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A Risk-Based Model For Retirement Planning

Article  in  Journal of Business & Economics Research (JBER) · February 2011

DOI: 10.19030/jber.v7i6.2304

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Journal of Business & Economics Research – June, 2009 Volume 7, Number 6

A Risk-Based Model
For Retirement Planning
Raida Abuizam, Purdue University Calumet, USA

ABSTRACT

This paper presents the use of @RISK simulation to estimate the value of a long-term investment
in a diversified portfolio along with the risk associated with that investment. A number of possible
investment scenarios in fixed income and equity securities are presented. Each simulation
considers a possible set of portfolio weights for combinations of the different securities. The initial
constraint is that the sum of the investment weights is equal to one. The simulation model creates
future scenarios by randomly choosing past scenarios, giving higher probability weights to more
recent years. The estimated future value of the investment is deflated to determine the amount in
today’s dollars. Finally, for each portfolio scenario, the model determines the value at risk VAR,
which captures the maximum possible expected portfolio value.

Keywords: Investment Strategy, Simulation, Retirement Planning

INTRODUCTION

R etirement planning is becoming a very hot topic. With advances in medical technology and
population increases, planning for the future is more important than ever. The baby boom
generation-those 77 million Americans born during postwar period of 1946 and 1964-has witnessed
the Dow Jones Industrial Average increase by a factor of 40 and has also enjoyed approximately 500 percent growth
in home equity during their adult lives. However, despite these increases, 25 million of the 77 million boomers
currently have a net worth of less than $1,000, excluding the value of their home equity (Levine, 2005). Indeed,
when the baby boomers’ financial situations are taken in conjunction with rising life expectancies, it is clear that
baby boomers will require high-quality retirement planning advice.

The goal for retirees is to have an amount of money at retirement that will support the desired level of
spending for their expected life, plus some number of years as a buffer. Retirees also would like to have some level
of confidence that the retirement plan will hold up under practical assumptions about possibly undesirable
investment results.

Money Tree, U.S News, Fidelity, Vanguard, Financial Engines, and NETirement are examples of
companies that offer Internet-based simulations to help retirees. For retirees who are unfamiliar with mathematical
simulations, or even the Internet itself, the process may well be regarded as a “black box” out of which flows
investment advice. With the plethora of choices presented, retirees would likely be overwhelmed as to which ones
are best for them.

The good news is that a generally accepted approach, often referred to as Monte Carlo and @RISK
simulation by Palisade, anticipates the probability of meeting specific financial goals at certain times in the future.
@RISK uses advanced Monte Carlo simulation techniques to analyze risk in any spreadsheet model. This is
accomplished by generating thousands of possible scenarios the retiree’s investment might take during the years
until he or she is ready to retire. Analysts can find out not only what could happen, but how likely it is to happen.
These scenarios can be used to answer important questions by the investor, such as “What is the chance that I will
meet my retirement goals?” or’ “What is the reasonable downside to the investment strategy that I am using?”

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To create these different scenarios, sets of financial statistics are combined over and over in new ways that
are consistent with what we know about the financial markets. The simulation model is based on creating future
scenarios by randomly selecting past scenarios, giving higher probability weights to more recent years. Finally, the
estimated future value of the investment is deflated to determine the amount in today’s dollars. The model also
applies the value at risk VAR method by examining probabilities of failing to achieve various target portfolio
values. In this study, VAR is the 5th percentile of the underlying distribution. It therefore provides the threshold
below which lies the worst case scenario.

LITRATURE REVIEW

Recent interests in retirement planning have resulted in a growing number of studies that examine the
survivability of retirement portfolios in relationship to asset allocations. Elton and Gruber (1975) use dynamic
programming to analyze multi period portfolio problems that maximize the utility of terminal wealth. The Elton and
Gruber work is based on the seminal scholarship of Merton (1969, 1971), Mossin (1968), and Samuelson (1969).
These early works provide useful insight about the structure of optimal portfolios.

Ho, Milevsky, and Robinson (1994) develop a model to estimate the optimal portfolio allocation between a
risky security and a risk-free asset. They conclude that retirement portfolios should have larger allocations of
equities than suggested by conventional wisdom on portfolio allocations by age of retiree. In a more recent study,
Milevsky, Ho, and Robinson (1997) extend their earlier research by simulating financial market returns and life
expectancies. They use Monte Carlo simulation in their recent analysis. The simulation provided empirical support
for larger equity allocations in retirement portfolios.

