Why Annuity Products that at Provide Guaranteed Lifetime Income Offer Better Retirement Solutions Than Taxable Bonds.
Higher pre-tax yields, reduced investment risk, longevity benefits, and after-tax benefits around an institutionally managed investment grade bond portfolio make these products hard to beat as retirement planning tools
In this post, I’m going to go over a case study that shows how a couple saving for retirement was able to increase their chance of meeting their retirement income needs from 56% to 74% and the amount of after-tax wealth they left to their beneficiaries almost 5 times from $1.5 million to $7.1M by using a guaranteed lifetime income annuity in place of a taxable bond fund in retirement.
Using a guaranteed lifetime income annuity in place of a taxable bond portfolio can improve client’s ability to meet their retirement spending goals while also significantly increasing the amount of wealth they leave to their beneficiaries |
Case Study: 55 Year Old Working Couple Wanting to Retire at Age 65
Let’s meet the couple for our case study.
John and Sally are both aged 55 and live in California—which has high state income taxes. Their combined household income from their salaried W2 income jobs is $500k. Their investment portfolio is at $3 million and is 60% allocated to stocks and 40% to bonds (60/40 portfolio).
They want to retire at age 65 and draw $250k/year in their first year in retirement and increase that amount by 2% every year to meet inflation.
What is their current chance of meeting their desired retirement income goals with their current allocation?
We can do a Monte Carlo simulation and determine the answer to that.
The graphic below summarizes John and Sally’s chances of meeting their retirement goals as well as the expected after-tax wealth they will have at age 95 with their current portfolio—which doesn’t use a guaranteed lifetime income annuity.
If John and Sally keep their current allocation, they only have a 56% chance of meeting their retirement income goals and will only have $1.5 million in after-tax wealth at age 95 |
As we can see from the above graphic, the client only has a 56% chance of meeting their retirement income needs with their current 60/40 portfolio and they only have about $1.5M in after-wealth at age 95 to pass on to their beneficiaries (or spend down in their later years).
Well what if they took the bond portion of their portfolio and instead invested in a guaranteed lifetime income product?
In other words, imagine that instead of investing $1.2 million in a bond fund, John and Sally used that amount to purchase a guaranteed lifetime income annuity that paid them $181,867 per year starting at age 65 for the rest of their life?
What would their chance of meeting their retirement income needs looks like then?
The graphic below helps us answer that question.
By taking a part or all of a client’s bond portfolio and using it to purchase a guaranteed lifetime income annuity, clients can withdraw more income in retirement and create more after-tax wealth for them and their beneficiaries |
By replacing the bond part of their portfolio with a guaranteed lifetime income annuity, the couple is able to increase their chance of meeting their retirement income goals to 74% and increase the aftertax wealth they have at age 95 by almost 5 times to $7.1 million. |
The above graphic helps illustrate two key conclusions:
1.Using a guaranteed lifetime income annuity in place of a taxable bond fund increases the chance that John and Sally can meet their income needs in retirement
By replacing the taxable bond fund portion of their portfolio with a guaranteed lifetime income annuity, John and Sally are able to increase their chance of meeting their retirement income needs from 56% to 74%.
2. John and Sally create more after-tax wealth using the guaranteed lifetime income annuity in place of the taxable bond fund
By replacing the bond portion of the portfolio with a guaranteed lifetime income annuity, the expected after-tax wealth John and Sally are expected to have at age95 is $7.1 million. This is a nearly 5 times increase over the $1.5 million they would be expected to have at age 95 if they just used a taxable bond fund.
In the next section we’ll cover what makes a guaranteed lifetime income product such a great fit for John and Sally’s retirement goals.
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What Type of Clients Are the Best Fit for Guaranteed Lifetime Income Products?
So what type of clients are the best fit for guaranteed lifetime income products and why is this such a great fit for John and Sally?
