Week 45 Day 5: The Probability of Ruin vs. the Magnitude of Ruin

Plan A: 92% success rate. In the 8% failure scenarios, money runs out at age 90 on average (5 years short). Plan B: 85% success rate. In the 15% failure scenarios, money runs out at age 78 on average (17 years short). Plan A is better even though it has a higher success rate AND less severe failures. Plan B's failures are catastrophic. Always ask: when my plan fails, HOW BADLY does it fail?

Examining failure scenarios: (1) Median failure age: the age at which the portfolio is depleted in the median failure scenario. A plan with a median failure age of 89 (6 years short) is much less dangerous than one with a median failure age of 78 (17 years short). (2) Worst-case failure age: the age at which money runs out in the WORST failure scenario. If the worst case is age 82 (13 years short), the magnitude of potential ruin is large. If the worst case is age 92 (3 years short), the magnitude is small and manageable with other resources (Social Security, downsizing). (3) Shortfall amount: in failure scenarios, how much additional money would have been needed to survive? A $50,000 shortfall might be manageable (work part-time, Social Security covers it). A $500,000 shortfall is catastrophic. How to reduce severity of ruin: (a) Income floor (Social Security + annuity ensures you never have literally zero income). (b) Guardrails (spending cuts in bad scenarios delay ruin by years). (c) Part-time work capacity (even $15,000/year of part-time work extends plans significantly). (d) Home equity (reverse mortgage as last resort). (e) Social Security bridge (delay claiming to 70 maximizes the guaranteed income available if the portfolio fails). Planning with severity in mind: (a) Run your Monte Carlo simulation. (b) Look at the FAILURE scenarios specifically. (c) In how many years do you run out? At what age? (d) What resources remain (Social Security, home equity)? (e) If the failure scenario is 'run out at 92 but Social Security covers essentials,' the plan may be acceptable at 85% success. If the failure scenario is 'run out at 78 with no other income,' even 90% success is too risky.

The focus on 'probability of success' as the primary Monte Carlo output metric has been criticized by multiple researchers. Milevsky (2006) argued that the expected shortfall (the average amount of money you are short in failure scenarios) is a more informative risk measure than the probability of failure alone. In risk management terms, the probability of ruin is analogous to 'Value at Risk' (VaR), while the expected shortfall is analogous to 'Conditional Value at Risk' (CVaR or Expected Shortfall). CVaR is widely regarded as a superior risk measure because it captures the SEVERITY of the tail, not just its probability. For retirement planning: (a) Plan with a 5% failure probability where the expected shortfall is $50,000 has low magnitude of ruin. (b) Plan with a 5% failure probability where the expected shortfall is $500,000 has high magnitude of ruin. Both have the same 'success rate' but very different risk profiles. Pfau (2015) proposed combining the probability-of-success approach with the income-floor approach: even in failure scenarios, the retiree's Social Security, pensions, and annuity income provide a floor. The magnitude of ruin is then measured as the gap between essential expenses and floor income (which should be zero if the floor is properly constructed) plus the loss of discretionary spending. If the floor covers essentials, the SEVERITY of portfolio failure is limited to the loss of discretionary spending -- an undesirable but survivable outcome.