Monte Carlo Simulation Explained: How Retirement Plans Use Probability

A Monte Carlo simulation runs thousands of hypothetical market scenarios against your retirement plan to calculate a probability of success. Ryan explains what that probability actually means: the percentage of simulated scenarios in which you do not run out of money before the end of your plan. The tool accounts for sequence-of-returns risk, meaning whether a bad market comes early or late in retirement matters a lot.

Ryan also tackles the counterintuitive point that a 100% probability score is not the goal. A plan that works in every simulated scenario may mean you are saving far more than you need and shortchanging your life today. Aaron shares that this came up in his own planning meeting, which keeps the conversation grounded. Talk to your financial advisor to understand what probability range makes sense for your specific situation.

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Introductions & Episode Setup

SPEAKER_00 0:05

Jordan State Week is With Canon with the founder of Alchemy Wealth Management and author of your physical physical. Ryan Nelson. Tune in to gain valuable insights and practical therapies as we simplify complex financial concepts into digestible lessons. From budgeting to retirement planning, this podcast is your go-to resource for mastering financial literacy.

Aaron Hoisington 0:33

Welcome everybody. This week's episode of the Fiscal Physical Podcast. My name is Aaron. We are coming to you kind of live, but not really. On the uh hopefully you guys are checking this out Tuesday mornings when the podcast drops. Um, but it wouldn't be a podcast without my co-host Ryan Nelson, founder of Alchemy Wealth Management. Uh Ryan, what's good, my man? Hi, everything's good. What's good with you? I'm I'm doing well too. It's funny, during these intros, sometimes I think about like uh like, oh, how do I cross up Ryan with like a different kind of question normally? And like I've been uh unsuccessful so far. So one of the one of these times we're quick on my feet, I guess. I'll get you one of these times. But uh today, Ryan, I want to jump right into this uh this episode because it's uh it's got a fun name

What Monte Carlo Really Means

Aaron Hoisington 1:20

to it. We're gonna talk about uh the Monte Carlo simulation. Uh and I I a little background on this here. You know, we've uh people hear Monte Carlo, they probably think of, oh, that's in Monaco, or they think of casinos, they think of these different things. And honestly, I mean I wouldn't blame them. I mean, if somebody said, Oh, what are your thoughts on a Monte Carlo simulation? I'd probably be like, I don't know, is that like a is that a craps game? Like something like that. But um, you know, actually, I just had my annual uh financial planning meeting with uh Alchemy Wealth Management, shout on Alchemy. Um, they uh uh, you know, this this handsome devil of an advisor talked about the Monte Carlo simulation, and and I think Oh, you changed advisors? Yeah, yeah, exactly. Yeah, definitely didn't know how to tell you. Uh but no, you you had mentioned when we were talking about the uh oh, this is what we kind of want, and you explained it a little bit, and I was like, awesome. I kind of get a little bit of the concept, but I'm gonna need to die. I mean gonna need a whole podcast episode on this. So um hopefully you can uh um you know give some explanation on this, Ryan, give a little breakdown for our listeners what it is, why it's important, and uh we'll just uh go from there if that works.

Ryan Nelson 2:26

Awesome. Yeah, well, cool. I'm I'm excited it uh that that meeting uh spurred um these thoughts. So what was uh out of curiosity, what was your takeaway from the meeting? What's your impression of what a Monte Carlo simulation is?

Aaron Hoisington 2:39

It was it was like uh pretty much it was like running the different like simulations of like the possibilities of your future is uh is financial future, I believe. And and the interesting piece of it is like, oh, like it's like how how how confident are you in this like financial plan working for you? Um that might be totally wrong, but that's kind of kind of what I got out of it. But the piece of it that I was like wanted to dig more into, because you're like, oh, we don't really want a hundred percent, like we want like lower than that, and I was like, wait, why would we want that? So that was really kind of triggered me here to be like, all right,

Sequence Of Returns Risk Explained

Aaron Hoisington 3:15

we need to we need to talk about this more here for sure.

