A Comparison of ORP and Forecaster3

Introduction

In August 2008 Laura Saunders, a Forbes Magazine contributing editor, suggested a comparison between Bruce Martin's Forecaster3 retirement calculator and the Optimal Retirement Planner (ORP). to show how the two seemingly similar computer programs are fundamentally different.

Forecaster3 requires that contributions and withdrawals are specified either by the user or are rules built into the software. ORP computes optimal schedules for contributions and withdrawals. Essentially Forecaster3 is a calculator while ORP is a planner.

A glossary at the end is provided for readers not familiar with the terminology of retirement planning.

The Similarities

1. Both programs were written by and are supported by veteran computer programmers with long experience in the field.
2. Both programs are available free of charge over the Internet.
3. Neither program is affiliated with any financial institution nor any other commercial sponsor. They are more a labor of love than a commercial enterprise.
4. Both programs separately model the retiree's and spouse's tax advantaged accounts, Social Security benefits, post retirement income and pension income.
5. Both programs have a similar, detailed list of parameters to be filled in by the user.
6. Both programs provide reports summarizing annual asset account status and cash flow during retirement.
7. Both programs offer a Monte Carlo risk assessment option.

The Differences

Order of Account Withdrawal

Forecaster3's default strategy for selecting the order of account withdrawal is the conventional rules of thumb [4]:

1. Spend the After-tax account first.
2. Spend the Tax-deferred account second.
3. Spend the Roth IRA last.

On May 1, 2008 New York University hosted a one day conference addressing the question of The Optimal Retirement Withdrawal Strategy[7]. One conclusion of the conference was that the progressive Federal income tax turned withdrawal strategy into a non trivial exercise. Papers presented at the NYU conference show that in many situations the conventional rules of thumb are inefficient because the retiree will be paying unnecessary income taxes.

ORP recognizes that the withdrawal strategy is highly situational in cases when there are savings in two or more accounts. After Social Security benefits, pensions, earned income and Minimum Requirement Distributions have been accounted for, ORP computes the optimal withdrawal strategy. Generally, the strategies are:

1. If there is money in the After-Tax Account and money in Tax-Deferred Account then ORP spends the After-tax Account and does partial rollovers from the Tax-deferred Account into a Roth IRA for as long as the After-tax Account lasts. When the After-tax account is empty then ORP will withdraw from the Tax-deferred Account and the Roth IRA in parallel. This strategy keeps the retiree in lower income tax brackets throughout retirement.
2. If there is money in the Tax-deferred Account and the Roth IRA then ORP withdraws from the Tax-deferred Account and the Roth IRA in parallel.
3. If there is money in the After-tax Account and money in Roth IRA then ORP follows the conventional wisdom and spends the After-tax Account first.

The sale of the retiree's house at some future age will put a large sum into the After-tax Account which ORP will schedule according to the strategies described above.

Adoption of this strategy will have an impact on which account will receive contributions before retirement. In some situations ORP will recommend stopping contributions to the Tax-deferred Account during the last few years before retirement and contributing to the After-Tax Account instead. Then strategy #1. above comes into play. In this manner ORP optimizes across the retirement boundary.

Descriptive vs Prescriptive Reports

Superficially Forecast3's reports are similar to ORP's reports. Their fundamentals are different

1. Forecaster3 requires that the user specify the retirement savings accounts withdrawal rate. Forecaster3 then computes the size of the estate or the year in which retirement funds run out. Forecaster3's reports are descriptive in that Forecaster3 reports the consequences of the user's parameter choices but does not offer planning guidance.
2. The ORP user specifies the desired estate size. ORP computes the maximum after-tax amount of money available for annual spending. The optimizer guarantees that the reported plan will yield the maximum amount of money available for spending during retirement (after taxes). ORP's reports are prescriptive in that they define a plan for contributing to and withdrawing from the user's retirement savings accounts.
3. Forecaster3's reports are much more attractive than ORP's reports.

Random Value Generation

1. Forecaster3 computes the probability of ruin,i.e. the chances of the money running out before life expectancy. ORP computes average and standard deviations below average of the amount of money available for spending,
2. Forecaster3's random value generator for investment returns creates a normal distribution in which successive years are independent of each other. This practice is condemned by academics who have studied the use of Monte Carlo techniques in financial modeling. [8][9]

Feature Differences

Forecaster3 contains these unique features:

1. Forecaster3 is a deterministic calculator. Run it once and get the state of play for each year of retirement. The amount of account contributions and the rate of withdrawals are determined by the user input parameters.