Clients that meet one or more of the following criteria are the best fit for these products:
- Clients that are in their 50s to 60s and 0-15 years away from retirement
- Clients that are investing in bond funds as part of their retirement plan
- Clients that need income in retirement
- Clients that are in a high tax-bracket while working, but will be in a lower tax bracket when they retire
- Clients that are in great health/wealthy
- Clients that elect to start annuitizing the rider instead of paying for it and not using it
Let’s explore each of this one by one:
1. Clients that are in their 50s to 60s and 0-15 years away from retirement
Guaranteed lifetime income products are first and foremost a retirement planning tool. They take part of your portfolio and guarantee an income stream for the rest of your life. The more of your portfolio you use, the higher this guaranteed income amount is.
So they are best for clients who are nearing retirement or already in retirement. Your payout rates are better if you defer the income for a number of years so it’s better to acquire these products a number of years before you retire (plus you’ll be deferring the taxes that you would be paying on the bond part of your portfolio by doing so).
Is the optimal time to defer 5 years or 10 years?
Well that depends on your age and the product. You have to test these out and determine both the optimal IRR and the optimal benefit for your portfolio. This is where the expertise of a financial planner comes in handy. They can help you determine what the best outcome is for you in terms of deferring the income. At Guaranteed Annuity Experts, we can help you determine this as well through the use of our own proprietary financial planning tools.
This is something that John and Sally need to determine prior to purchasing the guaranteed lifetime income annuity.
2. Clients that are investing in bond funds as part of their retirement plan
When you invest in a guaranteed lifetime income product you are essentially investing in the long-term bond portfolio of an insurance company. You’re just doing it in a more tax-efficient and risk-adjusted way.
Almost all retirement plans utilize bond funds as part of their strategy and typically increase the allocation to these bond funds as clients get closer to retirement (e.g. target date funds).
If you are saving for retirement and have a retirement fund or target date fund and you look at your investment allocations, you’ll see that a significant portion of your portfolio is in bonds already.
John and Sally for example have 40% of their investment portfolio in a bond fund. So these are the assets that would be used to purchase the guaranteed lifetime income annuity.
Remember that John and Sally are not using the equity side of the portfolio to purchase the guaranteed lifetime income annuity. By purchasing the guaranteed lifetime income annuity from the bond side of the portfolio, this allows the equity side of the portfolio to continue to grow and compound as we’ll talk about later.
3. Clients that need income in retirement
Similar to our previous point, not all clients need income in retirement. Some have enough wealth to draw down on that they are just looking for tax-efficient ways to pass down wealth to the next generation. If this is you, then guaranteed lifetime income products might not be the best fit for you.
However most people don’t have this type of wealth and need some level of income to meet their ongoing expenses in retirement. This is where a product like a guaranteed lifetime income annuity can make the most sense.
In this case, John and Sally need $250k/year in retirement and that amount will increase by 2% every year. So finding a guaranteed lifetime income annuity that will help meet this future liability is extremely valuable for them.
4. Clients that are in a high tax-bracket while working, but will be in a lower tax bracket in retirement
One of the key benefits of a guaranteed lifetime income annuity product is that it allows you to essentially defer the income on the taxes from your bond fund when you are in a high tax bracket during your working years until you are in a lower tax bracket in retirement.
Most Americans fit this criteria.
In our case, John and Sally’s tax bracket for the bond portion of their portfolio will drop from 44% while their working to 18% in retirement.
So the ability to defer these taxes from when they are working and in a high tax bracket to when they are retired and in a low tax bracket is extremely valuable for them.
5. Clients that are in great health/wealthy
Another key benefit of a guaranteed lifetime income product is that it is not underwritten. That means everyone who buys the product gets the same benefit—regardless of their health. This means that those who are in great health—or wealthy clients who have better access to healthcare—are benefitting at the expense of those who purchase the product and are in poor health or have limited access to good healthcare.
Both John and Sally are in good health and have amassed a decent amount of wealth. This will help ensure that they get great healthcare as they age which increases the chance that they live a long time and get the highest returns from the guaranteed lifetime income annuity.
But remember that even if John and Sally weren’t in great health, the guaranteed lifetime income annuity would still be a great fit for them over investing in taxable bonds. As we showed earlier, in order for the guaranteed lifetime income product to outperform the taxable bond portfolio, one of them has to live to at least 78.