Pye (1999, 2000) provides additional examples of simulation studies in retirement and endowment fund
planning and provides a useful explanation of Monte Carlo simulation as applied in retirement planning. He reports
the results of simulations that examine the sustainability of withdrawal from portfolios. He also concludes that
conservative withdrawal rates are sustainable over long payout periods if real portfolio returns are expected to be
eight percent with a standard deviation of 18 percent.

Vora and McGinnis (2000) address optimal asset allocation for retirement portfolios as the retiree draws
down the portfolio. Contrary to the conventional wisdom, they also conclude that retirement should rely heavily on
equities.

Cooley, Hubbard and Waltz (1998, 1999, 2001) employ overlapping periods of historical stock returns and
corporate bond returns to investigate the sustainability of a wide set of withdrawal rates over multiple payout periods
within different portfolio asset allocations. Monte Carlo simulation is applied by Cooley, Hubbard and Waltz (2003)
to the sustainability of retirement portfolios. Farrell( 2001), Milevsky and Panyagometh (2001), Savage (2004), and
Savage (2006) address a range of portfolio issues and problems of mutual funds using Monte Carlo simulation.

The purpose of this study is to demonstrate a defined programming method for constructing an optimal
portfolio. The programming process uses the @RISK simulation model to estimate the value of the investment
deflated in today’s dollars. The investment considered is a retirement portfolio comprising several investment
choices in Treasury bonds, Treasury bills, and equities. The value-at-risk VAR for the different scenarios considered
is calculated. VAR is the lowest possible expected return given a certain probability over the course of the
investment horizon.

METHODOLOGY

Historical annual returns are obtained for each of the financial assets to be considered. For this study, they
include Treasury bond, Treasury bill, and value-weighted equity index. As well, the corresponding inflation rates are
obtained from various Internet sources.

The simulation model is based on creating future scenarios by randomly choosing past scenarios, giving
higher probability weights to more recent years. The most recent year is given a weight of one. Then the weight for
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Journal of Business & Economics Research – June, 2009 Volume 7, Number 6

any particular year is a “damping factor” multiplied by the weight of the following year. Further, these weights are
transformed to probabilities and used in the scenario approach. Finally, the estimated future value of the investment
is deflated to determine the amount in today’s dollars. The model also applies value at risk VAR methods for
analyzing risk by examining probabilities of failing to achieve various target portfolio values.

THE SIMULATION

For simplicity, consider a 35- year -old investor who plans to retire at age 65. The investor plans to
contribute $1,000 at the beginning of each of the next 30 years into a retirement fund, which comprises three
securities: stocks, Treasury bonds, and Treasury bills. Fixed portfolio weights are chosen for each of these securities
in order to maximize expected portfolio value, calculated in present value terms.

At the same time, the investor is concerned about the downside risk involved in the process. To this end,
the @Risk simulation model is employed to measure the degree risk involved for each performance scenario.
Further, the model applies value-at-risk VAR methods by examining probabilities of failing to achieve various target
portfolio values. For the purpose of this analysis, VAR is defined as the 5 th percentile of a distribution. It identifies
the maximum expected return below which there is a five percent chance that the actual portfolio return would fall.
The spreadsheet modeling is outlined as follows:

Step 1. Collect historical data.

Historical data includes 3-month treasury bills (T-bills), 10-year Treasury bonds (T-Bonds), S&P 500 annual return
with dividend reinvestment, and inflation rates. Sample period is from 1982 to 2007. The historical data are
presented in Appendix 1.

Step 2. Set the initial investment weights for the three securities.

Fifteen trial investment weights are created. The sum of each trial set of weights should add to one. The trial weights
are presented in Appendix 2.

Step 3. Construct the probability distribution for the historical data.

