optimisation

Optimisation isn’t usually the first word that comes to mind when thinking about retirement. Some people have grand dreams, others hope to avoid poverty; many avoid thinking about it. Here at EvolveMyRetirement® we’ve recognised that optimisation is an important component of effective financial planning. And finances are the bedrock of a fulfilling retirement.

What is optimisation?

According to the Merriam-Webster online dictionary, optimisation is “an act, process, or methodology of making something (such as a design, system, or decision) as fully perfect, functional, or effective as possible”. The examples in this definition include decisions, and this is what we’ll focus on here. The kind of optimisation we’re talking about is the kind that helps us make the best possible decisions. When a grandmaster makes a move in a chess game, his brain is attempting to make the optimal move. If he can see far enough ahead, he can make the objectively best move. There’s no random uncertainty. But the kinds of decisions we’re interested in here are financial ones, and uncertainty abounds.

Let’s look at a very simple example where we optimise a financial decision. Say we have £1,000 to invest, and we know we won’t need it for another year. We have the choice of two savings accounts (assume there are no other possibilities). One pays guaranteed 3% interest and allows instant access. The other pays guaranteed 4% interest, but requires 90 days notice. We need to decide into which of them we should place our £1,000. If we optimise this simple problem, we should invest the full £1,000 into the 4% account, and give notice 90 days before we know when we need it.

That was an easy decision, between two choices, each of which has known consequences. Real-world decisions are not usually so simple. There are usually many more choices, and the consequences are often uncertain. Take investing in the stockmarket, for example. There are hundreds of companies to choose from. And the likely return on investment will be different for each, as will be the risk of losing money. Optimisation of investment decisions is incredibly hard, even for the most experienced experts.

Pension drawdown and optimisation

One of the classic problems in retirement planning is drawing down income from a pension pot. Let’s say you have £100,000 in your pension plan. How much is it safe to withdraw each year so you won’t run out of money during your lifetime? This is a problem in optimisation, and a hard one. It requires you to make a number of assumptions up front:

  • Your life expectancy.
  • The expected return on investment from your pension funds assets.
  • The risk (volatility) of your pension fund investments.
  • Whether or not your withdrawals are fixed, inflation-linked, or dependent on pension fund performance.
  • The degree of risk you’re willing to accept for running out of money.

In the 1990s, to help solve this optimisation problem, William Bengen came up with the 4% Rule, which has since entered retirement planning folklore. Bengen analysed the performance of a 50-50 mixture of equity and bonds over a 50 year period. He assumed a starting withdrawal of 4% of the initial capital. Each year, the withdrawal amount was increased in line with inflation. He found that, even during the worst market downturns, money never ran out in less than 33 years. There are, however, a number of important caveats:

  • Life expectancy is limited to 33 years.
  • It assumes a particular investment approach (50-50 equity and bonds).
  • It relies on historical (and US) investment performance, which may not be a good indicator of the future.
  • 50 years’ worth of data is a very small statistical sample.
  • It’s limited to strictly inflation-linked withdrawals.
  • It assumes zero tolerance for risk, and aims for a 100% success rate.

Despite its limitations, the 4% rule serves as a good illustration of financial optimisation in action. Only one variable was attempted to be optimised though: the drawdown rate.

Juggling competing decisions

If only retirement planning optimisation were as simple as optimising the drawdown rate! In reality there are many different decisions that need to be made, and traded off against each other. For example:

  • How much to save into a pension plan.
  • How much to spend (discretionary spending, that is).
  • The type of investment risk (e.g. equity versus bonds or cash).
  • Whether and how to vary investment risk over time.
  • Whether any assets should be converted into lifetime annuities, and if so how much.
  • How much to draw down from pension funds.
  • Whether to take out a pension cash-free lump sum all in one go, or to phase it.
  • How much to draw down from other assets.

It’s not possible to optimise these one at a time. For example, spending and saving are on opposite sides of the coin. Increasing spending is good for the enjoyment of life, but increasing saving is good for security. Increasing one necessarily means decreasing the other. As another example, consider buying annuities, which reduces risk but can also reduce income compared to drawdown. This may mean reducing spending, unless something else is changed, for instance increasing the investment risk and potential returns of other assets.

Changing one variable can have a knock-on effect that needs to be compensated for by changing another. And to make it even harder, uncertainties abound, for example:

  • Inflation will vary.
  • Investment returns will fluctuate.
  • Life expectancy is uncertain.

Juggling the optimisations of multiple variables when there’s uncertainty is an extremely hard problem. Many retirement planners consider it as much an art as a science.

Optimisation by EvolveMyRetirement®

There are numerous online retirement calculators, some more sophisticated than others. A few of the better ones have the ability to run Monte Carlo simulations in order to test the effects of uncertainty. This involves running thousands of simulated test scenarios, and statistically analysing the results.

However, EvolveMyRetirement® is the only online calculator app that not only runs Monte Carlo simulations, but also provides optimisation. It does this by means of a particular technique called a Genetic Algorithm. This uses simulated evolution to improve the quality of the financial decisions, based on a survival of the fittest. Hence the name of the calculator.

Users of EvolveMyRetirement® have sometimes reported that some of its optimised decisions are surprising and counter-intuitive. Unlike a human, the app is not swayed by emotion or preconceived notions. It judges each potential set of decisions by the quality of the likely outcome. So for example, you might feel that you ought to finish drawing down your pension before you touch your ISA investments. EvolveMyRetirement® might determine that the other way round leads to better outcomes. The reasons might have to do with income tax, or maybe with eventual inheritance tax. Of course it’s up to you whether you follow the optimisation or your intuition.

The ‘noise’ created by uncertainty means that optimisation is not the same as perfection. For this reason, it’s often a good idea to re-optimise as a check. If you’re still in doubt about the results, you can share your optimised plan with a financial adviser, who can provide an expert opinion.

Without such an optimisation feature, the best you can achieve using a retirement calculator is trial and error. This might be okay to fine-tune an already-optimised plan, but it’s certainly not the best approach to decision-making. It’s both error-prone and time-consuming.

Embrace optimisation for a more prosperous retirement!

Optimisation And Your Retirement

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