There is only a 2% chance that doesn’t happen at their current health. So even at a much worse health status, the chance of them both dying before age 78 would be still very low.
6. Clients that elect to start annuitizing the rider instead of paying for it and not using it
The best guaranteed lifetime income products are typically fixed indexed annuity products in which you have to pay an optional fee for the guaranteed income benefit.
Why is it better to buy products with an optional fee?
Because not everyone who pays for the fee ends up actually using the benefit.
This makes it cheaper for those who do use it.
Here’s a quick analogy to help you understand it better:
Assume I’m a fitness gym owner and it costs me $10/member to run the gym assuming every member who buys a membership comes to the gym.
But if only half the people who buy a membership come to the gym, then I’ve just cut my costs from $10/member to $5/member.
So the reason why your gym membership is so cheap is due to all the people who signed up for it and are paying the ongoing fee every month but never go.
If they all decided to start going to the gym, then the cost of your gym membership would be a lot higher.
The same is true with these guaranteed lifetime income products. You want to purchase a product in which everyone pays into the system for the feature, but not everyone actually uses it.
This is what allows you to get the highest benefit from the product.
So for John and Sally they have to buy a product with an optional fee to pay for the guaranteed income benefit AND they have to remember to actually turn on the guaranteed income feature years down the line when they need it.
This will set them apart from the many people who will purchase the optional benefit but never actually turn on the guaranteed income benefit.
7. Clients that use their guaranteed lifetime income product in retirement and let their equity portfolio grow
While remembering to turn on the guaranteed lifetime income rider is extremely important as we detailed previously, it’s also important to use the product properly in combination with a financial plan.
In other words, by drawing income primarily from the GLI side of the portfolio—and only withdrawing from the equity portfolio to meet any deficits in spending needs, the equity portfolio is allowed to compound more over time.
This allows the portfolio to compound to a greater extent than a 60/40 portfolio that is rebalanced every year to maintain the 60% stock allocation.
By allowing the equity side of the portfolio to grow over time to greater than 60% of the portfolio, John and Sally have significantly greater wealth in their later years of retirement than they do if they just rebalance every year and maintain the 60% Stock/40% Bond allocation.
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Book A CallWhy Do Clients Have Better Retirement Outcomes by Using Guaranteed Lifetime Income Annuities in Place of Their Taxable Bond Portfolio?
So now let’s explore the technical reasons behind why using a guaranteed lifetime income annuity in place of taxable bonds is so advantageous.
When a client invests in an annuity product, they are essentially investing in the investment grade long-term bond portfolio of the insurance company with a number of benefits that they couldn’t acquire elsewhere:
- Higher Pre-Tax Yields
- Guarantee against Loss
- Lower Tax Liability
- More Growth in Equity Portfolio
- Arbitrage Benefits that Come from Risk-Pooling
Most high income clients are phased out of contributing to retirement plans that would provide them access to tax-free or tax-deferred investing in bonds. By using life insurance and annuity products, these clients get access to tax-free and tax-deferred bonds with the following collection of benefits that would be difficult to find elsewhere: higher pre-tax yields, guarantees against loss, lower tax liability, more growth in the equity portfolio, and the ability to get arbitrage benefits that come from riskpooling. |
The table below provides a quick summary on the reasons why life insurance products and GLI annuities are better retirement planning tools than taxable bonds.
Life insurance and annuity products like GLI annuities can provide higher pre-tax yields, lower risk, lower tax liability, more growth in the equity portfolio, and arbitrage benefits than they can get from taxable bond funds. |
In the next section we’ll go over each of these points in greater detail:
1. Higher Pre-tax Yields
Instead of investing in a lower earning short or intermediate term bond portfolio like they would
in a taxable account to avoid risk, clients investing in a bond fund through life insurance and annuity
products get access to a higher earning long-term bond portfolio.
