Probabilistic Thinking and Retirement Income Planning
The fundamental question we’re trying to answer in retirement planning is this: will the money outlive the people or will the people outlive the money? The problem is we simply won’t know for sure until the event has happened, by which time it’s too late to plan.
Canadian author Shane Parish of Farnam Street has a great new post on the value of probabilistic thinking, which is very relevant for retirement planning.
‘Probabilistic thinking is essentially trying to estimate, using some tools of math and logic, the likelihood of any specific outcome coming to pass. It is one of the best tools we have to improve the accuracy of our decisions. In a world where each moment is determined by an infinitely complex set of factors, probabilistic thinking helps us identify the most likely outcomes. When we know these our decisions can be more precise and effective.’
There many unknowns when planning for retirement. Future returns, inflation, longevity, spending needs and taxes – along with many other factors – are precisely unknown. We do have control over some things, chiefly the amount we spend/withdraw from your portfolio. Therefore, it’s important that we have a withdrawal strategy with a high probability of success.
‘Our lack of perfect information about the world gives rise to all of probability theory, and its usefulness. We know now that the future is inherently unpredictable because not all variables can be known and even the smallest error imaginable in our data very quickly throws off our predictions. The best we can do is estimate the future by generating realistic, useful probabilities.’
Without the proverbial crystal ball, it’s impossible to come up with the perfect withdrawal strategy. The future is inherently unknown, so how do we make decisions? The answer is that we think in terms of probabilities.
We can’t say with absolute certainty whether someone will run out of money in retirement. However, there’s extensive data on longevity, historical return of asset classes and inflation, which can inform us of their chances of success.
- Suppose Jane plans to withdrawal £35,000 per year (adjusted for inflation) from her £1 million portfolio for a 30-year period. How do we know if this plan is likely to work?
We can look at extensive empirical data for some insight. We know that there are 88 rolling 30-year periods between 1900 and 2017. A withdrawal of £35,000 per year from £1 million invested in 50⁄50 global equity/bond portfolio would have lasted for a full 30-year period in 70 out of those 88-rolling periods. This is a probability of 80%. That’s after accounting for a fee of 1%pa. While we can’t offer an iron-cast guarantee, we know that the odds of success in this case are good.
- But suppose James plans to take £50,000 per year (adjusted for inflation) from his £1 million portfolio, and wants to leave a legacy of £250,000 to his estate after 30 years?
Using the same data as above, the probability of success is 30%. In other words, this plan hasn’t worked in seven out of 10 historical scenarios, giving a 70% probability of failure!
Probabilistic thinking enables us to consider a wide range of plausible scenarios and establish a realistic place to start.
‘Successfully thinking in shades of probability means roughly identifying what matters, coming up with a sense of the odds, doing a check on our assumptions, and then making a decision. We can act with a higher level of certainty in complex, unpredictable situations. We can never know the future with exact precision. Probabilistic thinking is an extremely useful tool to evaluate how the world will most likely look so that we can effectively strategize.’
Making course corrections
Of course, having a good starting point isn’t enough. We’re going to need to adjust along the way. Probability of success is best viewed as probability of staying on track.
This is very important. The very essence of ongoing financial planning is that we’ll monitor the plan against reality and make course corrections along the way.
What kind of course correction might we need to make to a retirement plan and how do we know if those changes are appropriate and adequate?
This is one reason we model spending strategies in retirement. In essence, these are rules that specify how we’re going to adjust our spending under various market conditions, particularly severe ones.
We can’t plan for every possible scenario but we can consider a wide range of scenarios based on extensive empirical data of asset class returns and inflation. We can’t control inflation, but we CAN control to what extent we adjust our withdrawal for inflation. By modelling rule-based spending strategies, we can again see if they improve the probability of success. We can visualise the impact of severe market conditions on the client’s income and lifestyle. More importantly, we can prepare the client for the kind of adjustment that might be required.