Ryan Nelson 3:17

So yeah, so the way I think about these Monte Carlo simulations, so in in um sort of specific to retirement planning would be we want we'd be taking um, you know, you know, the so you start saving a certain amount of money, you want to retire at a certain age, and you want to spend a certain amount of money in retirement. Uh, you know, in theory, we could just throw that into a financial calculator and say, hey, are you spending are you saving enough money to give yourself enough money by that? Are you gonna accumulate enough money by that retirement age to be able to spend that much money per per month, right? And so in theory, the calculation of how much to save would be a really, really simple just calculation. Um, where it gets a lot more complicated though, is there's variables and we don't know what the you right, we're making all these assumptions in your financial plan, and we don't know which assumptions are gonna be right, which assumptions are gonna be wrong. Probably all the assumptions are gonna be wrong and off to some degree, right? Um, but we don't know which ones will be off by how much. And so, you know, when we start calculating how much you need to save for retirement, it starts getting a little more complicated when you start looking at all these different variables, and we say, well, are you gonna get 7% returns? And maybe you say, Yeah, that sounds right. And it's like, okay, you're gonna get exactly 7% returns every single year for the rest of your life. It's like, well, no, I'm not gonna get exactly that. I'm gonna get 8% returns one year, 4% returns another year, plus 40% one one year, negative 20% one year, positive one, negative 12, positive eight. But then it's like, well, what if that big negative 20% return came the first year when you started retirement, or if it was the last year of your life? What if that big 40% positive return came the first year of retirement or the last year of your life? So there's an issue with what's called sequence of returns, and it has a really, really big impact on if your plan is successful. So you can start to see there's all these different um like struggles, right? And so the beauty of what a Monte Carlo simulation does is it can take multiple different, oftentimes and usually thousands of different scenarios and sort of sort of simulate them all simultaneously. So now again, specific to retirement planning, what we would do is we'd look at your situation. So we'd say, Aaron, if you're saving X number of dollars and you want to retire at age, whatever, 65, and spend X number of dollars in retirement, what's the probability that you'll be have a successful retirement? And so now instead of just looking at a fixed, like, oh, you're gonna get 7% returns every year for the rest of your life, now we can simulate thousands of different market scenarios. So maybe there's really good market returns in one of these scenarios. Another scenario might be really bad market returns. A third scenario might be good returns at the beginning followed by bad returns. A fourth scenario might be really bad uh returns at the beginning followed by good scenario returns. There might be a scenario with high inflation, a

Thousands Of Scenarios, One Plan

Ryan Nelson 6:00

scenario with low inflation, a scenario with low inflation and good returns, right? Like we you can see how we could pull together, again, thousands of different scenarios, right? Um, and take a look. So now now we have now we can be a lot more confident in your plan. We can say, okay, now, Aaron, if you said you wanted to retire, you know, save this amount of money, retire at this age, and spend this amount of money, now we can look at these thousand, let's call it just one thousand. We can look at these one thousand different scenarios and we'd see how many of these scenarios do you have a successful retirement. So what we would define by a successful retirement in this term would be how many times in these scenarios, these hypothetical little simulations, yeah, do you run out of money before you pass away, or do you not run out of money before you pass away? So if you do not run out of money, we'd call that a quote unquote successful retirement. If you do run out of money, we call that an unsuccessful retirement, right? So let's pretend we run these thousand simulations and in eight hundred and fifty of them, it shows in it in the model show that you do not run out of money. Perfect. That would mean eight hundred and fifty theoretical, hypothetical scenarios out of a thousand, you did not run out of money or you had a successful retirement. So eight hundred and fifty out of a thousand is an eighty-four five percent probability of success. So in this scenario, we would say, okay, based on your current savings rate, the age you told us you wanted to retire and the amount of money you wanted to spend in retirement, we think you'd have about an 85% probability of success. Or again, in other terms, 85%, 850 out of those thousand scenarios. You had a successful retirement where you didn't run out of money, and the other 150 out of a thousand scenarios, we would have had to make some tweak to your financial plan throughout your retirement to ensure that you didn't run out of money. Okay. Does that make sense? Yep, absolutely. Yeah.

Aaron Hoisington 7:40

That actually really paints a picture of like, cool, like even those 150 where I run out, like would run out. We it's not really your run out, you're just having to make changes to it, if you will.