On top of that, because of the return of principal and risk-pooling benefits (which we’ll discuss in
future points), the pre-tax yields of the GLI annuity is significantly higher than either the shorter-term
bond (10 Year High Quality Corporate Bond) or the longer-term bond (30 Year High Quality Corporate
Bond)
The GLI annuity provides clients access to a higher earning long-term bond portfolio in combination with return of principal and risk-pooling benefits that provide significantly higher pre-tax yields to bond investors than they could get elsewhere. |
For John and Sally this extra yield provides them with more income to help them meet their retirement needs and therefore increases their overall chances of being able to safely withdraw the $250k/year in retirement to meet their retirement spending needs.
2. Guarantee Against Loss:
Insurance companies protect client bond portfolios from interest rate risk and credit and default risk in exchange for a share of the long-term bond interest their portfolio is earning. These insurance companies have billions of dollars in reserves and surplus backing their guarantees as well as heavy regulation from the government to ensure that they fulfill their obligations.
This contrasts to taxable bond portfolios where there is no such protection for investors who invest in bond portfolios outside of an insurance company.
In other words, clients are getting a significantly better risk-adjusted return by investing in a bond fund through an insurance company than through a taxable account.
By protecting clients against these risks, there is less of a chance that a crash in the market depletes their portfolio to such an extent that it never has time to recover.
Let’s take a look at a quick example. Let’s say John and Sally can choose between a 10 year bond earning 4.75% or a 30 year bond earning 5.19%.
While the 30 year bond is higher earning, it also poses more risk.
If John and Sally chose the 30 year bond and interest rates rose by 1%, then they would lose 16% of their investment.
On the other hand, if John and Sally choose the short-term bond, then if interest rates rise by 1% they would only lose 8% of their investment.
So the short-term bond has a lower yield, but also lower risk.
The long-term bond has a higher yield, but also higher risk.
Which one should John and Sally choose?
The choice between investing in shorter term bonds versus longer term bonds is one of return versus risk. Those seeking higher returns will invest in a portfolio that is heavier on the longer term bonds while those who want more safety will choose the shorter-term bond. Most retirement portfolios invest in primarily shorter/intermediate term bonds to avoid this risk posed by bonds if interest rates rise.. |
The choice really becomes one about risk tolerance and risk-adjusted return.
It’s worth noting that most retirement funds invest heavily in the shorter and intermediate term bonds to avoid this interest rate risk problem that bonds are exposed to when interest rates rise.
By investing in a bond fund through the insurance company via an annuity, the insurance company is giving the client the best of both worlds: higher returns than the shorter term bonds would provide and less risk than the longer term bonds would provide.
In other words, the annuity is helping the client maximize the risk-adjusted return here on the bond side of the client’s portfolio.
What the insurance company does when they provide John and Sally an annuity is that they are essentially providing a guaranteed return that is in the middle of the intermediate-term bond and long-term bond yields while protecting clients from the interest rate risk.
So in the example above, let’s assume the insurance company provides John and Sally a guaranteed return of 5% with protection against interest rate risk if interest rates rise.
What the insurance company does is invest John and Sally’s money in the long-term bond earning 5.19% and keeps 0.19% as a spread for taking all the interest rate risk.
That way John and Sally get a higher return than they would if they invested in the shorter-term bond fund without any of the interest rate risk that puts their investment at risk of a loss.
So John and Sally are getting higher returns and lower risk by investing in a bond fund through the annuity product than if they were to invest in a shorter term bond in a taxable account.
In the above graphic we see that instead of the client investing in either the 10 year High Quality Corporate Bond earning 4.76%, the insurance company provides the client access to a higher 5% Pre-Tax yield without exposing the client to any interest rate risk and keeps the 0.19% spread for itself.
However, the GLI annuity yield is actually much higher than this 5% yield due to the return of principal feature and risk pooling benefits of the GLI annuity that we’ll be talking about in later points.
This higher risk-adjusted return contributes to John and Sally’s chances of meeting their retirement spending needs increasing from 56% to 74% by using a guaranteed lifetime income annuity product instead of a taxable bond fund.
The guarantees and protections the insurance company is providing directly increases John and Sally’s ability to meet their retirement income goals.
They cannot get these same guarantees and protections and reduced investment risk from investing directly in a taxable bond fund.
