As soon as I’m put in charge of simplifying all our financial jargon, one of the first ones I’d like to take on is Monte Carlo Simulation. Or it’s sometimes called Monte Carlo Analysis.

Either way, the terms don’t tell you much. Despite sounding like a video arcade game, or something out of a James Bond movie, Monte Carlo Simulation is seriously essential to everyone’s realistic retirement planning – the kind I talked about in my last video on sustaining your standard of living in retirement.

Since I don’t have the power to rename this critical planning tool, let’s focus on what it is, and how it works. Call it what you will, Monte Carlo Simulation or Monte Carlo Analysis is a hugely helpful tool we use to help people better answer this universal question: Can I afford to retire?

What Are the Odds?

Beyond just quantifying your current net worth and projecting it forward, Monte Carlo Simulation helps us account for future unknowns. By factoring uncertainty straight into the equation, it can reduce the stress of never knowing for sure what the future has in store.

To accomplish this, instead of just calculating that you need “X” amount to “win” at retirement, Monte Carlo Simulation calculates your odds of success, depending on whether future financial markets send you good news, bad news, or the usual mixed bag.

I know. That can be hard to wrap your head around! In an earlier video, I covered the thought process behind it. Basically, we plug in your income, investing, and spending numbers, along with several other assumptions. The simulation software then runs your personalized numbers through thousands of “What if?” scenarios – from best- to worst-case and everywhere in between. We can then show you a spectrum of potential outcomes, ranging from a retirement you can most likely plan for, to outcomes that would require a snowball’s chance in you-know-where to actually occur.

This helps you think through quality-of-life tradeoffs in your career, spending, saving, and investment risks. If your odds of success are too low, would you willing to work longer, spend less, save more or invest more aggressively? If your odds of success are higher than expected, would you want to retire even sooner?

Monte Carlo Planning in Action

Still not very clear? To be honest, I think this calls for a “show and tell,” so you can see a Monte Carlo Simulation in action. For this, you may want to view the video version of this post embedded above. But here’s the general premise.

First, there’s the input. I won’t bore you with every little step it takes to create your personalized report. The biggest point is, if you input garbage assumptions, that’s exactly what you’ll get back out as an analysis. That means there is some homework needed on your part and your advisor’s, to make sure you’re using numbers that are as accurate as possible for at least six key assumptions:

What’s your income? All of it, including salaries until you retire; expected benefits upon retirement; and annuities, Canada Pension Plan (CPP), and Old Age Security (OAS) entitlements.
How much are you saving and investing? – How much do you have today? How much more do you plan to save and invest, for how long? How aggressively are you investing in the market’s risks and expected returns?
When do you hope to retire?
What do you expect to spend once you’re retired? As I covered in my last post, try to establish realistic, number-driven assumptions.
What’s your life expectancy? How long do you hope to be in retirement?
How do you define “success”? For example, are you okay with spending down nearly all of your wealth by the time you’re through? Or do you have your heart set on leaving behind a substantial legacy?

If you’re a couple, figure all of this for both of you. We’ll also plug in other, broader assumptions, such as the potential impact of inflation and expected market returns on your investments. Then – presto, change-o – we run your Monte Carlo Analysis and present you with the results. Again, check out the video version to view an example of what that might look like.

Challenge Your Assumptions

Like retirement planning in general, Monte Carlo Analysis is not a one-and-done report. Once you’ve got initial numbers in hand, you may want to “play” with them, especially if the results aren’t what you had in mind. For example:

If you work a few years more or less than planned, how does this impact your odds of success?
What happens to your odds if you decide to spend a little more or less in retirement?
What if you take on more risk in your investment portfolio in pursuit of higher returns? Or if you decrease your investment risk to generate more stable, but likely lower returns?

It’s also worth thinking through what you’re comfortable with for your potential outcomes. As I covered in that past video, you may be okay with slightly lower odds of success, as long as you and your family have multiple “Plan Bs” to fall back on if things don’t go as hoped for. For example, would you be okay with working a little longer or spending a little less if needed? On the other hand, if you’ve got little or no safety net available, you may want to keep running through scenarios until you’ve achieved a higher likelihood of success you can live with, no matter what.

What else can I tell you about Monte Carlo Simulation and other funny financial terms worth taking seriously? Subscribe to my YouTube channel or connect with me on LinkedIn to learn more!