Ryan Nelson 7:49

Okay. So if you originally you said, hey, I want to spend $10,000 a month in retirement. Well, uh, if we start heading down the direction of one of those 50, 150 scenarios where it shows we're going to be you know kind of running short on money, we might have to say, oh, let's make a tweak to your retirement plan. The earlier we can make it, this the smaller change you have to make, right? So if you think about your car, if you're driving down a path, if you just barely are veering off track, you just have to make a little micro correction to the steering wheel to get you right back in the center of the the uh road, right? Now, if you start going way in the wrong direction, you have to make a harder kind of tweak to the steering wheel, right? So the further off track you start getting, the further you have

Defining Success Probability

Ryan Nelson 8:30

to tweak the steering wheel. So the sooner you can acknowledge that you're heading off track and you just make these small tweaks, it can you can again get by and fix this situation with a small tweak. So if we can catch the issue early, we may say, hey, you wanted to spend um $10,000 a month, we're gonna have to reduce your spending down to $9,700. And maybe that gets you back on track, right? Whereas if we don't catch it early and it compounds, it might get to a point where we have to cut your spending to nine or eight or seven or six thousand. And going from ten thousand a month to six thousand a month is really, really hard. Right. Going from ten thousand a month to nine thousand seven hundred is a nuisance, it's an inconvenience, but it's probably doable. Um, so we'd want to catch those situations as quickly as possible. And these Monte Carlo simulations help us do that while we're maintaining it through your retirement. It helps us do that as well. Cool. But you touched on something else there where um, you know, one of the things I like to talk about with our clients and what you alluded to is like myself as a human, like I think as I as I think about retirement, as I start planning for retirement, I think to myself, like, man, when I retire, I want a hundred percent probability of success. I do not want to run out of money in retirement. Like once I pull that trigger and I retire, I don't want to find out 30 years later I'm gonna be running out of money. Like I want to have a hundred percent probability of success. The problem with that is if I for me to get a hundred percent probability of success, that means like it, that means in all thousand theoretical scenarios, they're successful. So now you take a thousand theoretical, hypothetical scenarios, you're taking the absolutely worst theoretical scenario, and you're saying, How do I make this successful without having to make any tweaks to it ever in retirement? And so, you know, the market's crashing, it's terrible, high inflation, right? All these things, it's the worst scenario, and you're saying, How do I build a plan where even that one scenario is successful with me not having to make a single tweak in retirement? So you can imagine how conservative your plan would have to be to allow that worst case scenario to still be successful. And so what it would end up meaning is my, you know, if I was to plan for that, I'd have to work until I'm like 80, 90 years old and save every penny I ever make, right? And and so that's not realistic. So in real life, we have this tug of war between spending money and enjoying life today with saving money and making future errands successful in the future, right? And so, where's that balance? That's like one of the hardest things for most people is to find that balance in life of am I saving enough money now or am I saving too much money? Like everybody knows, hey, everybody has this story about some family member or friend who um unfortunately passed away young in life and didn't get to enjoy, you know, they worked their butts off and they never got to enjoy life, right? Yeah, and so we all can learn from that story and say, man, we need to enjoy and appreciate life today. But then on the flip side of that, there's plenty of people we've ran into who are living paycheck to paycheck. They're elderly, they can't have they don't have the quality of life they deserve. And so we should also learn from that scenario, right? So there's always this tug aware, tug-of-war, where if we spend every penny we ever, if we spend every penny we ever make and we enjoy life to the fullest today, we're not setting future us up for success, and that's not a balanced life. The flip side of that coin is if we save every penny we ever make and we don't enjoy our life today, that's also not setting us up for a balanced life, right? So there's this tug-of-war and there's this line, and it's really hard to find that line of of how much do I need to be saving to both enjoy life today and set future me up for success. And these Monte Carlo simulations help us determine where that line is. Right. So you know we don't want a hundred percent probability of

