended!) when it comes to delivering robust retirement planning insights.

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OUR TAKE: It’s got a pretty impressive name too: Regime Based Monte Carlo Analysis. How’s that for a conversation starter?

Garbage In, Garbage Out – The Role of Assumptions

At the end of the day, your retirement plan is only as good as the assumptions used. If we’re not thoughtful with our assumptions, our forecasts can end up off the mark. Considering that retirement is a one-time event (hopefully!), the importance of careful planning cannot be overstated.

Not to get too serious, but the consequences of inaccuracies or errors can be long-lasting and impactful, making it critical to devote time, effort, and expertise to ensure the accuracy of your plan’s foundations.

Retirement should be a time of joy and relaxation. By using a forecast that provides the most realistic view, you can plan for a worry-free retirement. And with the right tools and guidance, you can navigate it with confidence and peace of mind.

By Jason Siperstein, CFA, CFP®, RMA®

Jason Siperstein is a fee-only financial planner that specializes in retirement planning. He is based in Rhode Island and serves clients locally and across the country. Jason is called on by local and national news to share his insights.

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