ORP contains these unique features:

1. At the heart of ORP sits an industrial strength linear programming optimizer[6] which finds the very best model solution from the set of the model's possible solutions. ORP does more than compute future states of the retirement savings accounts. Looking at the entire time period, ORP computes a schedule of contributions and withdrawals.
2. ORP models the progressive Federal income tax. This is vital because tax levels affect the choice of accounts to withdraw from and the levels of withdrawals. Academic research [1] [2] shows that tax considerations during withdrawal significantly affects the total amount of money available for retirement spending. Personal income taxes determine the choice of which account to contribute to and which retirement account to withdrawal from.
3. ORP's Monte Carlo option uses a random value generator that is based on S&P500 returns from 1955 to the present. The generator incorporates a feature that links successive year returns which leads to some trend following.

Implementation Differences

How the software is made available to the user is not mathematically critical; it is more of a matter of user convenience.

1. Forecaster3 runs entirely on the user's computer. Thus a download of the software is required. Generally, this is a risky practice but this case is a trusted exception. Additional downloads are required to obtain later releases. Forecaster3 currently runs only on Windows PCs.
2. ORP is an Internet client/server implementation. The only thing that runs on the user's computer is an Internet browser displaying pages from the ORP server. All of the computations take place on the ORP server. ORP users are always running with the latest software. ORP runs all computers that support a web browser.

Conclusion

The second fundamental difference between the two calculators is that the Forecaster3 user specifies withdrawal rates and Forecaster3 computes the estate. The ORP user specifies the estate and ORP computes the optimal withdrawal schedule.

The third fundamental difference is the order of account access for withdrawals is fixed as part of Forecaster3's input parameters. ORP computes the order of withdrawal so as to level income tax payments.

A model's usefulness is determined by how well its results fit the real world situation being modeled. In retirement planning personal income taxes matter. Welch [3] indicates that factoring taxes into the picture and computing the retirement plan accordingly will increase the amount of money available for retirement spending by 4% to 6%. That's not chump change for a $3M retirement account. To put it another way Forecaster3's results are overly pessimistic and will call for under spending during retirement, sacrificing the retiree's standard of living in favor of a larger estate while overpaying personal income taxes.

Glossary

1. With an After-Tax Account, usually a conventional brokerage account, money is saved after taxes have been paid and where capital gains and personal income taxes are paid annually. Funds may be withdrawn from the After-tax account without paying additional taxes and without paying any penalties.
2. The initial Amount of Retirement Withdrawal is computed as the user specified withdrawal rate multiplied by the total assets at the year retirement. This amount is withdrawn each year, increased by inflation, from any or all of the retirement savings accounts.
3. The estate is the amount of money to be left at the end of the plan that may be inherited by the retiree's heirs or, in ORP's case, serve as insurance for a longer than the user specified life expectancy.
4. Life Expectancy or Term of the Plan is the age at which the retiree expects to die.
5. A Monte Carlo calculator runs the model many times with random values for the asset return rate and the inflation rate [5]. The results are a statistical profile of the model under uncertainty.
6. Roth IRA savings are made after taxes have been paid on earned income. There are contribution limitations. No taxes are paid on withdrawals except penalties have to be paid on early withdrawals. During retirement Tax-deferred account withdrawals may be rolled over into the Roth IRA after taxes have been paid on the IRA withdrawal.
7. The Tax-deferred Account receives before-tax contributions from earned income. That is contributions to the Tax-deferred Account are deducted from earned income before taxes are computed. Personal income taxes are paid on all withdrawals. Penalties are applied to withdrawals before retirement. There are contribution limitations.
8. Withdrawal rate is the percentage of the retirement assets to be withdrawn as determined during the first year of retirement. It is used to compute the amount of retirement withdrawal. Most retirement calculators require that the user input her preferred withdrawal rate. The withdrawal rate usually ranges from 4% to 7% of the assets at the year of retirement.

References

1. Withdrawal Location with Progressive Tax Rates; Stephen M. Horan; Financial Analysts Journal; June 2006; Volume 62, No. 6; pages 77-87
2. Extending Retirement Pay outs by Optimizing the Sequence of Withdrawals, John J Spitzer and Sandeep Singh; Journal of Financial Planning; Apr 2006; 19, 4; ABI/INFORM Global pg. 52
3. Optimal Retirement Withdrawal Strategy , James S. Welch, Jr., July 2008.
4. Can You Afford It?, Forbes 2009 Retirement Guide, Laura Saunders, October 2008, p35.
5. A Critique of Monte Carlo Retirement Calculators James S. Welch, Jr., July 2008.
6. Advanced Linear-Programming Computing Techniques, William Orchard-Hays, McGraw Hill, 1968
7. The Optimal Retirement Withdrawal Strategy Conference , New York University, May 1, 2008
8. Evensky,H.; Heading for Disaster; Financial Advisor, April 2001, pp. 64-69
9. Nawrocki, David, professor of finance, Villanova University; Finance and Monte Carlo Simulation; Journal of Financial Planning/November 2001;

November 19, 2009		© 2009, James S. Welch, Jr