Why 100 Percent Isn’t The Goal

Ryan Nelson 12:00

success. Sure. On the other side of that coin is we certainly don't want a zero percent probability of success in retirement either, right? And so we can use these tools to start working with clients to start gauging what percentage of their like theoretical simulations are successful, figure out what their probability of success is, and then alchemy, we have it a targeted probability of success we want to work with with our clients. And if they come back at a higher probability of success, so let's hypothetically say we're shooting for this client an 80% probability of success, and they come back with a 90% probability of success. What that means is they're almost oversaving, or their retirement goal is not aggressive enough. So we can start moving their retirement age up so they could retire earlier and enjoy life more, right? Sure. Or they could start spending more money today to increase the quality of their life. So either way, we're we're taking tweaks to their plan that increase quality of life today or in the near future. Or um there's other clients who, if we're targeting an 80% probability of success, maybe their current probability of success is say 40%. That's an indication that, hey, we're maybe spending a little too much now, right? Not putting enough in a way for the future. We need to increase our savings, right? So it's what what we find is one of the most challenging questions for clients is finding that balance and am I saving enough or am I saving too much? Like, you know, and this is like an objective measure to start to get an idea of where you fall on that. And if you need to start saving more, how much more? Um, and it's all using these this Monte Carlos or these hypothetical scenarios. Um that's awesome.

Aaron Hoisington 13:26

Do you do you do that for pretty much every one of your clients? Is that like something that that you run for each everybody? Yeah. Okay, cool. And do you run it often? I'm just curious, do you run it often or like yearly, or like I it probably depends on the individual naturally.

Ryan Nelson 13:39

But yeah, so the way that it works is so so like if I was you know, theoretically it's not gonna make a difference, like if we ran it today and then again tomorrow. Right. Right? Like, like when we'd want to be running, like almost rerunning it, so to speak, is when there's a change to the inputs. So um if you start earning more money, there's a change to an input, we would want to be re-evaluating things. Okay. If you start saving more money, or let's say, let's say something happens, uh, you get laid off our work, or you have a kid, or an unexpected medical bill pops up, and so you say, hey Ryan, we got to reduce our spending. Cool. There's a change to the input, we would want to be re-evaluating, right? Um so I think that's the best way of thinking about it is if there's a change to an input, then we'd want to be reevaluating. And so so then the question becomes like, how often does that happen? Right? Like the cheesy example I always use with our clients is like, think of us as a primary care physician. Like, we want to see you at least once a year to do like an annual checkup, right? What we call our fiscal physical, uh, like our like a checkup on your finances. Um, but then how many times are you gonna see your your primary care physician this year? Like you might be super healthy, smooth sailing, and not see them again until next year's physical, but then there's gonna be other years where you're sick, you're trying to figure something out, it feels like you're in your primary care physician's office every week, right? So it's kind of the same thing with us. We have some clients where, man, some years it's just like, yeah, there wasn't any big changes. We were just steady, jobs were the same, we didn't get any big pay raises or pay decreases. It was just kind of the same, right? And then the next year for that same client might be like, yeah, we had a kid, we moved states, we bought a new house, we changed jobs because we moved states, we got an inheritance. It's like, oh my god, you're like, you know, and I've seen those we're we're rerunning things every single week for them. Like, so so it really is just dependent. We don't know how often those inputs will change. So not the best answer to your to your question, but it's it may be more as like a

Balancing Today’s Joy With Tomorrow’s Needs

Ryan Nelson 15:30

as needed, more so than a standardized process, but I would say at least once a year. Yeah, and no, no less than once a year, but oftentimes more than once a year.

Aaron Hoisington 15:36

Sure. No, I like the the primary care because I go once a year to my primary care physician. I'm like, cool, like do I need to come more? And they're like, no, you're doing good, or hey, let's work on your cholesterol, whatever it might be, these certain kind of things. But I I really like you put it in here too. You kind of gave the reference of like it's like a weather forecast. And I think that really hit home with me too. It's like, because most of the time, like if I see like, hey, we're supposed to get you know, 60% of the areas getting snow, probably gonna get snow, and so you can kind of plan for it, but like, hey, like you know, if if it's supposed to be sunny all week and then randomly there's a you know a rainy day in there, you're like, what the heck, where did that come from? Like, um, it's like, hey, you can't predict everything, but it really gives you a good idea of how to plan and how to adjust your plans. You can kind of think of that in your financial plan as well, too. Like, okay, like you mentioned, you're at 90%. Okay, could we move up your age uh uh a year or whatever it might be? So I I really think that that that hits home about what this success rate really means and like what to don't take it as gospel too.

