Overview

Financial planning involves uncertainty. We do not know exactly how long we will live, what investment returns we will earn, or what unexpected expenses may arise. MaxiFi addresses that uncertainty in two different ways:

  • A deterministic Base Plan, built using assumptions intended to be close to “for sure” or near certain, so that it can provide actionable guidance for spending in the current year.
  • A probabilistic Monte Carlo analysis, which shows the range of outcomes that might occur over an entire lifetime when investment returns are uncertain.

Both approaches are useful, but they serve very different purposes.

That distinction matters because an assumption that may be perfectly reasonable when considering average outcomes over many years may be inappropriate when deciding how much money you can safely spend this year.

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The Two Approaches

MaxiFi Planner provides two complementary planning approaches:

1. The Base Plan: a deterministic, safety-first plan

The Base Plan asks:

How much can I safely spend this year while maintaining my living standard over the rest of my lifetime, using assumptions I can treat as near certain?

The Base Plan is deterministic. Whatever assumptions you enter are treated as if they will occur with certainty. If you enter a particular rate of return, the Base Plan assumes that return occurs as specified. If you enter a longevity age, the plan assumes you live to that age. There is no probability attached to those assumptions inside the Base Plan. That is why cautious assumptions are so important.

The Base Plan is intended to provide practical guidance for the current year. From a planning perspective, we live only one year at a time. What might happen on average over an entire lifetime is important, but it does not tell us how much we can safely spend this year.

2. Monte Carlo: a statistical view of possible outcomes

The Monte Carlo Risk Analysis asks: What range of living standards might I experience over my lifetime given my asset allocation and spending behavior?

Rather than assuming one rate of return each year, Monte Carlo draws returns statistically and shows a range of possible outcomes.The purpose is not to produce a single "safe" answer. It is to reveal the upside and downside possibilities associated with your investment and spending decisions.

These two approaches complement one another, but they should not be confused.

Why does the Base Plan use cautious assumptions?

Suppose you enter a 7% return in the Base Plan. The software does not interpret that as: “7% is the average return I expect over many years.” It interprets it as: “Assume I earn 7% as specified.”

If a historical average return is entered into a deterministic plan, the resulting plan can appear to happen with near certainty even though the return itself contains substantial risk. The uncertainty has not disappeared. It has simply become invisible.

For the Base Plan to serve as a meaningful spending floor, its assumptions should be ones you are comfortable relying on in the current year with a very high degree of confidence. The more investment risk you take, the more cautious you may need to be when deciding how much to spend now.

Longevity Is Its Own Planning Risk

Longevity deserves separate attention because it presents a different kind of uncertainty. An insurance company can rely on actuarial averages because it insures thousands or millions of people. Some people die earlier than expected, others later, and those outcomes can be pooled.

You cannot pool your own longevity risk because you have one financial life. If the average life expectancy for someone like you is 84, that does not mean planning to age 84 is safe. You might live to 95, 100, or beyond. For that reason, a lifetime financial plan should not be based merely on how long you are expected to live. It should consider how long you could reasonably live.

That is why MaxiFi generally encourages planning to an advanced age such as 100 rather than simply using actuarial life expectancy. The purpose is not to predict that you will live to 100. It is to protect your current spending plan against the possibility that you might.

Safe Returns v. Expected Returns

The same distinction between what is expected and what is safe to rely upon applies to investment returns. When selecting a return assumption, consider two different questions:

  • What return do I think I will probably earn over a long period of time?
  • What return am I willing to count on when deciding how much I can safely spend this year?

Those questions can produce very different answers. Historical averages can be useful when evaluating investment outcomes probabilistically. That is one purpose of Monte Carlo analysis. But using an average return as though it will occur with certainty in a deterministic Base Plan can result in spending guidance that contains an unspecified amount of risk.

Once money has been spent, it cannot be unspent.

If your plan tells you that you can safely spend a particular amount this year because it assumes a risky return will occur, and that return does not materialize, the spending decision has already been made. That is another reason why MaxiFi separates expected returns from safe spending guidance.

