R$P 2000 Frequently Asked Questions
Remember, R$P 2000 is not intended to be used as an ultra-detailed tax model. The
program gives a general picture of the wealth a user will have at some
critical future age: empty nesthood, retirement, old age. Therefore the
program is not set up to handle every tricky possibility. However, there is
hardly any situation that cannot be treated by some workaround involving a
little creativity and/or a calculation on the side. The FAQs here will
document some of those as well as more routine issues.
Do you have any ideas as to how to explain to clients about the concepts of probability and randomness?
Here's one idea. You could use dice, and have specific outcomes in mind which have probabilities of occurring corresponding to the key risk numbers. For example, if you roll three ordinary dice the probability of the total score being less than or equal to five is .0463, close enough to .05.
So when appropriate, with clients who need it, you could do the little experiment and observe the outcome. The downside to this or any other such gimmick is, sometimes the unlikely event will occur. Like 5% of the time. And then the client may say, "Aha! I may be that unlucky with your estimate of whether I will run out of money." So you need to have a speech ready for that development. Like, "Well let's repeat it a few times and you'll see it really doesn't happen very often." We will add more material like this from time to time as we think of useful ideas.
( 11/15/00 )
What are some examples of Monte Carlo experiments that researchers have done that my clients might understand?
Someone published a book quite some time ago on optimal strategies for the board game Monopoly. Here is a perfect example of a pretty simple game which can't be analyzed mathematically, you need to write a computer program which can generate plays of the game, with rules for decision making coded. And run competing strategy ideas 1000s of times and look at the results. The author showed that buying railroads is good, but buying the utilities is bad. Holding out for the most expensive properties and declining to buy the cheaper ones is also bad. If I recall correctly he showed that the green properties were also the best in some sense. So, not a very practical example, but easy to understand and explain.
( 11/15/00 )
Why do you use draws from a lognormal distribution for returns instead of just using numbers from an historical data base?
There are several reasons why structuring the model to accept user inputs on mean and volatility and using an appropriate distribution for the draws is much preferable. First of all a user can simulate the historical data very nicely this way by just putting in the mean and standard deviation of the historical data and out will come numbers consistent with the historical data. Second, if the user wants to do something else, because he doesn't trust the historical data to be representative of what's going to happen in the future, he enters different parameters that he does believe in. The user has a choice.
Finally drawing from a fixed finite set of numbers without replacement can have disastrous results, making the final distribution look concentrated when it should not. As an extreme case, suppose you had 25 returns, and you're simulating a 25 year history, and you wanted to simulate the amount of wealth for a situation with no spending and no deposits. You would get exactly the same number for every replication! Because multiplication is commutative it doesn't matter in what order you draw the 25 returns. But if you take 25 samples from a theoretical distribution with the same mean and standard deviation, and repeat that a few hundred times, you will see the appropriate spread.
( 11/15/00 )
Where do I get data for investment volatility?
For mutual funds see the data in Morningstar publications. Your wealth
advisor will have access to more expensive data sources such as Ibbotson.
For generally useful numbers that might characterize different asset
classes there are books such as John Bowen's The Prudent Investor's
Guide to Beating Wall Street at Its Own Game. Sensible default numbers are
provided when you create a new client case.
( 12/23/98 )
How should I treat ownership of an asset, such as property? What if I plan
to sell it in a certain year?
Knowing at what age the sale will be, add the amount cleared from the
transaction to either of the Income columns on FirstDetails, SecondDetails,
or DetailedInputs. If the
proceeds will be taxed in some way other than ordinary income, to get the
tax consequences right you should actually enter
(proceeds - expenses - taxes)/(1 - marginal tax rate).
If you don't want to make an assumption
about when the asset would be sold, include its value in the portfolio and
adjust return and volatility appropriately to represent the composite
portfolio.
( 12/23/98 )
How do I modify entries in Detailed Schedules that are populated by
previous entries, with the inflation factor applied? Suppose I want to
look at a scenario where that spending is reduced by say 1% every year
after age 80.
Select the first cell to be so modified. Then move the cursor up to the
formula bar and insert "*.99" after the formula therein. Enter. Return to
that cell and copy down. The same procedure should be used for other such
edits. If you mess up, hit the FIX button and start over. See Chapter
nine of the User's Manual for other related tips.
( 12/23/98 )
What single number in the output analysis should I be focused on?
It's partly a matter of taste. There are four graphical displays in
Detailed Charts, and the information they convey overlaps a great detail.