3. Lower Tax Liability
Bond coupons are highly taxable. This is a problem for high income clients who are shifting their assets from tax-efficient, but riskier stocks to safer, but tax-inefficient, bonds in their high earning years prior to retirement. Annuity products like guaranteed lifetime income annuities allow these clients the ability to defer the taxation on these bonds until they are in retirement and in a lower tax-bracket. This is not possible if these clients were to invest in taxable bond funds directly.
Since John and Sally make $500k/year and live in California, they would lose 44% of their bond gains while they are working if they were investing in a bond fund while they are working. By deferring their gains until retirement when they have no income, they are essentially replacing a 44% tax-rate on their bond gain while working to a 7% tax-rate while in retirement assuming no other income. Note that in our modeling of this case study we assumed an 18% tax rate in retirement due to assuming John and Sally had additional income.
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Book A CallDeferring income until retirement can increase after-tax income on bond gains by 60%+
While John and Sally are working, their $500k household income puts them in a high tax bracket—especially since they live in California which has high state income taxes. Simply by deferring their taxation on their bond gains until retirement when they have no W2 income—they can reduce the tax rate they pay on these bond gains to less than 7%–assuming they have no other taxable income coming in.
Another problem of investing in bonds is that you have to wait until the end of the term to get your principal back.
For example, if John and Sally invest $1,000 in a 20 year bond earning 4%, they would only get $40/year in income (that is fully taxable) until the end of year 20 when they would get their original $1,000 back.
However, with an annuity the insurance company returns part of the principal each year so that John and Sally don’t have to wait all the way until the end of the term to get their original $1,000 back.
For example, let’s assume John and Sally were to invest in that same 4% bond except instead of waiting until the end to get the $1,000 principal back, they would get $50 of their principal back each year for 20 years ($50*20=$1,000).
That means in addition to the $40 of taxable income they would get from the bond they would get $50 back of their own principal which isn’t taxable (since they are just getting their own money returned to them).
So when we look at what John and Sally would be getting each year in after-tax income for the first 20 years from the bond that only returns the principal at the end of 20 years versus the one that returns a little bit of the principal each year, we can see that the one that returns a little of the principal back each year provides
John and Sally with a lot more after-tax income.
In the above table we see that even though both bonds have the same 4% yield, the one that pays part of the principal back each year provides John and Sally with more than 3 times more after-tax income ($74 vs $24) than the bond that only pays the principal back at the end of 20 years.
This means that even if taxable bonds and annuities had the same pre-tax yield (which they don’t since annuities have a higher yield as we mentioned in the first point) clients are getting more after-tax income from the annuity than they would if they were investing directly in a taxable bond fund.
Since John and Sally make $500k/year and live in California, they would lose 44% of their bond gains while they are working if they were investing in a bond fund while they are working. By deferring their gains here until retirement they are essentially replacing a 44% tax-rate while working to an 18% tax-rate while in retirement.
Furthermore, since only 76% of their annuity income is taxable for the first 38 years, this means that their effective tax-rate on the annuity income is only 13.68% (18%*76%=13.68%).
So instead of losing 44% of their bond gains for the first 10 years to taxes, they are deferring this until retirement and only losing 13.68% of these bond gains to taxes for 38 years.
On top of that, remember that John and Sally are also getting higher pre-tax yields from the annuity as mentioned previously.
So by investing the bond part of their portfolio in a guaranteed lifetime income annuity, John and Sally are getting both higher pre-tax yields and higher after-tax income.
4. More Growth From the Equity Side of the Portfolio
Since clients are getting more after-tax income from the bond side of the portfolio, this means that clients who use a guaranteed lifetime income annuity in place of taxable bond funds don’t need to draw as much income from the higher-earning, tax-efficient equity side of their portfolio. Since the equity portfolio is allowed to compound for longer periods of time this allows the after-tax wealth of this side of the portfolio to grow faster for those who are using annuities versus those who aren’t.
A traditional 60/40 portfolio would always maintain an allocation of 60% Stocks/40% Bonds to reduce risk in the portfolio.
But since the guaranteed lifetime income product is already providing more after-tax income than the taxable bond part of the portfolio would, the equity percentage of the portfolio is allowed to safely drift upwards over time without needing to be drawn down on as much.