The most challenging modeling phase is to decide on a way to use historical returns and inflation factors to generate
future values of these quantities. One suggestion is to use the “scenario” approach. The model will think that each
historical year will be considered as a possible scenario, where each scenario specifies the returns and inflation
factor for that year. Then for the future years, the model will randomly choose one of these scenarios. It is more
logical and applicable to give greater likelihood for more recent years to be chosen. To implement this idea, the
model uses a weight associated with each scenario. The highest weight of one will be assigned to the most recent
year, 2007. Then the weight for each preceding year is a “damping factor” multiplied by the weight from next year.
For example, the weight for 1999 will be a damping factor multiplied by the weight of year 2000. To change theses
weights into probabilities, each weight is divided by the sum of all the weights. For this analysis, the model uses
eight damping factors ranging from 0.92 to 0.99 with an increment of 0.01. Appendix 3 represents the probability
distribution for a damping factor equal to 0.99.

Step 4. Calculate the deflation factors (deflators).

The deflation factor for year 1982 is equal to 1 divided by the inflation factor for year 1982. The deflation factor for
1983 is equal to 1 divided by the product of the inflation factor for the years 1982 and 1983, and so on. In other
words, the deflator effect for year 2007 will be 1 divided by the product of all 25 inflation factors up to that year.

Step 5. Calculate the final cash value in today’s dollars.

The initial investment of $1,000 is invested using the trial investment weights for the randomly selected scenario
year. The beginning cash for the second year is equal to the ending cash for the first year plus the additional $1,000.
The beginning cash grows in every year. To estimate the value of the investment at the end of the investment period
in today’s dollars, the final cash at the end of the 30 years is multiplied by the deflator for year 30. Notice that this is

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similar to calculating the net present value. The only difference is that the inflation rates are not constant through the
30 years, while NPV calculations usually involve the same discount rate each year.

Step 6. Run the simulation.

The model employs the @RISK simulation program to simulate 30 scenarios, one for each year. Each scenario is
randomly selected based on the probability distribution. More recent years have higher probabilities, meaning that
they have a greater chance of being chosen. The model then runs 1,000 iterations for each simulation and would test
15 simulations, one for each trial investment weight. Those 15 simulations will be repeated for each damping factor.

SIMULATIONS RESULTS

The Palisade @Risk simulations results for the 15 trial investment weights are presented in Tables 1, 2, and
3. Table1 shows the mean final cash in today’s dollars along with value at risk VAR for 0.92, 0.93, and 0.94
damping factors. Table 2 presents the results for 0.95, 0.96, and 0.97 damping factors. Table 3 presents the results
for 0.98, and 0.99 damping factors

Table 1: Mean of Final cash (Today's Dollars) and Value at Risk For 0.92 -0.94 Damping Factors

Sim. Trial Invest. Weights DF = 0.92 DF = 0.93 DF = 0.94

No. T-Bills T-Bonds Stocks Mean VAR Mean VAR Mean VAR
1 0.05 0.05 0.9 $80,656 $29,327 $85,758 $31,464 $89,915 $31,434
2 0.1 0.1 0.8 $71,992 $29,838 $76,027 $31,724 $79,445 $31,518
3 0.15 0.15 0.7 $64,303 $30,201 $67,477 $31,716 $70,260 $31,661
4 0.2 0.2 0.6 $57,481 $30,418 $59,960 $31,668 $62,204 $31,901
5 0.25 0.25 0.5 $51,428 $30,263 $53,349 $31,410 $55,137 $31,808
6 0.3 0.3 0.4 $46,058 $29,994 $47,531 $31,150 $48,936 $31,802
7 0.35 0.35 0.3 $41,292 $30,000 $42,407 $30,832 $43,494 $31,337
8 0.4 0.4 0.2 $37,064 $29,472 $37,892 $30,135 $38,717 $30,841
9 0.45 0.45 0.1 $33,310 $28,935 $33,909 $29,201 $34,520 $29,788
10 0.5 0.5 0 $29,977 $27,346 $30,394 $27,647 $30,831 $27,823
11 0.3 0.2 0.5 $50,698 $29,679 $52,577 $30,988 $54,322 $31,312
12 0.2 0.3 0.5 $52,169 $30,860 $54,134 $31,839 $55,965 $32,356
13 0.4 0.2 0.4 $44,774 $29,225 $46,179 $30,283 $47,516 $30,960
14 0.2 0.4 0.4 $47,381 $30,900 $48,927 $32,046 $50,403 $32,782
15 0.5 0.25 0.25 $37,780 $28,708 $38,682 $29,609 $39,570 $30,072