Final Wealth Distribution shows the probability distribution of wealth
at the Target Age. You want it to have significant mass to the right of
some minimal target amount of wealth. The table of Percentiles picks off
some key interesting percentiles from those same distributions.
ProjectedRetirement Spending shows in what years does the portfolio run
out (without having to toggle backwards in time) if the Withdrawal Cap is
disabled. If the Withdrawal Cap is enabled then Projected Retirement
Spending also is helpful in designing a spending plan which is more
likely to succeed. Finally the Projected Wealth percentiles graphs the
same information which the table of Percentiles present over entire
analysis period.
Back to your question. Is there a single number to focus on? Yes.
It's the probability of having more than a certain target amount, at a
certain target year. The target year is year of retirement for someone
still significantly within the accumulation period, say with ten or more
years of earning still to occur. And for a retiree it's an age he
thinks he's unlikely to live beyond, say five years beyond expected
lifetime. For someone just a few years away from retirement, he
should look at the projection to year of retirement and to expected
lifetime plus five years. Projections beyond thirty years are to be
discouraged: the results are too diffuse, bad cases will be cured along
the way by reduced spending, good cases will inspire higher levels
of spending.
The target amount depends on the client's ambitions: to leave nothing
behind, a moderate amount, or some substantial amount. Those in turn
may have to be tuned after an initial pass. A vague desire to leave
$1,000,000 to one's alma mater may be abandoned when it is realized that
spending 25% less than planned would be required.
What level of probability is recommended? It depends on risk tolerance,
and that in turn may have to be revised in light of realities. Everyone
would like to be 99% confident that their plan is going to work, but
few can afford that level of confidence. Or adjust to the reduced spending
that might be dictated.
So, final answer? General rules of thumb: an accumulator should be 75%
confident of having the desired amount for retirement, at retirement age.
That amount is arrived at by a side analysis. A retiree should be 85%
confident of having a positive balance at some advanced age, like 90.
( 3/15/00 )
Why doesn't RSP model uncertainty in inflation?
It should, but we haven't decided on a model that we are happy with, yet.
There are problems: returns will be correlated with inflation, and
differently for the various asset classes. There are other modeling
problems, such as more difficult conversion of nominal dollar results
back to inflation-adjusted, since we'll have to keep track in the
program of what inflation was in each year, in each replication. For
now we recommend just use a safe highish value for the constant inflation.
( 3/26/00 )
Why doesn't RSP average annual success probability weighted with
mortality data as some other programs do?
We believe using a target age is better for planning purposes. The
problem with the actuarial approach is that it counts on the fact that
one may die young and thus greater spending is allowed. The actuarial
approach is appropriate for an insurance company which counts on people
dying according to a certain distribution, they set their prices and
their benefits accordingly, and, sure enough, their customers in
aggregate die roughly on schedule. An individual is advised to
cover as many likely scenarios (like living to age 90) as he can afford.
( 4/13/00 )
I am now 40 years old and expect to work until age 62. The projections
I do that take me to that age and then through 25 years of retirement
seem to yield such a broad range of possibilities that it is difficult
to know what conclusion to draw.
Normal volatilities of 10, 12, or 14% have an enormous impact over a 50 year
span and result in a spread of outcomes that, as you say, is difficult to
assess. Users of your age and younger should focus on the amount of wealth
you would like at retirement. You should do a separate analysis to see what
happens with an amount like $1,000,000 or $2,000,000 over a 25 year
retirement span with the spending you’d like, and that tunes your thinking
as to what amount you’d like to have at retirement age.
( 1/21/99 )
What does the withdrawal cap do?
The withdrawal cap must be enabled by the user for it to take effect.
(It is enabled by clicking the Switch toggle button.) When enabled,
the withdrawal cap limits the maximum percentage of the current
portfolio total that the user is allowed to draw from the portfolio for
after-tax expenses. If your desired spending exceeds income plus the
withdrawal cap multiplied by total wealth, then spending for that
year is reduced. The values that appear when you enable the cap are based
on an analysis presented in an article by Jonathan Clements in the
Wall Street Journal, (6/2/98), somewhat modified in our presentation
after extensive experimentation. When disabled, the withdrawal cap
column is filled in with ’100%’ for the whole column. In cases where
the withdrawal cap is needed and invoked to solve a case of too
high spending, by disabling it you see total wealth reduced precipitously
at some later age. With the withdrawal cap enabled, the reduction of
total wealth still occurs, but more gracefully.
