What Is a Monte Carlo Simulation?

Key Points – What Is a Monte Carlo Simulation?

What Is Your Probability of Success for Retirement and How Is It Determined?
There Random Variables that Factor into Your Probability of Success
Using Monte Carlo Simulations Before and After Retirement
6 Minutes to Read

Doing a Monte Carlo Simulation on Your Financial Plan

When you hear the words “Monte Carlo,” what’s the first thing that comes to your mind? Some people may think of Chevrolet Monte Carlos. Others may think of the Monte Carlo quarter of Monaco and the Casino de Monte Carlo. And then there’s the movie Monte Carlo with Selena Gomez, Leighton Meester, and Katie Cassidy. However, some of our team members might have a different answer: a Monte Carlo simulation.

Our financial advisors regularly use Monte Carlo simulations when creating or reviewing a financial plan. Before we dive into how a Monte Carlo simulation works, we can’t stress enough that a comprehensive financial plan isn’t complete if it’s not tailored to your goals.

Defining a Monte Carlo Simulation

Before we outline how Monte Carlo simulations are specifically used in the financial planning world, let’s review Merriam-Webster’s definition of Monte Carlo.₁

Monte Carlo: of, relating to, or involving the use of random sampling techniques and often the use of computer simulation to obtain approximate solutions to mathematical or physical problems especially in terms of a range of values each of which has a calculated probability of being the solution.

So, how does that apply when it comes to your retirement? For retirement planning, Monte Carlo simulations run thousands of different iterations and situations against your retirement plan to show you that probability of success.

What’s Your Ideal Probability of Success?

If your probability of success is X%, what exactly does that mean? That means that from a historical perspective, you can do everything you want to do X% of the time and never need to adjust your spending. Our advisors typically strive to make sure that clients and prospective clients have a probability of success that’s between 75% and 90%.

You might be wondering why the ideal probability of success wouldn’t be 100%. Well, that means that you’re either A, saving more than you need to; B, not spending as much as you could; or C, taking on more risk than necessary. If your probability of success is 100% or anything that’s starting to get into the mid to upper 90s, you’re assuming that the markets will be in bad shape for several years.

We can’t predict what future returns will be, but we can learn from history to help make educated and informed decisions. Look at Figure 1 below to see the historical annual returns from the past century.

FIGURE 1 – S&P 500 Historical Annual Returns – Macrotrends₂

You don’t need to go too far back to remember the S&P 500 lost 19.44% in 2022. However, it gained 24.23% and 23.31%, respectively, in 2023 and 2024. When we experience market downturns, remember that markets are cyclical. Financial uncertainty can be uncomfortable, but it’s not uncommon.

Stress Testing Your Financial Plan

While Figure 1 shows that the S&P 500 has generated positive annual returns more often than not since the turn of the century, years like 2022 and events like the Great Recession (see 2008) and Dot-Com Bubble (see 2000-2022) can’t be ignored and should be planned for. That’s why we stress test financial plans against various economic cycles, including prolonged market downturns that may feature high inflation and/or high interest rate environments. If those type of events happen while you’re in retirement and you don’t have a paycheck to fall back on, will you be OK?

Instead of stewing about whether you’ll be OK, download a copy of our Retirement Plan Checklist. It consists of 30 yes-or-no questions that gauge your retirement readiness and age-and date-based timelines of retirement planning considerations.

Retirement Plan Checklist

An Example of a Monte Carlo Simulation with Joe and Jane Average

To help explain how Monte Carlo simulations work, we’d be remiss if we didn’t share an example. We’re going to run a Monte Carlo simulation for a sample couple named Joe and Jane Average. Here are some key details about their situation and goals.

Joe and Jane Average are both 55 years old.
Jane wants to retire at 60, while Joe wants to retire at 62.
Most of the$1.5 million they’ve saved is in their 401(k)s.
Both max out their 401(k)s all pretax and receive a 4% company match.
Their goal is to spend $8,000 a month in retirement (including health care expenses) and they haven’t done any Roth conversions
However, they want to spend $40,000 a year for the first 10 years of retirement on vacations.
Spending priorities (living expenses + travel) at the end of each year have an inflation factor of 3.88%.
They have an initial 60/40 asset allocation (60% stocks/40% bonds).
Filing age for Social Security is at Full Retirement Age 67
Planning horizon is age 92 for Joe and 94 for Jane
Given the information above, their probability of success with this Monte Carlo simulation would be 85%, as shown below.

FIGURE 2 – 85% Probability of Success

Monitoring Your Spending

Again, this means that 85% of the time, Joe and Jane can accomplish their retirement goals without having to adjust their spending. If that 15% comes into play, that means they might need to briefly adjust their spending at some level. They might need to consider some trade-offs in that scenario.

Let’s say that Joe and Jane feel pretty good about their 85% probability of success. So good, in fact, that they go from spending $9,000 a month instead of $8,000 a month and don’t even realize it. If they consistently did that over the course of their retirement, their probability of success would dwindle to 71%.

FIGURE 3 – 71% Probability of Success

It All Goes Back to the Plan

When we’re building a financial plan, the whole idea is to not only get you to retirement, but through retirement. We’re focused on helping you accomplish your personal retirement goals. To do that, we need to know what your goals are, and how you think and feel about money to set up a spending plan for your retirement.

Keep in mind that your spending is going to be much different between your working years and in retirement. It will change throughout retirement as well, just as your goals will continue to change. That’s one of the reasons why we have review meetings with our clients to make sure their plan is current.

Knowing how you think and feel about money will allow us to determine how much risk you’re comfortable with taking. This is where the Monte Carlo simulations come into play, as they help determine how much you should be spending.

Without a financial plan in place that goes through these Monte Carlo simulations and is stress tested through various economic conditions, you’re just doing guess work. We don’t ever want to see someone doing guess work on their retirement planning. That’s why our team of wealth management professionals collaborate on behalf of our clients to build and review their comprehensive financial plans.

What Should You Be Planning for?

There can be many random variables that can suddenly change how you go about life in retirement. On the bright side, you could become a grandparent and want to help pay for your grandchildren to go to college. Or maybe you want to go on a dream trip to a place like Monaco and make a big purchase (like a Monte Carlo at a car show).

And on the flip side, there are things like a long-term care stay or an early death of a spouse that can completely change the direction of your retirement. You’re factoring in different variables like that and many more to determine your probability of success. Games like roulette, dice games, and slot machines that you can find at the Casino de Monte Carlo also have quite a few random factors—all which go into determining your probability of success in each game.

We Can Help You with Determining Your Probability of Success

We hope that this article has given you a better perspective on what a Monte Carlo simulation is and how it can relate to your retirement. You can try some Monte Carlo simulations out for yourself by testing out our financial planning tool. Just click the “Start Planning” button below to begin building your plan and see what your probability of success for retirement will be, whether that’s in the next couple of years or 10 to 15 years down the road.

START PLANNING

As you’re using our financial planning tool, please keep in mind that it’s intended to be used by professionals. We are here to lend a hand if you have any questions that come up while you’re using our planning tool. Rather than rolling the dice on planning your retirement on your own, consider working with a team of professionals that strives to help get you to your ideal probability of success. We’re ready to help you build a comprehensive financial plan that’s tailored to your goals.

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Resources Mentioned in This Article

Downloads

Retirement Plan Checklist

Other Sources

[1] https://www.merriam-webster.com/dictionary/Monte%20Carlo

[2] https://www.macrotrends.net/2526/sp-500-historical-annual-returns

Investment advisory services offered through Modern Wealth Management, Inc., a Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management a Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.