The Impact of Asset Allocation, Savings, and Retirement Horizons, Savings Rates, and Social Security Income in Retirement Planning: A Monte Carlo Analysis

Article excerpt

Abstract

This study uses Monte Carlo simulation to evaluate the ability of various deposit percentages and asset allocation weights to support withdrawals in retirement that permit smoothed income over the life of an individual. The results indicate that, in general, individuals need to deposit at least 15% of pre-retirement salary for 30 or more years in a portfolio consisting of at least 50% equity to achieve a high success rate for portfolio withdrawals. When Social Security payments are excluded from the retirement income, the success rate is greatly impacted by the savings rate, the savings period, and the amount of equity investment in the portfolio.

© 2009 Academy of Financial Services. All rights reserved.

JEL classification: G11-Portfolio choice

Keywords: Retirement planning; Portfolio choice

1. Introduction

Traditionally, retirement planning and spending has focused on the "three-legged stool," consisting of pension benefits, Social Security, and personal savings. In recent years, structural changes indicate that for many workers, the three-legged stool is quite wobbly. Increasingly workers cannot count on pension benefits in their retirement planning as they are non-existent for many workers. In fact, less than 20% of private sector workers are covered by a defined benefit plan. Even more perilous for retirement planning than the disappearance of defined benefit pension plans is the looming insolvency of Social Security. In its 2009 annual report to Congress, the Social Security Trustees estimated that unless changes are made, the Social Security Trust Funds will be exhausted by 2037.

With the increased individual responsibility in retirement planning, there are several critical questions facing individuals: The fundamental question a retiree faces is: How should I prepare financially so that I will not outlive my retirement portfolio? To answer this question other questions have to be answered. First, what level of pre-retirement income is necessary to retire comfortably? Second, how much of my income must I save to retire comfortably? Third, what should be the asset composition of my retirement portfolio? Fourth, when should I begin saving for retirement? Fifth, what is my expected retirement income horizon? Sixth, when I retire, should I manage my funds or purchase an annuity? Seventh, if I decide to manage my funds what should be my retirement withdrawal rate? The specter of reduced or non-existent Social Security further exacerbates retirement planning. Each of these issues is important in its own right and has been examined by recent academic research in isolation or conjointly with selected other topics. However, these decisions are interdependent and need to be addressed concurrently. Our purpose in this paper is to jointly examine the nexus of decisions surrounding retirement income planning in the presence and absence of Social Security income.

The remainder of the paper is organized in the following manner: The next section discusses prior literature on the topic, the third section outlines our data and research methods; the fourth section discusses our results; and the last section contains our concluding remarks.

2. Literature review

Fundamental to addressing retirement portfolio asset allocation, savings, and withdrawal decisions is the question: "What level of retirement income is necessary to maintain my current standard of living?" This issue has been addressed in perhaps the most complete longitudinal study on the topic by Aon Consulting/Georgia State University commencing in 1988 and repeated approximately every four years. Although the replacement ratio varies according to pre-retirement income, in the most recent iteration of this study (Aon Consulting, 2008) postretirement income of about 78% of pre-retirement income is generally sufficient to sustain current life styles for families with pre-retirement income of $60,000 or greater. …