Financial planners who rely solely on Monte Carlo analyses to weigh the potential role of annuities in retirement income planning are doing their clients a disservice, according to Derek Tharp, the retirement researcher and financial planning expert.
Tharp offered this perspective in a new video assessing the retirement income modeling process posted to his YouTube channel. While noting the power of Monte Carlo simulations in other aspects of the planning process, Tharp cautions that the statistical method is "pretty terrible" at demonstrating annuities' protective value.
Monte Carlo analyses, he maintains, do a poor job of providing clients with context beyond binary success and failure metrics. As a result, two plans (one with an annuity factored in and one without) could look nearly identical in terms of the probability of success with a certain assumed spending rate and longevity assumption.
Yet, the actual experience of the client across the two scenarios could be vastly different, with one providing a stable ride and the other leaving the client subject to an emotional rollercoaster in retirement. Unless clients are themselves well-versed in statistics, Tharp says, it's not likely that any given client will be able to appreciate this nuance.
A better way to position annuities' potential role, according to Tharp, is for advisors to use historical modeling techniques and emerging projection capabilities now available within popular planning platforms such as Income Lab, to which he is a senior advisor.
The key is to help clients understand that annuity allocations alter their risk profile in a way that can be masked by binary projection techniques — even advanced ones. It's also important, Tharp offers, for advisors to study up on the proliferation of modern annuity products that may offer specific features that could meet a given client's needs.
Ultimately, there is nothing simple about either annuities themselves or the best ways to teach clients about them. But that just means that well-informed advisors have more opportunity to deliver added value in this area.
Masked in the Numbers
In the video, Tharp walks through two traditional Monte Carlo simulations in which a person with $1 million in retirement assets targets a spending level of $5,500 per month.
In one case, the person is assumed to live simply off withdrawals from a 60/40 portfolio of stocks and bonds. In the other, the client is assumed to deploy $200,000 toward a single premium immediate annuity, with the premium payment being taken from the money going to the bond allocation.
Tharp runs the numbers to shows that, in both cases, the probability of success is 94%, and both result in a median end portfolio value of about $1.2 million.