Ryan Nelson 16:36

I think that's a big thing as well. Exactly. So none of this stuff when anytime we're looking forward into the future, whether it's your finances or the weather, right, we can't we can't know with certainty exactly. And so um, you know, similarly, if we think you have an 80% probability of success, that's good to know. Just like if we think there's an 80% probability of snow tomorrow, you know, if I'm trying to go drive over the past tomorrow and there's an 80% probability of snow tomorrow, but no snow on the forecast today, it might make more sense for me to go today. Right. Yeah. Um now does that mean it's guaranteed to snow tomorrow? Absolutely not. Right, right? Um, yeah, so I absolutely I like kind of thinking about it in a similar vein. You know, most of us kind of I I think sometimes um we think of this financial planning as like more exact and it is really all about probabilities. Whereas with weather, we already sort of intuitively know that because we've been burned enough times where we'll see, oh, it's supposed to be snowing, or it's gonna rain tomorrow. Oh, it never rained. Right, right? Or or it says it's raining right now, it's not raining. You know, um, so so yeah, I'd say yeah, you know, just think of it as probabilities just like a weather forecast.

Aaron Hoisington 17:40

Cool. I like it, man. That was awesome. Uh, anything, anything else to say on this topic here, Ryan, before we kind of wrap up.

Ryan Nelson 17:46

Yeah, I think we I think we covered the the main points for sure. Yeah.

Aaron Hoisington 17:50

I think so. I think so as well, too. So if if anybody wants to sound smart out there, like you can talk about your Monte Carlos simulation or uh uh go get it checked and see if you get a financial plan and such too, and maybe you haven't done one of these with your financial advisor, maybe just ask the question too, like hey, like I would assume they're probably doing something to this case, but at least you have a little bit you know just enough to be dangerous, if you will, when you're gonna go in there for sure.

Ryan Nelson 18:14

So yeah, and they may not use the term. I mean, Monte Carlos is like a fairly technical term, right? Um, so it may not, you know, they may be doing something like this behind the scenes and may not be aware of it. But also it would probably be good for you to know if these types of, you know, if if they're using these types as tools, and if so, like where you where you stand on this.

Aaron Hoisington 18:32

Yep, absolutely. Awesome, man. Well, I appreciate it, Ryan, as always. And uh we'll go ahead and take a quick pause here, be back on the other side with some uh personal stuff.

Adjusting Spend And Retirement Age

Aaron Hoisington 18:40

Uh everybody uh hang tight.

SPEAKER_00 18:41

And now to put the personal in personal finance.

Aaron Hoisington 18:48

Welcome back, everybody, to this side of the fiscal physical podcast. Appreciate you uh hanging tight with us here. Uh Ryan, I got a uh question for you, and hopefully it's one that will get some some engagement as well with the listeners. I feel like there's you know movies made about this question, and everybody talks about these things too. So I'm curious what your um you know thought process is on this. So my question to you is what is your favorite family vacation memory? Um, I'm not sure if you guys took vacations as kids or just like a family memory of like a trip or something that you you might have uh in your in your in your memory bank there.

Ryan Nelson 19:25

Yeah, uh there's a couple. Um definitely we always went on a lot of trips. Um one one we went on this trip, like it was a road trip to um a bunch of different national parks. Oh, cool. I was young, as I don't even remember all the details, right? But we went through like the Dakotas and stuff, and uh there were all these uh like prairie dogs, nice, which I just love. They're like these, you know, just so like cute and like little. And um, so yeah, I loved uh seeing the prairie dogs again. I don't even know how old I was when we went on that trip. Um, but yeah, that was a good one. And then uh uh a second sort of independent one was like camping, and um I just I I still do and have always loved like playing with the campfire. Uh-huh. Um just like making it bigger and poking it. True. Yeah, absolutely. It's good. Doing the classic fire tending stuff. And uh and uh I can't remember. You know, now that I think about this, I I I think I'd I think my parents were like going for a walk or something. Why would they leave me unattended with a firearm and now questions my questions? Yeah, yeah. There's like some questionable parenting there, I think. Uh but uh they uh you know, so I so when they were gone, I'd like put all these uh uh I basically like found this like almost like dead tree. It was just like uh all the pine needles were still on it, you know. But it was like all the pine needles were still attached to the branch, so it was just like this branch full of dead pine needles, and so I just like put it on the fire and it just like just like yeah, like a 20-foot five like high fire. Uh so yeah, that was fun. Uh I I think yeah, that so that was fun. Uh, but those are probably two two that come to mind quickly. What about