Table 2: Mean of Final cash (Today's Dollars) and Value at Risk For 0.95 -0.97 Damping Factors

Sim. Trial Invest. Weights DF = 0.95 DF = 0.96 DF = 0.97

No. T-Bills T-Bonds Stocks Mean VAR Mean VAR Mean VAR
1 0.05 0.05 0.9 $94,254 $33,538 $99,552 $36,827 $104,688 38,606
2 0.1 0.1 0.8 $83,035 $33,501 $87,291 $36,401 $91,421 38,598
3 0.15 0.15 0.7 $73,208 $33,269 $76,609 $36,154 $79,909 37,635
4 0.2 0.2 0.6 $64,602 $32,861 $67,300 $35,452 $69,918 36,837
5 0.25 0.25 0.5 $57,065 $32,602 $59,188 $34,823 $61,247 36,182
6 0.3 0.3 0.4 $50,464 $32,216 $52,117 $33,939 $53,720 35,373
7 0.35 0.35 0.3 $44,683 $31,462 $45,951 $32,779 $47,183 34,288
8 0.4 0.4 0.2 $39,618 $30,899 $40,574 $31,843 $41,505 33,175
9 0.45 0.45 0.1 $35,181 $30,016 $35,881 $30,603 $36,571 31,705
10 0.5 0.5 0 $31,291 $28,278 $31,784 $28,661 $32,280 29,175
11 0.3 0.2 0.5 $56,204 $32,258 $58,278 $34,361 $60,286 35,601
12 0.2 0.3 0.5 $57,940 $33,132 $60,114 $35,292 $62,225 36,775
13 0.4 0.2 0.4 $48,969 $31,381 $50,543 $32,976 $52,065 34,202
14 0.2 0.4 0.4 $52,008 $33,231 $53,744 $35,092 $55,431 36,544
15 0.5 0.25 0.25 $40,541 $30,116 $41,575 $31,160 $42,577 32,556

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Table 3: Mean of Final cash (Today’s Dollars) and Value at Risk For 0.98 -0.99 Damping Factors

Sim. Trial Invest. Weights DF = 0.98 DF = 0.99

No. T-Bills T-Bonds Stocks Mean VAR Mean VAR
1 0.05 0.05 0.9 $110,903 $41,537 $117,474 $44,229
2 0.1 0.1 0.8 $96,374 $41,158 $101,586 $43,159
3 0.15 0.15 0.7 $83,837 $40,205 $87,942 $41,931
4 0.2 0.2 0.6 $73,015 $39,581 $76,222 $40,779
5 0.25 0.25 0.5 $63,670 $38,406 $66,150 $39,487
6 0.3 0.3 0.4 $55,595 $36,861 $57,493 $38,107
7 0.35 0.35 0.3 $48,615 $35,198 $50,047 $36,430
8 0.4 0.4 0.2 $42,578 $33,690 $43,640 $34,822
9 0.45 0.45 0.1 $37,353 $31,910 $38,124 $32,528
10 0.5 0.5 0 $32,828 $29,374 $33,370 $29,725
11 0.3 0.2 0.5 $62,655 $37,786 $65,076 $38,802
12 0.2 0.3 0.5 $64,702 $39,038 $67,243 $40,136
13 0.4 0.2 0.4 $53,855 $35,784 $55,660 $36,818
14 0.2 0.4 0.4 $57,396 $38,095 $59,391 $39,298
15 0.5 0.25 0.25 $43,743 $33,301 $44,900 $34,062

DISCUSSION OF THE SIMULATIONS RESULTS

Different damping factors provide different probability distribution for scenario selections. Therefore,
different simulation results will occur. The results show that the first simulation, which invests heavily in stocks, is
easily the winner when a damping factor of 0.99 is used. Its mean final cash is $117,474 in today’s dollars value. Its
VAR value is $44,229, which means that there is 5% chance of ending up with no more than this amount. This is the
value investors always worry about. To invest $1,000 yearly for 30 years and end up with a value very close to the
initial investment is something to worry about for any investor. There are always various amounts of risk associated
with any investment. It is also important for any investor to know, in advance, the expected return, along with the
associated risk is for any investment.

