(This is the second article in a four-part series. Click here to read Part 1).

By:  Henry VanBuskirk, CFP®, Wealth Manager

We last left off our story with Mr. Fox understanding that the stock market doesn’t predictably earn a set 4% per year. While you may be able to predict the day that you retire, the market is indifferent to your projected retirement date and will do whatever it’s going to do in the future. We will guarantee that the market will be predictably unpredictable in the days, weeks, and months leading up to, on, and following your projected retirement date. This is Sequence of Returns risk and is the risk of simply having bad luck at the time of your retirement. After all, we’ve all heard the horror stories of friends or family that retired right when 2008 happened. If your portfolio has a large loss in the early years of your retirement, then your retirement may be less comfortable as your account balance may never fully recover. Mr. Fox understands this risk but cannot quantify it. He proceeds to ask a new advisor to the story, Ms. Sequence, to run the numbers for him.

Ms. Sequence knows that Mr. Fox isn’t trying to spend his twilight years repeating, “Welcome to Walmart”, thousands of times a day to aloof passers-by to make ends meet. Ms. Sequence also knows that assuming a return of 4% per year into perpetuity doesn’t paint an accurate financial portrait. To account for sequence of returns risk, Ms. Sequence takes Mr. Fox’s financial plan and runs two different scenarios:

Let’s assume that Mr. Fox lives to age 100 (distribution period of 20 years) and this investment return pattern repeats every 5 years. As illustrated above, both scenarios have a 4% average return. At the end of the 20 years, Scenario 1 shows an account value of $11,326 and Scenario 2 runs out of money when you are 94. Here are the numbers:

Mr. Fox reviews the two scenarios and is surprised by the huge discrepancy in his financial plan’s success rate. He is also concerned that the $80,000 per year distribution plan does not seem feasible unless the stock market starts off on a good note. After meeting with both Mr. Valuation and Ms. Sequence, Mr. Fox would feel more comfortable withdrawing $70,000 per year rather than $80,000 per year. To dive deeper into why Sequence of Returns Risk is in a category of paramount risks to consider, please feel free to watch our short video on Sequence of Returns Risk.

Mr. Fox asks Ms. Sequence, “This is amazing that you can run these different scenarios. How does your Financial Planning Software Work?”. Ms. Sequence gives Mr. Fox a blank stare and says, “I don’t know”. Mr. Fox calls a friend, but she also isn’t sure how to help him. For many people like Mr. Fox, their stories end here and are just told, “The financial planning software is always right.” I guess as long as we don’t continuously chant, “Four legs good, two legs bad” as an unconscious response, our financial advice and retirement infrastructures will be fine. After all, if you bought a Big Mac at McDonald’s and ask the franchisee what goes in it and they respond, “I don’t know.”, would you want to take a second bite?¹. It is important to know that the financial planning software is not infallible, and assumptions have to be made. Mr. Fox is curious to learn what assumptions are used in Ms. Sequence’s financial planning software and goes through his list of contacts, thinking who he should call for help. Mr. Fox decides to call his friend, C. Montgomery “Monty” Carlo, who Mr. Fox believes can help him answer his questions.

Monty is the old miserly owner of a nuclear power plant who spends most of his days tinkering with his Financial Plan on his Financial Planning Software, Krusty Co. He is too engrossed in scenarios showing a 100% success rate to learn where that 100% probability of success comes from. His only other hobby besides tweaking his own financial plan is siccing his attack hounds on strangers asking Monty for money. Monty agrees to help Mr. Fox since Monty wants to make sure he understands why his plan is always 100% successful, regardless of the various scenarios he puts into his financial plan. He calls Krusty Co. and has the following conversation to ask where the assumptions come from:

Krusty Co. Representative: “Hi, this is Waylon.  Thank you for calling Krusty Co., how can I help you?”

Monty: “Hi Waylon, my name is Monty and I have a few questions for you.”

