When someone raises the subject of their financial situation, my first thought is always the same: I wonder what their number is.
I don’t mean their net worth, their credit score, how much money they make, how much their last car cost, or what age they plan to retire. While some of those might factor into calculating the number I’m focused on, none are the number itself. The number I’m most interested in is their financial plan Monte Carlo Success Rate—one number that collapses their current situation and possible future outcomes into a single indicator of financial well-being.
In my nearly 20 years running and reviewing financial plans, I’ve come to rely on the Monte Carlo Success Rate to help hundreds of families achieve financial success and security. It’s a valuable tool in creating financial plans for new clients, monitoring clients’ progress, and adjusting financial plans over time.
How It Works
While every financial plan is unique and tailored to the family or individual it’s made for, the process used to create it is similar each time. Here’s how the process typically unfolds and how the Monte Carlo Success Rate fits in:
Initial meeting: The client and advisor first meet to discuss the client’s near-term and longer-term financial and personal goals and intentions. During the conversation, ideas take shape and scenarios for study emerge. Because resources are always limited and some goals can be contradictory, analysis is required to see what’s possible.
Gathering data: Next, the client provides the advisor with information about their current assets, liabilities, incomes, and expenses. The client also provides information about future income, future expenses, and financial goals. For example, future income might include expected bonuses, equity compensation (e.g., stock options, restricted stock units [RSUs]), rental property, pension income, and Social Security benefits. Future expenses might include an upcoming wedding, a home renovation, a large vacation two years from now, and a new car every eight years. Paying for the kids’ college, buying a vacation home, and retiring by age 60 might be financial goals.
Software modeling: The advisor then creates a detailed model of the client’s financial situation using financial planning software. The software calculates cash flows each year and projects cash flows through retirement to the end of life. The software makes calculations of the investment portfolio’s growth and fluctuations, home loan payments, federal and state income taxes, inflation, and many other factors.
Running a Monte Carlo analysis: With the software model complete, the advisor runs a Monte Carlo analysis to determine how well the initial financial planning scenario “worked.” Although the name makes it sound like gambling, it’s not. This analysis is a mathematical technique in which the software calculates all of the cash flows over your lifetime and determines if you have enough cash to pay your expenses in a given year. It does that hundreds of times, varying the rate of return on your investments in each year to mimic what happens in the real world. Each time you run out of cash, the software counts that as a failure. Each time you do not run out of cash, the software counts that as a success. The percentage of times you do not run out of cash—that’s the Monte Carlo Success Rate. It’s the number that tells you how likely it is your financial plan will work.
Reviewing preliminary results: With the software model built and an initial Monte Carlo analysis complete, the advisor and client meet to confirm the model data and review the initial Monte Carlo results. The advisor knows what Monte Carlo Success Rate is high enough for your financial future to be secure. For example, when using one particular financial planning software, a Monte Carlo Success Rate in the range of 70% to 80% would be a good target.
Testing scenarios: Here’s where the financial planning happens. The client and advisor now decide on packages of features to test in a financial planning scenario, and they determine a Monte Carlo Success Rate for each scenario. Features can be changed to find scenarios that work (e.g., a Monte Carlo Success Rate above 80%) and that meet the client’s objectives. For example, the client might be able to retire three years earlier if their company’s stock price increases by $10 per share, making their stock options become more valuable. Monte Carlo analysis is also used to check the sensitivity of a potential change to features of a scenario. For example, cutting expenses by 5% might increase the Monte Carlo Success Rate of a scenario from 68%—too low—to 74%, which is in the acceptable range. By testing a variety of scenarios, the client and advisor can explore the boundaries of what’s possible.
Selecting a final plan: The final step is the client and advisor choosing a set of features or a working scenario to use going forward. This will serve as the client’s financial plan for the next year or two.
Ongoing Monitoring
Of course, the only thing that’s constant in our lives is change. Your financial life is no different; in fact, it can be even more predictably unpredictable. Your family situation, the economy, tax laws, your interests, and your career opportunities and setbacks are all sources of change.
Monte Carlo analysis in financial planning is a powerful tool to navigate change in your life as it happens. Creating and adjusting financial plans with the Monte Carlo Success Rate can help you rest in the knowledge you’re on track for financial success and security.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’d like to know what your one number is and make sure you’re on track for financial success and security, schedule a complimentary consultation.