How the Approaches Work Together

Many conventional planning tools begin by asking you how much you expect to spend and then calculate the probability that your assets will support that spending. MaxiFi approaches the problem differently. The Base Plan determines a sustainable lifetime living standard based on your resources, assumptions, reserve funds, bequests, housing, taxes, and other inputs. Then, separately, Monte Carlo Risk Analysis allows you to explore the uncertainty created by investment returns and spending behavior. Keeping those two purposes separate has an important advantage:

Risk is not hidden inside a single deterministic answer.

The Base Plan can remain cautious and actionable, while Monte Carlo provides the statistical context around what could happen.

So, what is a reasonable "safe" return assumption?

There is no single return assumption that fits every household. People have different levels of risk tolerance and different investment strategies. However, MaxiFi's default inflation and return assumptions are informed by the market for long-term Treasury Inflation-Protected Securities, or TIPS. TIPS are often used as a benchmark for relatively safe real returns because their principal adjusts with inflation and they are backed by the U.S. Treasury. MaxiFi updates its default assumptions periodically using current market information. The key principle is that the return used in a deterministic Base Plan should be cautious enough to match the purpose of the plan.

But, what if my investments perform better?

Cautious planning does not mean that you permanently give up investment upside.

Suppose your Base Plan uses a cautious return assumption, but your investments perform very well during the year. At the beginning of the next calendar year, you update your MaxiFi plan with your new asset balances. 

Those gains are now real.They become part of your financial resources, and your Base Plan may consequently support a higher living standard for the new year.

The same process works in the other direction. If markets perform poorly, your updated financial position may support a lower level of spending.

This is an important part of the MaxiFi approach: Make a cautious spending decision for the current year based on what you know now. Then update the plan next year based on what actually happened.

We cannot live our entire financial lives at once. We live them one year at a time.

Why not simply use average returns in the Base Plan?

Because doing so blends two different planning purposes. If you place a historical average return into a deterministic model, the result is still displayed as one clean lifetime path, but the uncertainty behind that return assumption is no longer visible.

The plan may appear to be a dependable spending guide when it is actually relying on an uncertain investment outcome.

If you want to study historical market returns, MaxiFi gives you a place to do that: Monte Carlo Risk Analysis.

There, the expected return appears alongside the full range of upside and downside outcomes

Monte Carlo Risk Analysis

Statistical probabilities still matter. That is precisely why MaxiFi provides Monte Carlo Risk Analysis. Monte Carlo uses historical return and risk characteristics to show a range of possible living-standard trajectories based on your asset allocation and spending behavior. Some outcomes will be better than the deterministic Base Plan. Some may be worse. The important point is that the statistical average is shown in context. It is one possible trajectory among many, not a guaranteed destination.You do not get to choose which market path becomes yours. Monte Carlo helps answer the question: How much uncertainty does my investment and spending strategy introduce into my future living standard?

In Summary

MaxiFi’s deterministic Base Plan and probabilistic Monte Carlo analysis serve different purposes. The Base Plan is designed to provide near-certain guidance for spending in the current year. Because its assumptions are treated deterministically, cautious assumptions about longevity and investment returns are essential.

Longevity should reflect how long you could live, not simply how long someone like you is expected to live. Investment returns should reflect what you are willing to rely upon when making an irreversible spending decision this year, not simply the average return you hope to earn over your lifetime. Monte Carlo Risk Analysis then complements the Base Plan by showing the range of outcomes associated with investment uncertainty.

If investments perform better than the cautious assumptions in your Base Plan, those gains are not lost. When you update the plan in the next calendar year, the additional resources become part of your new Base Plan and may support greater spending going forward.

Financial planning cannot eliminate uncertainty.

The goal is to hedge against it appropriately: use cautious assumptions to guide the decisions you must make this year, and use probabilistic analysis to understand the risks and possibilities that lie beyond it.

See also

[Inflation and Rate of Return Data]

[Spending Behavior in Monte Carlo]