(Insurance NewsNet) - Important events sometimes occur with too little notice. Occasionally, even a monumental development can escape adequate attention. An example of this occurred on Jan. 9.
That day saw a historic development in the field of retirement in planning. Wade Pfau, professor of retirement income at The American College, and co-author Massimo Young revealed research that once and for all thrust a dagger into the heart of Monte Carlo simulation when used in the context of retirement income planning. I believe that positive implications of their research will be felt for decades.
For several years, I have written about my skepticism of Monte Carlo simulations, especially in the context of their use with constrained investors. It is these retirees for whom I have the greatest concern. My objection to Monte Carlo simulations is a practical one. In practice, they are too often used as a proxy for safety. This results in a grave disservice to many retirees who come away with a plan that creates a false sense of security.
What Pfau and Young revealed is that Monte Carlo simulations are anything but scientific. Rather, they are arbitrary, unscientific, dependent upon the capital markets assumptions used, and they produce vastly differing results depending upon the firm a client may be meeting with.
Two decades of experience in the retirement income field has taught me that there is a large segment of clients for whom risk mitigation must be the paramount planning priority. These individuals, millions of Americans who reach retirement with savings, have enough to retire, but not enough to afford investing mistakes. This is because the amount they’ve saved is not high in relation to the level of monthly income that they must create to fund a minimally acceptable lifestyle. In my view, it is virtually malpractice to fail to protect these retirees against risks that can reduce or even wipeout their incomes. Therefore, protection against retirement timing risk and longevity risk is essential.
My objection to Monte Carlo simulations
To address retirement income, investment advisors and financial planners typically rely upon Monte Carlo simulations in conjunction with the recommendation of a systematic withdrawal plan. I am so opposed to constrained investors’ relying upon systematic withdrawal plans, I’ve publicly stated that I would ban the practice if I had the power to do so.
I’ve also asserted that Monte Carlo simulations ought to be similarly banned when applied to constrained investors. One reason for my view is that nothing in a Monte Carlo simulation guarantees the continuation of any retiree’s income. Yet, constrained investors require protection against longevity risk. This is why an annuity is an essential component of a constrained investor’s income plan.
Pfau and Young’s research examined the capital markets assumptions (used by 40 investment managers. These included some of the largest in the U.S., names such as Goldman Sachs, Merrill Lynch, Morgan Stanley and others. Did Pfau and Young find that firm were using similar CMAs? Hardly. What they discovered instead was a wide disparity in CMAs. For example, they discovered projected returns on stocks ranging from 5.15% to 10.63%. And bond return assumptions ranging from 2.545% to 5.82%.
Conclusion? Because each firm’s CMAs differed, and due to the wide disparity in those assumptions, one firm may tell a client that the probability of their income lasting is 95%, while another firm may state to the very same client that the probability of continuing income is only 62%.
Imagine a married couple, Bob and Helen, who seek help in planning their retirement income. They decide to interview three advisors. After assessing their financial situation, advisor #1 states that his plan has a 65% chance of success. Advisor #2 tells Bob and Helen that her plan has an 83% chance of success. And Advisor #3 asserts that his proposed plan has a 95% chance of success. Which advisor is Bob and Helen likely to choose to hand over their money to? You see, not only do Monte Carlo simulations crate a false sense of security, but they also create a perverse incentive for conservative clients to choose the advisor whose plan is based upon the most aggressive assumptions.
Better financial outcomes as a result
Exposing Monte Carlo as unscientific and arbitrary will, I believe, lead to more investors enjoying better financial outcomes in retirement. This is a wonderful development for those who embrace annuities. That said, while I am a fierce defender of annuities, I don’t for a minute believe that annuities are the sole answer. Nor do I believe that capital markets investments are the sole answer. The one true answer, for most investors, is a combination of both. Again, because of longevity risk, annuities are a vital element in virtually every constrained investor strategy.
Some reading this will say, “But I’m not licensed to recommend securities.” Fair enough. But that is no reason to leave a constrained investor with half a plan. My advice is to work with an advisor who can address the securities portion of the client’s investing strategy. There are many securities licensed advisors who would love to gain more assets under management. These advisors also are positioned to recommend that you address the insured needs of their clients. The key to developing these productive business relationships with securities licensed advisors is to educate them on constrained investor income planning, so that they can understand the urgency for guaranteed income.
Fiduciary investment advisors who continue to reflexively reject annuities, although their historical objections have been rendered obsolete, do a grave disservice to their baby boomer women clients. This will blow back on them, I believe, in the form of lost clients and lost assets. But insurance agents should not be gleeful about this. Instead, adopt a balanced perspective. A solution based on 100% safety is not the answer. Agents cannot lose sight of the fact that inflation is a cruel reality that hits retirees hard.
Helping women retirees
All of this matters even more for women. The wealth management and insurance industries are on a collision course that, unless altered, will cause them to misfire on a nearly trillion-dollar revenue opportunity. The research on this from multiple credible firms is quite clear.
There is a reason why seven out of 10 boomer women fire male financial advisors after their husband’s death. The alienation process that builds up over years as the male advisor directs his attention, questions and comments towards the husband, while disregarding the wife, disqualifies the incumbent advisor from continuing to manage the wife’s assets once the husband has died. What do you say about a business that fails to keep seven out of 10 of its customers. Broken? In need of reform? Destined to fail?
Education and cooperation among all types of advisors is the solution to properly serving millions of retirees. The in-fighting over how different advisors are compensated, arguments over “product,” and disagreements over who is acting like a true “fiduciary” are largely “inside baseball” distractions that prevent forward progress on behalf of the clients we wish to serve.
It’s time to move past it. All of it.
By David Macchia
March 28, 2023
David Macchia is founder of Wealth2k. He is the developer of the The Income for Life Model and Women And Income.
