Case Study 1_ Retirement Plan
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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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