Monte Carlo Simulations: Are Your Retirement Projections Trustworthy?

Retirement planning software typically uses Monte Carlo simulations to model a range of possible future outcomes for an individual’s retirement portfolio. The core of this process is built on assumptions about investment returns and volatility. 

Here's how it works: the software begins by using a set of estimated return rates for various asset classes—stocks, bonds, cash, and other investments—based on historical performance or projected market conditions. In addition to returns, the software incorporates assumptions about volatility, or how much those returns might fluctuate over time.

With these assumptions in place, the Monte Carlo simulation generates hundreds, or even thousands, of hypothetical future scenarios, each representing a different combination of returns. These scenarios reflect the unpredictable nature of markets by including both favorable and unfavorable periods. For example, one scenario might simulate steady returns, while another might include sharp declines followed by recoveries. Each scenario creates a potential outcome for the retirement portfolio, which is then aggregated into a probability of success—essentially, the percentage of scenarios in which the portfolio meets the individual’s financial goals.

For instance, if the software runs 1,000 simulations, it will tell you how many of those resulted in a "success"—meaning the portfolio didn’t run out of money. If the probability of success is 85%, that means 850 of the simulations showed that the retirement plan would work as expected without needing adjustments. While this can provide a sense of security, it’s important to remember that these outcomes are based entirely on the return and volatility assumptions used.

If the return or volatility expectations are overly optimistic or conservative, they can skew the results, giving a false sense of security or undue pessimism. That’s why understanding the underlying assumptions of these simulations is key to interpreting the probability of success accurately. Without that knowledge, you could be placing confidence in projections that may not hold up in the real world.

Case Study of Wildly Different Results

To illustrate the significant impact that return and volatility assumptions can have, consider the following scenario:

A husband and wife, both age 62 and newly retired, are planning their financial future. One spouse has a full retirement age Social Security benefit of $3,300, and the other has a benefit of $2,000. They both plan to file for Social Security at their full retirement age. Their current monthly living expense is $8,000, which they expect to increase by 2.5% per year, and they are planning for income through age 95.

Their retirement planning software provided three different options for return assumptions:

1. Historical returns: Based on the last 50 years of historical returns and volatility.
2. JP Morgan’s forward projections: Based on JP Morgan’s projected market outlook.
3. Vanguard’s forward projections: Based on Vanguard’s forecasted returns.

By changing nothing but the future return assumptions, they saw dramatic differences in their probability of success:

• Historical returns: The probability of success was 85%.
• JP Morgan projections: The probability of success dropped to 68%.
• Vanguard projections: The probability of success plummeted to 42%.

As you can see, the same retirement plan produces vastly different outcomes based solely on the return assumptions used. This underscores the importance of understanding the assumptions behind these retirement projections. 

Relying on historical returns alone might provide a sense of security, but forward-looking assumptions—such as those from JP Morgan and Vanguard—may paint a less optimistic picture. This case study highlights the importance of scrutinizing the assumptions driving your probability of success and ensuring they align with realistic expectations for future market conditions.

In my opinion, relying solely on historical returns for retirement planning is risky and may leave you in a tough spot for several reasons. First, stock prices are at historically high valuations, which could lead to lower future returns. Additionally, slower economic growth, driven by aging populations and high debt levels, may reduce corporate earnings, further limiting stock market performance. Also, the tailwind of falling interest rates that boosted stock prices in the past is gone, and an uncertain inflationary environment could erode future returns.

So I think that using historical returns may paint an overly optimistic picture, leaving your retirement plan vulnerable to lower-than-expected returns. A more moderate approach is to use forward-looking projections, like those from JP Morgan, which are based on current market conditions and trends. While we can’t be certain that these forecasts will be accurate, they provide a more realistic and cautious outlook compared to historical averages. 

Why Honest Guidance Matters More Than Good News

Financial advisors naturally want to keep their clients happy and provide good news. After all, they’ve worked hard to earn the business and trust of each client. So, it can be difficult to risk that relationship by delivering tough news—especially when another advisor might have told the client, "You’re in great shape!" But the reality is that sometimes hard conversations are necessary.

Professional advisors who truly care about your long-term success understand that it’s better to be honest now, even if it’s uncomfortable, rather than allowing you to face potential devastation down the road. Running out of money in retirement is a reality no one wants to experience, and it’s far better to hear difficult truths and adjust your plan than to face that risk unprepared. The best advisors don’t just tell you what you want to hear—they tell you what you need to hear to protect your future.

Ultimately, it’s important not to accept Monte Carlo projections at face value. While these simulations can offer valuable insights, they are only as good as the assumptions behind them. To make truly informed decisions about your retirement plan, take the time to explore and dig deeper into the return and volatility assumptions that drive the probability of success. Understanding these underlying factors will help you assess whether the projections are realistic and whether your plan is truly built to withstand future uncertainties. Don’t rely on projections alone—ask the right questions, and ensure your retirement strategy is as strong as it appears on paper.