When To Rerun The Simulation

Ryan Nelson 21:00

for you?

Aaron Hoisington 21:00

No, that's that's good. I've got uh it's always those funny ones that you're like, wait, these funny things happened like on this trip, for example. Uh uh for myself, same thing growing up. We we always we had like a big like Ford Aerostar van. And so it was like you know, multiple different rows, and we had also we had I'm one of four kids, so there was like six of us sometimes that were traveling. And uh one time we we took a trip um at the time my dad was looking to open up a restaurant, and so we had to go get these this training in Austin, Texas. Okay, just kind of where the franchise was located. So we're like, hey, you know what? Let's do like a family road trip down there. And uh so we actually we we did it, we did it, broke it up in different spots. We actually stayed in Reno one of the nights, which is funny. We drove down from Idaho through Nevada to Las Vegas and then over. We stayed, stopped in like I don't know, we did this whole trip. But when we were in Reno, the funny thing is uh um it was just a just a blast. We always had like books on tape and like fun things that we were listening to or songs and stuff, and we'd stop in different places. We weren't in a hurry. But I actually I spent we spent the night in a hotel in Reno and I got like a really bad crink in my neck. Okay. And I was like probably like nine at the time and didn't really know what it was, but I was like convinced I needed to go to like the doctor. Yeah. Because like I couldn't like move my neck. It was like and we we actually ate at a buffet here in Reno, and my sisters didn't want to like hang out with me because I was walking around like with like my head like hunched over and I just looked like an idiot. And uh but it hurt really bad. Um but it was just a super fun trip. We stopped we went to ended up going to the Grand Canyon as well. Like went down, spent a couple days in Phoenix and just had a bunch of fun. And I just remember that trip like it's a lot of hours in the car. A lot of hours. Then we when we drove home as well, too, but got to see some awesome, awesome country, and it was just a a lot of fun like to go visit these different places that you just like maybe have heard about, like grow growing up in a small town in Idaho and actually get to like go visit state capitals and such too. Like I remember we went and we stayed stopped in Boise, saw the state capitol in Idaho, went down to Reno, and then I didn't know at the time I learned that state capitals Carson City right down the road. Went to that one. We ended up going to Phoenix. We went to I one other one as well, too. It was fun, had a good time. But anyway, that's that's my favorite kind of family vacation memory there. But um, I'm curious to see out there with the listeners. Hopefully, this ignites something in the back of the brain where you guys kind of think about those things and what was good, what was bad about it, but uh what's what's memorable overall. So um awesome. With every that in mind here, Ryan, I think we've uh covered everything uh we need to, and uh I'll uh turn it over to you, my man. As always, stay the course.

SPEAKER_00 23:40

Thank you for joining us for the Fiscal Physical Podcast. Until next time, happy listening. And as always, stay the course. If you have a question or topic suggestions, please email us at podcast at alchemywealth.com. If you enjoyed today's discussion, subscribe to the podcast to

Weather Forecast Analogy For Planning

SPEAKER_00 24:00

ensure you never miss an episode and consider leaving us a rating and review on your favorite platform. This helps other listeners like you find the show. For more resources, you can visit Alchemy Wealth Management's website at www.alchemywealth.com or find your fiscal physical, the book on Amazon. We'd be remiss if we didn't mention that personal finance is just that. Personal. Please don't take anything we say as advice. The preceding content is for informational and entertainment purposes only. It's not an offer or a solicitation, nor should it be construed or relied upon for tax, legal, or investment advice. It doesn't consider your personal financial situation or objectives and may not be suitable for you.