Figure 1: Final Cash (Today’s dollars) Histogram Distribution for Simulation #1

(Damping Factor DF=0.99)

Palisade @Risk simulation also provides more summary statistics and graphs for a specific simulation
output. In our discussion, the present mean final cash value is produced by simulation results that warrant thorough
analysis. The behavior and the histogram distribution of the mean final cash value from simulation 1(0.05 invested

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Journal of Business & Economics Research – June, 2009 Volume 7, Number 6

in T-bills, 0.05 invested in T-Bonds, and 0.90 invested in stocks when a damping factor of 0.99 is used) is shown in
figure 1. Appendix 4 represents the histogram distributions of the final cash for simulation 1 using different damping
factors.

As displayed in Figure 1 and in Appendix 4, the histogram of the final cash is a positively skewed
distribution and indicates a lot of variability. Figure 1 also shows that the 95 th percentile is over $228,000. By
analyzing all the simulation results for simulation # 1 using different damping factors, we can conclude that
investing heavily in stocks and using a damping factor of 0.99 will provide the best final cash (today’s dollars) and it
also grants the best value at risk VAR. Figure 2 displays the mean final cash and the value at risk VAR versus the
fraction invested in stocks when a damping factor of 0.99 is used.

Figure 2: Mean Final Cash and VAR versus the Fraction Invested in Stocks
when a Damping Factor of 0.99 is used
$140,000

$120,000

$100,000
Mean Final cash & VAR

$80,000

Mean of Final Cash

VAR

$60,000

$40,000

$20,000

$0
0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 0.50 0.50 0.40 0.40 0.25
Fraction Investwd in Stocks

Figure 2 shows that as the fraction invested in stocks decreases, the mean final cash also decreases deeply
and value at risk VAR decreases mildly. If the investor decides not to invest in stocks, the mean final cash (today’s
dollars) is getting very close to its value at risk VAR. For example, simulation number 10 suggests 0.50 invested in
T-bills, 0.50 invested in T-bonds and none invested in stocks. When a damping factor of 0.99 is used, the mean final
cash (today’s dollars) is estimated to be $33,370 and the VAR is estimated to be $29,725. Therefore, the investor
will decide not to implement this strategy.

CONCLUSION

A variety of industries have used the Monte Carlo methods. In 1940, Scientists at Los Alamos, N.M. used
its principles when they worked on the atomic bomb. Another application to the Monte Carlo simulation is used by
urban planners to predict traffic patterns. Today, financial planners are using it to plan for retirement.

One of the primary benefits of using probability simulation in a spreadsheet model is the ability to alter the
input parameters and re-run the simulation. This will help financial planners determine the effect of changes to the
input parameters on the long-term simulation results. This interactive modeling can be used to create more effective
models that have a greater chance of achieving a particular goal. In our example presented in this study, any changes
in the retirement date or in the yearly contribution amount, or some combination of each input parameter, will
change the output results.

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Because this approach has its limitations, these models are only as good as their assumptions. Using these
models doesn’t eliminate uncertainty. By recognizing uncertainty, however, @RISK Monte Carlo simulation is an
improved and more sophisticated form of advice as compared to traditional plans. As an added complication, it’s
clear that the popular approach of basing future expectations solely on what has happened in the past isn’t reliable.
There is no guarantee that a mutual fund that outperformed the market in one period will ever do so again. Similarly,
there is no guarantee that the historical performance of any given asset will be repeated in the future.

Some people may believe that the Monte Carlo simulation is more similar to gambling than to financial
planning – it is not. Stanislaw Ulam, the mathematician who discovered that you could predict a series of probable
outcomes, was actually playing endless games of Solitaire when he realized the possibilities of simulation. Being
able to predict what is going to happen in Solitaire-not the next card you will turn over in a game, but how a
particular game will turn out based on what has happened with dozens of card combinations-is the foundation of
being able to project probable financial outcomes, or traffic patterns, or telephone usage, or any other event driven
by numerical information.