( 1/21/99 )
Your model assumes that returns are based on draws from some distribution
that are independent from year to year. What is the basis for that?
Price changes for individual stocks and asset classes and the market as a
whole have been analyzed many times over the years. The classic reference is
by Eugene Fama, published in the Journal of Finance in January, 1965, pp.
34-105. He shows that daily changes of the 30 Dow Jones Industrial stocks
are consistent with the hypothesis of independence. Among other things this
means that runs of gains, or losses, have no influence on what might happen
in the next or any other non-overlapping time period. For annual percentage
changes, and whole asset classes, that would hold all the more so, as any
departures would tend to be smoothed away. In practice the market
does occasionally overreact up or down, and there is then a correction for
the reversion to the mean. But for long term planning, what RSP is for,
those swings are irrelevant.
The exact mechanism for the change in price is to multiply by a lognormal
random variable, one whose underlying normal has the mean and standard
deviation which the user enters. That is consistent with what Fama and
others have seen in market data over the years.
( 3/25/99 )
Is there a way to get at the tax model to do some experiments involving
different hypothetical tax situations?
Yes, there is. While RSP is open, go to the Excel Format menu and click on
Sheet, Unhide, and Tax Tables. Then click on Tools, Protection, Unprotect
Sheet. Then alter the first schedule of thresholds and rates, appearing in
rows 5 to 9 and columns 7 and 8. Now those rates will prevail if you select
the Married Joint button on the input sheet. Be sure to click
File->Save As to save your workbook under another name so you don't loose
the original tax tables.
( 7/16/99 )
Is there a way to change the default values for the Return and Volatility
numbers that appear on the PortfolioDescription sheet so that when I
start a new case I don't have to change them?
Here are two ways to do what you want [method 1 is preferred]:
-
Start a New case, calling it ’New Client -- New Case’; Change the returns
and volatilities to your favorite values; Put favorite values in any
other inputs you want; Save the case; When you want to do a new case,
first Open ’New Client -- New Case’, and then do a Save As using the
new client's name and case.
-
Change the returns and volatilities to your favorite values; Insert
a worksheet; Copy the returns and volatilities from PortfolioDescription
and paste them to the inserted worksheet; When you want to do a new
case, use New, and copy and paste the returns and volatilities from the
inserted worksheet to the PortfolioDescription worksheet.
( 4/18/00 )
What if I don't know the cost basis of an account?
You’d better put in something other than the default value of $0.
An educated guess is better than nothing.
( 4/24/00 )
Are the tax tables indexed for inflation?
Yes, the thresholds for each rate increase using the entered inflation factor.
( 4/28/00 )
How are minimum distributions computed?
The default formula used for the Tax-deferred Distributions column is
1/(Average Life Remaining), refigured for each year beginning when
the Client (or First Person) reaches age 70. The default choice for
the Average Life Remaining table used is the IRS Unisex Joint Life table.
Clicking the Switch button above the Tax-deferred Distributions column
will switch to the IRS Unisex Individual Life table. If Joint is selected
for a one-person case, the Individual table is used. If Joint is selected
for a two-person case, the Joint table is used until one person dies, then
the Individual table is used for the survivor. If Individual is selected
for a two-person case, the ALR for the first person is used until they die,
then the ALR for the second person is used. Note that the minimum
distributions are unaffected by the withdrawal cap. (See Previous question
on the Withdrawal Cap.)
( 5/13/00 )
How do I use the Term Certain method for minimum distributions?
R$P 2000 implements the Refiguring method by default. You can use the
Term Certain method by replacing the contents of the Tax-deferred Distributions
column with the following Excel formula, in R1C1 notation:
= IF(R DetAges < 70, 0, IF(R DetAges = 70, (1/R DetARLs),
IF(AND(R[-1]C > 0, R[-1]C < 1), 1/(1/R[-1]C-1), 1)))
( 5/29/00 )
Why does my portfolio experience dramatically reduced returns at retirement?
This sounds like an effect caused by the rollover of Profit Sharing and 401-K
accounts that occurs during the first year of retirement. These accounts will
be absorbed by the IRA accounts. Make sure that you have meaningful (non-zero)
returns and volatilities for your IRA accounts, even if you have no initial
balance in them.
( 6/14/00 )
If portfolio returns are generated randomly, why do I get the same
answers whenever I rerun a client case?
The random nature of the Monte Carlo simulations is not completely
random, as we use what is known as a pseudo-random number generator.