Waylon: “How can I help you, Monty?”

Monty: “What is a Monte Carlo Simulation and how is this implemented into the Financial Planning Software?”

Waylon: “The Financial Plan uses a Monte Carlo simulation of 1,000 randomly generated market returns and volatility assumptions called trial runs and aggregates these trial runs into a percentage probability of success.”

Monty: “So since the scenarios are random and do not incorporate current stock market valuations, the Financial Planning Software does not factor in whether or not the stock market is in a bull or bear market at the time of the trial?”

Waylon: “Correct. This is an assumption we have to use. Financial Planning Software is not robust enough to also factor in current market valuations on top of generating a Monte Carlo simulation for a Financial Plan.”

Monty: [To himself: This is nice to know, but I want to make sure my plan is bulletproof] “I use Standard Deviation to gauge portfolio risk. Is there an issue with relying on Standard Deviation to gauge portfolio risk?”

Waylon: “Yes. Sequence of Returns risk addresses a very real concern.  Standard Deviation at the tails (very high unexpected returns or very low unexpected returns) is not factored into a Monte Carlo simulation because the number of trials we would need to run is much too high, and the program is not robust enough to do this. We believe that 1,000 trials are sufficient. Enough trials where we get a satisfactory result without needing to take an hour to run each scenario.”

Monty: “The last question that I have is I have some Series I bonds that I bought this year and as you know they are only taxed at the federal level and not at the state level. I live in a state that has a state income tax². I’m likely to move to Florida where there is no state income tax, but I would like to understand the tax implications on the Series I bonds if I don’t move. How would I model this into the program?”

Waylon: “There currently isn’t a way to model this in. It would be best to assume that the bond is also taxable at the state level so that your financial plan is more conservative than it actually is.”

Monty: [To himself: In reality, I would not need to pay as much in taxes over my life than what the financial plan is projecting if I don’t move to Florida, but I like the conservative approach to this workaround]. “Those are all of the questions that I had. Thank you, Waylon, for your time.”

Waylon: “You are welcome, Monty. Have a good day.”

Monty: “Thank you. You as well.”

After hanging up the phone, Monty then strangely mumbles “Excellent” to himself in a Machiavellian tone, delighted to get answers to his questions. The next day, Monty proceeds to call Mr. Fox to discuss the conversation that Monty and Waylon had about the Financial Planning Software assumptions. Mr. Fox thanks him for the information and then mentions the phrase “Roth Conversion” to Monty. Mr. Fox says that it’s a way to take money from your IRA, pay taxes, and then convert that amount into a Roth IRA. As long as you are over age 59.5 and wait 5 years before taking money from the Roth IRA, distributions are tax-free. Monty appreciates the information but mentions he only has $10,000 in an IRA and doesn’t see the benefit of converting his IRA since Monty’s net worth is $100,000,000 and Monty only spends $5,000 per month. Monty and Mr. Fox then end their phone conversation. Unbeknownst to Monty, his janitor, Mr. Hill, was in the room and heard the full conversation and thought a Roth Conversion might be a good idea for his parents. Mr. Hill decides to discuss this when he goes to visit his parents in Texas next week, which is when we will pick this story back up.

Footnotes:

1. Snowball is not an ingredient in a Big Mac and Napoleon is not the CEO of McDonald’s. Big Macs use 100% all-beef patties. Snowball was last seen on Foxwood Farm (or was it Pinchfield farm? I can’t remember). Napoleon was last seen in the Bahamas fighting extradition to the United States for his (alleged) multi-billion-dollar fraud scheme through his now-bankrupt cryptocurrency exchange, Windmill.
2. We know that Monty currently lives in Springfield, but we do not know exactly which Springfield it is since Monty is a very private person.  All we know is that it is a Springfield in a state with state income tax.

Disclosures:

Past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk.  Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Benefit Financial Services Group [“BFSG”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  BFSG is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.bfsg.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.