Most retirement calculators are based on a number of simplifying assumptions - one of the most flawed is the use of constant annual returns to project future wealth – an unrealistic assumption that can leave investors with a false sense of security.

The only thing that can be said about using constant annual returns to forecast the performance of investment portfolios is that the results will almost certainly be wrong. Future returns will fluctuate and the timing and magnitude of these fluctuations will have a dramatic effect on future wealth.

Toron developed our own simulation primarily to help investors understand the impact that volatility can (and will) have on their investment portfolio. Where most retirement calculators would forecast future TSE returns at a flat 7% year after year, this model considers all the possibilities (good, bad and everything in between) and their probability of occurrence. The model uses a tool called Monte Carlo simulation to address the volatility issue.

While we were developing our simulation, we also decided to address some of the other omissions typical of most retirement calculators – consideration of income taxes, the impact of portfolio turnover, asset mix, the cost of portfolio management, etc.

What is Monte Carlo Simulation? Why is it Important?

The Monte Carlo simulation process involves running a computer model many, many times – a new set of relevant variables is randomly fed into the model during each run and the results generated by each run of the model are recorded. The result is a range of answers and their probability of occurrence. Monte Carlo simulation can be used to model any process that involves random variables and was first utilized in the Manhattan Project in the 1940s (the development of the atomic bomb).

In the context of investment planning, Toron uses Monte Carlo simulation to consider the impact of a large number of possible return combinations on future wealth. This approach is better than conventional retirement calculators because rather than producing one result, Monte Carlo simulation yields a range of possible results and, more importantly, their probability of occurrence.

Monte Carlo simulation is important because it adds an important dimension to the analysis – probability. Using a traditional approach, you may learn that, on average, you will have enough money to retire. Monte Carlo analysis might tell you that while you can expect to have enough money to retire, there is also a 15% chance that you will run out of money. If you are uncomfortable with a 15% chance of running out of money then you can consider saving more, delaying your retirement or adjusting your asset mix as appropriate. Had you relied on the traditional average return approach, you may not have seen the need to make an important adjustment.

What is the Retirement Simulation? What Can it Tell Us?

The Retirement Simulation is a detailed computer model that Toron developed to simulate the cash flows that impact your retirement. The Retirement Simulation considers the impact of the following items on your registered and non-registered accounts:

• investment performance (80 years of historical Canadian and International equity and fixed income returns are incorporated)
• consumer price inflation
• income from employment, pensions and other non-portfolio sources
• living expenses
• the application of savings to registered and/or non-registered accounts
• portfolio turnover
• asset mix (i.e. fixed income vs. equities)
• income taxes (based on income from employment, interest, dividends, capital gains and registered plan contributions / withdrawals)
• portfolio management fees

• Will we have enough money to meet our retirement goals?
• What can we do to increase the likelihood of meeting our retirement goals?
• How does the asset mix decision impact our retirement plans?
• How does our time horizon and asset mix decision impact the volatility of our portfolio?

What the Retirement Simulation is and what it isn’t

The simulation is a sophisticated calculator – it is not a crystal ball and it is not likely to identify your optimal retirement scenario. Toron developed the simulation to generate thought and discussion – not to identify the optimal retirement plan for a particular investor. No retirement calculator can predict the future.

For detailed retirement planning advice, you should consult your accountant, lawyer or financial planner (or we would be happy to provide a referral). If the simulation highlights an issue you hadn’t considered, then it will have fulfilled its purpose.