This allows for John and Sally to have more after-tax wealth in their later years that they can either spend or give to their heirs.
Instead of maintaining a steady 60% allocation to equities, use of the GLI income annuity allows clients the ability to have the equity part of their portfolio slowly and safely increase over time towards an 85% equity allocation. This increase in the equity allocation allows for the client to significantly grow their wealth over time so that they have more wealth in the later years of retirement than they would if they just maintained a steady 60% stock/40% bond portfolio for the rest of their lives. So not only does the portfolio with the GLI annuity support higher withdrawal rates, it also creates significantly higher after-tax wealth for clients. |
In fact in our case study by using the guaranteed lifetime income annuity, John and Sally end up with nearly 5 times more wealth at age 95 than they would have had if they used just a taxable bond portfolio ($7.1 million vs $1.5 million).
The table below shows the difference in the growth of John and Sally’s portfolio over time if they use a guaranteed lifetime income annuity in place of their taxable bond portfolio.
Using a GLI annuity instead of taxable bonds leads to significantly higher growth in the client’s portfolio in the later years due to the ability of the tax-efficient equity portfolio to compound. |
In the above table we can see that the value of both portfolios stays fairly similar from age 55 until John and Sally retire at age 65. At that point John and Sally start taking income and the portfolio with the GLI annuity starts to trail the one with taxable bonds due to the sequence of return risk associated with the GLI annuity
portfolio having a higher equity allocation as described previously.
However, as John and Sally get into their 70s, the taxable bond portfolio starts to get depleted because the withdrawal amount is greater than what the 60/40 portfolio can withstand.
However, the portfolio with the GLI annuity really starts to take off at that point. As mentioned previously, this is due to the fact that the GLI portfolio has an increasing equity allocation that has had a long investment horizon of about 20 years (i.e. from age 55 to 75). This increasing equity allocation is given enough time to compound and grow while the equity portion of the 60/40 portfolio has to be drawn down upon in order to meet John and Sally’s increasing retirement spending at that point.
5. Arbitrage Benefits of Risk Pooling:
One of the key benefits that guaranteed lifetime income benefits provide is the fact that it’s based on a pool of applicants that pay into the policy, but when it’s time for them to receive the lifetime income benefit not everyone elects to use it. This makes the feature that much more valuable to those few who do elect to use it.
Another key benefit is that the product doesn’t require underwriting. This means that people in poor health get the same benefit as those in great health. But those who are in great health will live longer and get the benefit that would have gone to those who were in poor health and paid into the product. Since wealthier clients tend to be in better health than their less wealthy counterparts, they tend to be the ones who are receiving the bulk of the benefit.
These two key features of the product allow certain populations to get an arbitrage benefit here at the expense of other populations.
This arbitrage opportunity is not present in the buying of taxable bond funds quite as easily. In fact, if either John or Sally live to age 95, their after-tax IRR on the annuity is 6.26% this is significantly higher than the 3.45% after-tax IRR they would be getting on the bond portfolio if they live to age 95.
The GLI annuity has a higher pre-tax yield, less risk, and a higher after-tax IRR to age 95 than the 10 year High Quality Corporate Bond. The reason these returns are so high is due to the arbitrage benefits afforded to clients who invest in bonds via the GLI annuity instead of directly in a taxable account. Not everyone who purchases the GLI annuity will use it efficiently and so those who do use it properly receive a significantly higher value from doing so. |
In fact in order to outperform the bond portfolio, either John and Sally have to live to age 78 or longer.
And there is less than a 2% chance of John and Sally both dying before that.
So 98% of the time, John and Sally will do better on an after-tax basis by investing in a bond fund via a guaranteed lifetime income annuity than directly via a taxable account.
Conclusion: Guaranteed Lifetime Income Annuities Help Improve Retirement Outcomes and After tax Wealth for Clients
The bottom line is that for John and Sally—and many others saving for retirement—life insurance and annuity products like guaranteed lifetime income annuities help increase the amount of income they can safely withdraw in retirement AND increase the amount of after-tax wealth they pass onto beneficiaries due to the higher yields and reduced risk that these products can provide to a clients portfolio.
