Why Monte Carlo Is 'Pretty Terrible' for Analyzing Annuities

“So does that mean the annuity is making no difference here?” Tharp asks. “No, I don’t think that’s really the case.”

Digging deeper into the scenarios, Tharp says, shows how owning the annuity changes the lived journey to this shared ending point. That is, throughout the annuity scenario, the client will be able to enjoy the knowledge of having a certain guaranteed income floor — even in the case of outlier scenarios where the markets dramatically under-deliver.

So, if the client got “unlucky” and was living in the 6% of scenarios in which the plan failed, the client wouldn’t be left destitute while owning the annuity. This can’t be said of the pure portfolio plan, Tharp says, and that’s not made clear by the probabilities.

On the flip side, Tharp warns, the binary probability metrics also don’t reflect that the person who buys the annuity is potentially giving up $200,000 in estate value if the client dies early in retirement. That makes essentially no difference in the probability of success calculation for a 30-year retirement assumption, but it does matter in the real world.

Additional Considerations

Tharp shows advisors a few techniques that they can use to help clients better appreciate the potential role of annuities, mostly based around the historical stress testing tools available in Income Lab.

He runs through three scenarios, including putting the two portfolios through the Great Depression, the Great Recession and the stagflation era in the late 1960s and early 1970s. Tharp also factors in his dynamic guardrails methodology to put each plan in a context that reflects peoples’ ability to make adjustments along the way.

“The main point here is just showing there is so much more nuance going on under the surface of your Monte Carlo analysis,” Tharp said. “And keep in mind, these scenarios are looking at the simplest and most basic type of annuity. Income Lab lets you model much more sophisticated products that can result in very different outcomes.”