Modeling Your Personal Finances: Part 2

Software that models what I like to call a “Financial Life Plan” has greatly improved over the past decade.  New, user-friendly, graphics-based software has made individual financial life plans easier to construct, easier to understand, and more widely available.

The predominant use of this software is for analyzing strategies to support retirement plans (which is discussed below), but many other capabilities are provided that are useful to people who are just starting out or in mid-career.

Early and Mid-career clients

For my Early and Mid-career clients, I use software that enables the graphical visualization and analysis of:

  • Current spending and cash-flow 
  • Education savings needs
  • Student loan repayment options
  • Tax implications of putting more money into 401(k) or Roth IRA accounts
  • The impact of life insurance plans
  • Investment rebalancing opportunities
  • Financial benefits of Roth IRA conversions

For People Approaching or in Retirement

The basic question for retirement planning is “Will I have enough money?”  Development of a satisfactory answer to that question is unique to each individual and family and is more complicated than anyone wants it to be!   Which is why the use of computer models is extremely helpful.  As described last month, you want a plan for your assets that generates a Monte Carlo Simulation chart like the one shown here where there is a greater than 75% chance of having money in the bank at the end of your life.

This chart is for a fictional 63 year-old (her age is along the horizontal axis) who is nearing retirement and who has just under $1million in assets (vertical axis).  The dark line (in the middle of the shaded area) is the median simulation, meaning there were 500 simulations with results below that line, and about 500 simulations with results above that line.  This particular plan shows a 75% confidence level that her assets will last until she is 100 years old, and a 5% chance that she will have almost $4Million when she gets to 100 years old.

Although everyone’s financial life plan is unique, it is useful to know the primary and secondary drivers of a successful retirement plan.

Primary Drivers of a Successful Retirement Plan:

  1. Your spending minus your income from pensions and/or Social Security.  Any difference here will need to be covered by your invested assets and their growth.
  2. Your available assets at the time you retire:  This is sometimes called your “Number”.  Conservative financial planning typically aims for a portfolio of assets that is 25 times the amount needed in #1 above.
  3. The age at which you and your spouse retire.  This is a big deal because typically money stops flowing into your accounts, and starts flowing away from your accounts.
  4. Investment rate of return.  Modern retirements can last for 30 years or more, so your invested assets have many years to grow (or decline).  The inherent variability of investment returns is what creates the shaded areas of the chart.  Unfortunately investing is somewhat like gambling (thus the name, “Monte Carlo Simulation”):  your results are not guaranteed, but they can be mathematically modelled.

Secondary Retirement Plan Drivers:

  • Inflation
  • Taxes
  • Large purchases (like children’s college, weddings, or a new car periodically),

How Do Clients React?:

In my experience, people typically have one of two reactions the first time their Financial Life Plan is created. The most common is relief.  The majority of families are living day-to-day and hoping that their Financial Life Lack-of-a-Plan is going to work.  For many, the simulation shows that the standard of living they have now, and were hoping to maintain in retirement, works fine.  The other reaction (which usually takes longer to get to) is, “OK, now I know where to focus to achieve what I want.” 

Modeling your finances can uncover and answer a lot of questions about how your money needs to be managed.  Ideally your Financial Life Plan specifies how your money will support your goals and the life you want.

John Krehbiel is an independent, fee-for-advice, financial planner/advisor in Brevard County, Florida.  Krehbiel Financial LLC is a Registered Investment Advisor in the State of Florida and Texas. The information in this article should not be relied upon for the purposes of transacting securities or other investments. You should consult with a financial advisor or other professional to determine what may be best for your individual needs. 

MonteCarlo Sim example

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