Using @RISK simulation by Palisade in spreadsheets helps financial planners anticipate the probability of
meeting specific financial goals at certain times in the future. @RISK uses advanced Monte Carlo simulation
techniques to analyze risk in any spreadsheet model. This is accomplished by generating thousands of possible
scenarios the retiree’s investments might take during the years until he or she is ready to retire. Analysts can find out
not only what could happen, but how likely it is to happen. Fortunately, these scenarios can be used to answer
important questions by the investor, such as:

 What is the chance I will meet my retirement goals?

 What is the reasonable downside to the investment strategy I am using?

Appendix 1: Historical Data From 1982-2007

3-months 10-years S&P Inflation

Year T-Bills T-Bonds Stocks Rate
1982 0.1110 0.1300 0.2478 0.0616
1983 0.0894 0.1111 0.2097 0.0322
1984 0.0990 0.1244 0.0697 0.0430
1985 0.0773 0.1062 0.2852 0.0355
1986 0.0616 0.0768 0.1870 0.0191
1987 0.0596 0.0838 0.0977 0.0366
1988 0.0688 0.0885 0.1593 0.0408
1989 0.0839 0.0850 0.2853 0.0483
1990 0.0774 0.0855 -0.0160 0.0539
1991 0.0554 0.0786 0.2801 0.0425
1992 0.0352 0.0701 0.0762 0.0303
1993 0.0307 0.0587 0.0980 0.0296
1994 0.0437 0.0708 0.0182 0.0261
1995 0.0566 0.0658 0.3245 0.0281
1996 0.0515 0.0644 0.2138 0.0293
1997 0.0520 0.0635 0.3030 0.0234
1998 0.0491 0.0526 0.2763 0.0155
1999 0.0478 0.0564 0.2003 0.0219
2000 0.0600 0.0603 -0.0818 0.0338
2001 0.0347 0.0502 -0.1076 0.0283
2002 0.0163 0.0461 -0.2274 0.0159
2003 0.0103 0.0402 0.2606 0.0227
2004 0.0140 0.0427 0.1062 0.0268
2005 0.0321 0.0429 0.0509 0.0339
2006 0.0485 0.0479 0.1490 0.0324
2007 0.0447 0.0463 0.0578 0.0285
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Appendix 2: Trial Investment Weights

Fraction Invested in
Sim. # T-Bills T-Bonds Stocks
1 0.05 0.05 0.90
2 0.10 0.10 0.80
3 0.15 0.15 0.70
4 0.20 0.20 0.60
5 0.25 0.25 0.50
6 0.30 0.30 0.40
7 0.35 0.35 0.30
8 0.40 0.40 0.20
9 0.45 0.45 0.10
10 0.50 0.50 0.00
11 0.30 0.20 0.50
12 0.20 0.30 0.50
13 0.40 0.20 0.40
14 0.20 0.40 0.40
15 0.50 0.25 0.25

Appendix 3: Probability Distributions for Damping Factor DF=0.99

Year Prob. Wts Probability

1982 0.7778 0.0338
1983 0.7857 0.0342
1984 0.7936 0.0345
1985 0.8016 0.0349
1986 0.8097 0.0352
1987 0.8179 0.0356
1988 0.8262 0.0359
1989 0.8345 0.0363
1990 0.8429 0.0367
1991 0.8515 0.0370
1992 0.8601 0.0374
1993 0.8687 0.0378
1994 0.8775 0.0382
1995 0.8864 0.0385
1996 0.8953 0.0389
1997 0.9044 0.0393
1998 0.9135 0.0397
1999 0.9227 0.0401
2000 0.9321 0.0405
2001 0.9415 0.0409
2002 0.9510 0.0414
2003 0.9606 0.0418
2004 0.9703 0.0422
2005 0.9801 0.0426
2006 0.9900 0.0431
2007 1.0000 0.0435

Sum 22.9957 1.0000

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Appendix 4: Final Cash (Today’s dollars) Histogram Distribution for Simulation #1, (Damping Factor DF=0.92-0.99)

DF = 0.92

DF = 0.93

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DF= 0.94

DF = 0.95

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Journal of Business & Economics Research – June, 2009 Volume 7, Number 6

DF = 0.96

DF = 0.97

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DF = 0.98

DF= 0.99

AUTHOR INFORMATION

Raida Abuizam is an Assistant Professor of Operations Management in the Department of Finance and Economics
at Purdue University Calumet, Hammond Indiana, USA. She can be reached at [email protected]

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