These products are not just for the wealthy either. John and Sally receive an enormous amount of benefit because they are in a high tax-bracket while they are working and a significantly lower tax bracket when they retire. While not all clients may have as much wealth as John and Sally, almost all clients will be in a significantly higher tax-bracket when they are working and a lower tax bracket when they retire. As such, they can benefit from products like a guaranteed lifetime income annuity that allow them the ability to defer the taxes on the their bond gains as well as to benefit from the higher yields, guarantees, protections, and compounding growth of the equity portfolio that these products allow for.
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How a Guaranteed Lifetime Income Annuity Can Increase the Amount of Money You Can Safely Spend in Retirement While Also Creating More After-Tax Wealth for Your Beneficiaries?
Book A CallMethodology and Assumptions
The analysis done in this case study was performed using a Monte Carlo simulation. A Monte Carlo simulation simulates results based on an expected mean and standard deviation.
For example, assume a client has 3 million dollars and wants to know what his portfolio value will be at the end of 40 years if he starts taking $250k out each year in retirement. Assuming the expected return of the portfolio is 7% and the standard deviation is 11.25%, we could use a model to simulate 40 years of returns and get the following value at the end of 40 years: $7,917,693.
However, that’s just one simulation. As we know, returns can vary. One simulation is not enough to get an accurate picture of what the expected portfolio value will be at the end of 40 years. It also doesn’t tell me the percentage chance that I will run out of money.
In order to do that, I need to simulate 40 years of returns a number of times. In other words, I need to run multiple simulations. Each simulation will give me a different portfolio value at the end of 40 years that indicates what my portfolio value could be according to different scenarios.
For example, below are 10 different simulations. Each simulation simulates 40 years of returns in order to show the portfolio value at the end of 40 years.
| 10 Simulations of Portfolio Values after 40 Years | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| $7,917,653 | $0 | $0 | $1,089,509 | $1,545,397 | $981,397 | $11,255,808 | $0 | $0 | $12,866,212 |
In the above table, we can see that the portfolio value at the end of each simulation varies fairly dramatically from as low as $0 to as high as $12,866,212.
We can do some summary statistics on the simulations above which are provided below:
| 10 Simulations of Portfolio Values after 40 Years | ||
|---|---|---|
| Mean Portfolio Value at End of 40 Years | Median Portfolio Value at the End of 40 years | Chance of running out of money |
| $3,565,602 | $1,035,453 | 40% |
From doing 10 simulations we can see that the mean value is $3,565,602 but the median value is $1,035,453. This means that there is a lot of variance in our expected outcomes. The variance is due to the fact that 40% of the simulations resulted in a $0 portfolio value. In other words, in 40% of cases, the client would run out of money in retirement.
That’s the value of doing Monte Carlo simulations. They help give clients and understanding of not only what the expected terminal portfolio value will be, but also the chance that they will run out of money.
The more simulations you run, the more accurate you can expect the numbers to reflect the underlying probable outcomes.
We chose to run a 1000 simulations in our case study as that provides a solid confidence interval for determining expected outcomes.
Here are the assumptions we used in running our simulations:
Monte Carlo Simulation Assumptions
| Client: | John and Sally |
| Portfolio at age 55: | $3 million total portfolio (60% stocks/40% bonds) |
| Current W2 income: | $500k/year |
| Desired Retirement Age: | Age 65 |
| Retirement Spending Each Year: | Starting at $250k and increasing by 2% each year |
| Equity portfolio Assumptions: | 9.5% expected return with 18% standard deviation |
| Bond portfolio Assumptions: | 4.5% expected return with 4.5% standard deviation |
| Annuity portfolio Assumption: | Takes $1.2 million that would have been invested in a bond fund and purchases a GLI annuity that pays $181,867/year every year starting at age 65 as long as either John and Sally are alive |
| Tax Assumptions: |
While working (55–65): 44% ordinary income tax rate, 32% capital gains tax rate While retired (65+): 18% ordinary income tax rate, 25% capital gains tax rate |
