Case Study 1_ Retirement Plan

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Trine University *

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5823

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Finance

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Apr 3, 2024

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Case Study 1 Page 1 Case Study 1: Retirement Plan Xuan Tu Trine University FIN 5823

Case Study 1 Page 2 This article discussed two approaches to compute the safe retirement income: traditional approach and actuarial approach. The traditional approach takes 2 inputs: - expected return - median remaining lifespan The actuarial approach takes 4 inputs: - expected return, - portfolio volatility, - median remaining lifespan, - confidence level Both approaches compute the extraction rate. The traditional approach is based on the assumption that: - the expected return is a constant value - the inflation is a constant value, - the lifespan is fixed The disadvantage of this traditional approach is that it does not account for the randomness in lifespan, inflation and market returns. It uses the average value to represent the expected return which means there is a 50% possibility that the return is below average and the retirement plan will fail. Similar case also applies to the inflation rate and lifespan. In reality, many customers are uncomfortable with the 50% chance of failure in their retirement plan. However, the traditional plan cannot compute the extraction rate which gives a higher success rate of retirement plan. The actuarial approach can better handle the randomness in lifespan, inflation and market returns using Monte Carlo analysis. The portfolio volatility is taken into consideration. This is achieved by finding a combination of stocks and bonds which provide the same expected return as the traditional approach. Given the volatility of the portfolio, the probability of a fully funded retirement can be estimated. In the case study, the arthur took an example of the following condition: - total return: 7% - inflation: 3%

Case Study 1 Page 3 - portofolio volatility: 13.25% - median remaining lifespan: 20 years The probability of a successful retirement plan with respect to different extraction rate is shown in the figure below. Figure 1: probability of a fully funded retirement at different extraction rates When using the traditional approach, we will get the estimated extraction rate of 7%. With the 7% extraction rate, there is a 65% chance that the retirement plan will succeed, and a 35% chance that the retirement plan will fail. When using the actuarial approach, we can find out the mapping between different extraction rates and the corresponding success rates. It turns out that a 4.5% extraction rate can give us 85% probability of a fully funded retirement. Many clients feel that the confidence level of 80% to 85% is most comfortable, thus the actuarial approach will suggest an extraction rate of 4.5%. The Monte Carlo analysis plays an important role in retirement planning because it can take into account the randomness of inflation, market return and lifespan. It considers the possible futures by creating alternative histories from historical market data. It can also provide a more accurate confidence interval than actuarial approach. When using the Monte Carlo models, it is important to properly select the historical data. The short term historical data may lead to a different prediction result compared with the long term data.

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