|Higher Taxes, More Uncertainty: When Can You Retire Now?|
By Douglas Carey JAN 08, 2013 4:30 PM
Inside the new tax laws and how they might affect your life after the 9-to-5, with help from Monte Carlo analysis.
With a new year upon us, and with income taxes, capital gains taxes, and dividend taxes going way up for those making over $400,000 per year ($450,000 for joint filers), and payroll taxes going up for everybody else, it’s time once again to ask how much the typical couple might need to retire.
I want to look at a sample couple’s probability of never running out of money in retirement using Monte Carlo analysis, a statistical method that approximates the probability of an outcome -- in this case, never running out of money -- by running multiple simulations on investment returns. The simulations of investment returns are generated using an average return assumption for each investment, the historical volatility (standard deviation) of returns for each investment, and historical correlations among the investment asset classes.
Using these variables along with a random number generator, the investment returns are changed each year in every simulation. We then take the number of simulations where funds never run out divided by the total number of Monte Carlo simulations generated. This gives us the probability that funds are never depleted.
Let’s take a look at how this works. I ran a couple’s retirement plan in our retirement planning application. Here were my starting assumptions:
The probability of never running out of money increased by a sizable 15%. From here this couple can tweak their plan further by saving more money or retiring later to increase the probability to an even safer number. As an example, if they push out their age of retirement to 67, they would increase the probability that they never run out of money to 75%.
Now let’s take the scenario I just highlighted. The probability of success for the couple in this scenario is 75%. But what if the government decides to change the dividends and capital gains tax rates for everybody? What if the new 20% rate is eventually applied to all tax brackets?
I ran this scenario and found that the probability of them never running out of money drops to 68%. It’s not catastrophic, but it does put a dent in their ability to feel comfortable about their retirement situation.
Of course, there is also the question of Social Security benefits and whether any of us will receive what was promised. Let’s say that we believe Social Security payments will be cut by 10% for this couple. What does that do to their probability of success? It drops it to 59%. Needless to say, assumptions about Social Security in the future play a large role in most people’s retirement plans.
We live in a world of change and nothing is static. Building a retirement plan is fraught with assumptions, even those that use Monte Carlo analysis. But we can give ourselves a more realistic look at how things might pan out if we use statistical tools and run plenty of what-if scenarios to see how our retirement might pan out when things change.Editor's Note: Douglas Carey is a regular contributor to Minyanville's blog.