These generate a long repeating sequence of integers which is "seeded"
by selecting another integer to determine where in the sequence you
start. These integers are then used to determine the pseudo-random
returns that are applied to your portfolio.
We use the same seed for all RSP runs, so that you will get identical
results each time you run with the same inputs. This is different from
what Excel's RAND function would produce, as it seeds itself from the
system clock, and produces a new random number each time you recalculate
the cell that uses it. We must do it the way we do, so we can reproduce
problem cases when you need help.
( 7/28/00 )
Are Social Security survivor benefits automatically handled?
RSP does not automatically handle Social Security benefits for
survivors. You must manually enter the benefit, in current dollars,
on the survivor's detailed worksheet (FirstDetails or SecondDetails).
Enter these numbers only in those cells of the Social Security Income
column that correspond to the years after the other party is assumed to die.
( 7/28/00 )
How can I avoid entering my clients' pre-retirement income and expense,
and still have them save a target amount before retiring?
You have to enter an income that is sufficient to cover the planned savings,
spending, and taxes. If you want exact amounts to be saved during pre-retirement,
ignoring income and taxes, we have implemented this feature in RSP 3.
For more information, please send an E-mail to
RSPinfo@pa.wagner.com
, requesting details on upgrading to RSP 3.
( 8/2/00 )
How do I use Monte Carlo to decide on a safe retirement spending schedule?
As you know, your portfolio returns are subject to fluctuations and uncertainty, and the
Monte Carlo method can be used to assess the impact of that on your wealth distribution
at some target advanced age, to make sure your assets will survive you. RSP enables
individuals and advisors to do this job for you, efficiently and insightfully.
We are sometimes asked why can't this process be simplified by performing many production
runs of the analysis and boiling it all down into rules of thumb. Such as, if my
portfolio has to last 30 years, it is safe to spend 4.5% of it in Year One.
That can actually be done to some extent. But realize that the correct withdrawal rate
depends on more than just the number of years the portfolio has to last. It also
depends most importantly on: the expected return, the volatility or standard deviation
of the return, the individual's tax status (how much of the portfolio is sheltered and
what is the cost basis of the taxed part), an assumption about inflation, and what is
the desired confidence level. To a lesser extent it also depends on the relative
magnitude of the portfolio (implying different effective tax rates), the size of tax
deductions, and the ages of the clients.
But we could consider all nine of those effects, pick a suitable number of cases for
each variable, and grind out the answers for all combinations. The figure here shows
our analysis for a starting portfolio of $1,000,000, a desired confidence level of 90%,
three different lengths of time, and three extreme assumptions concerning tax status
of the portfolio. The right hand column gives the safe Year One withdrawal amount we
derived using RSP. Note that even for a fixed length of time, say thirty years, the
safe rate can vary between 4.2% and 5%, depending on tax status.
Now look at the notes to see what other assumptions characterize this table of answers.
You'll see that this was a moderately aggressive portfolio, low inflation, moderate
amount of deductions, and this couple was of an age that they were about to retire.
If you were to make a reasonable number of assumptions for all these variables
(perhaps six standard portfolios and two or three cases for each of the other
variables) you would need about 300 sheets like this table. Well, that's not an
unreasonable number. Not as many pages as Don Quixote or Les Miserables. More like
the size of Great Expectations.
The problem is, even if you could get someone to run all those cases and publish the
book, it would still not be adequate. The charts would be based on static assumptions
about savings and spending, they only work for the in-retirement (drawdown) part of
the game, and they would all have to be redone every year or two as tax law changes,
and the return/volatility profile for reasonable notional portfolios changes. By
static assumptions, we mean essentially constant, other than inflation adjustments.
If you need to plan for tuition and weddings and gifts, then you may have to vastly
overspend the safe rate and make up for that by underspending that rate in the other
years. No amount of additional rule-of-thumb charts can cover all those
contingencies and complications.
So what's the solution? The solution is you have to plan and re-plan on an annual
basis, using a tool like RSP, with fresh input data. As the Pentagon general was
reported to have said on November 8 this year, No plan survives contact with the
enemy. For this application the enemies are inflation, unexpected losses, and
unforeseen expenses. The planning is worth it. And you will never run out of money
as long as you have the flexibility and discipline to reduce withdrawals to the amount
the planning process recommends.
( 12/10/01 )
Copyright 1999-2001 by Daniel H. Wagner Associates, Inc. - All rights reserved.
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