Overview
Wealth forecasts in the new planning area in the Morningstar Office 3.4 release are generated using the Ibbotson Wealth Forecast Engine (IWFE). This tool runs Monte Carlo simulations which incorporate client information such as income, tax rates, savings, college and other expenses, retirement needs, social security, and pensions. IWFE models tax rules for most taxable and tax-deferred investment accounts, such as 401(k), IRA, Roth IRA, and Variable Annuities. Tax rules are applied throughout the process, including minimum required distribution (MRD) rules that apply to some tax-deferred accounts.
IWFE performs 500 individual simulations of the client’s current portfolio based on its asset allocation and the market assumptions used to create the plan. For each year in the simulation, the following steps are performed:
Withdrawal
If withdrawal is needed, the assets will be depleted. If there is an MRD in a given year, it will apply toward the withdrawal.
Apply Returns
Returns for all accounts will be determined. This will depend on the asset allocation for each account and the particular returns associated with that asset allocation. Returns will trigger taxes in non tax advantaged accounts. Returns consist of an income return (interest, dividends) and a capital gain return.
Account Contributions
All accounts will receive contributions at this time.
Calculation of Taxable Income & Rates
At this point in the Yearly Sequence, taxes incurred will be calculated. This is the amount of the total tax liability for the year.
Portfolio Rebalancing
Portfolios are rebalanced each year.
This process is repeated for the target allocation. Results are presented at the 10th, 50th, and 90th percentile levels.
Expected Retirement
Expected Retirement Age is used in the wealth simulation to determine when the current employment income will end and when the expenses based on retirement needs will begin.
Life Expectancy is used in the wealth simulation to determine the plan horizon. The forecast will continue until the last of the client or spouse reaches their life expectancy age.
Employment Income
Income amounts entered here are used in the wealth simulation to determine federal income and capital gains tax rates. The Wealth Forecast Engine is able to use different tax rates at different times based on changes in the income level. (e.g. pre-retirement and post-retirement).
Income amounts may also be used to calculate the value of account contributions expressed as a percentage of salary. (e.g. 401(k) accounts)
Incomes are not automatically adjusted for inflation, but can be adjusted by the Income Growth Rate entered on this screen.
Social Security
Social Security income is entered in current value and will be adjusted up each year for inflation.
The year when social security income begins is determined by the Age to Collect.
Retirement Needs are subtracted from Social Security income, and the difference is applied to the simulation as a cash flow.
The Wealth Forecast Engine models the spousal benefit of social security income, whereby one spouse may receive 50% of the other spouse’s benefit if it exceeds his/her own, and 100% of the benefit after the spouse passes away.
Pensions
Pension income which is entered as having a cost-of-living adjustment (COLA) benefit is considered to be in terms of current value and will therefore be adjusted for inflation each year until the first year of eligibility throughout the remainder of the pension.
If the pension income does not have a COLA benefit, the amount entered is considered to be in terms of future value. This value will not be adjusted for inflation.
Pensions may be treated as either taxable or nontaxable.
Insurance Benefits
An insurance benefit for a life insurance policy is added to the simulation as a cash inflow when the insured dies before the spouse.
The Benefit Amount is not adjusted for inflation.
Account Contributions
Contributions may be defined as either a currency amount or a percentage of salary.
Future account contributions entered as amounts are assumed to be in current value, and are adjusted each year for inflation.
Contributions are added to the portfolio accounts at the end of the calendar year in which they occur.
Contributions are deposited into the account in the same asset allocation as the existing account.
Employer Match is entered as a percentage of the employee’s contribution, not a percentage of the employee’s income.
Annual contributions will be capped automatically at their limits for specific account types such as 401(k) and IRA.
Post-tax contributions to tax-deferred account types such as 401(k) defined outside of planning are not considered in the simulation.
Retirement Needs
Retirement Needs, when specified as a percentage, are calculated as the specified percentage of the client’s current income. This amount is inflation-adjusted to reach it’s future value and the inflation adjustment continues throughout the retirement period.
When specified as a currency amount, retirement needs should be entered in current value, not future value. The amount entered will be adjusted up for inflation from the current year.
If the client is already in retirement, the retirement needs must be entered as a currency amount.
Education
Education costs should be entered in current value. They will be adjusted up for both inflation and the specified tuition premium value.
Miscellaneous Expenses
Miscellaneous expenses can be entered in either current value or future value, depending on whether Inflation Adjusted is set to Yes or No.
If a Growth Rate Above Inflation is entered, the expense amount will be adjusted up each year according to this rate in addition to inflation, if Inflation Adjusted is set to Yes, or instead of inflation, if Inflation Adjusted is set to No.
Treatment of Cash Outflows
Cash outflows are subtracted from portfolio balances at the beginning of the calendar year in which the outflow occurs. Hence, if the outflow occurred in December, IWFE would subtract the outflow to the balance in January of the same year.
Cash outflows are specified as after-tax amounts. For tax-deferred accounts the actual amount withdrawn from the account is calculated so that it will produce the correct total after-tax amount. Any withdrawals from tax-deferred accounts may also be assessed an early withdrawal penalty (described later), which is also taken into consideration for this calculation.
Cash outflows are withdrawn from the portfolios in a particular sequence. Withdrawals are made from a given portfolio until funds are exhausted, then funds are withdrawn from the next portfolio in the list. Outflows will be withdrawn in the following sequence:
(1) Taxable Accounts
(2) After-Tax IRA
Roth IRA
Roth 401(k)
After-Tax 401(k)
Variable Annuity
Qualified Tax Deferred
Non-qualified Tax Deferred
(3) Pre-Tax IRA
Pre-Tax 401(k)
403(b)
457 Plan
Calculation of Taxes During Wealth Forecast
Every year in the wealth forecast, IWFE estimates taxes on yield and capital gains during the wealth forecast for taxable accounts. To compute taxes on yield, the Engine determines if the yield is in the form of an equity dividend or a fixed income coupon. Federal dividend tax rates are applied to equity dividends and federal marginal ordinary income tax rates are applied to fixed income coupons. To compute capital gain taxes, IWFE first assumes that a percentage of the portfolio is sold each year in the forecast. Then the long-term capital gain rate is applied to these estimated realized capital gains.
In some instances, income from Social Security amounts is subject to taxation. This occurs if total income from all sources exceeds certain federally-defined levels and depends on filing status.
As noted earlier in this document, the most current tax laws are applied to these returns.
Forecast Results
A total of 500 individual Monte Carlo simulations are performed using all of the information entered in the plan. These individual runs are sorted separately by ending balance for each year, in order to determine the value of the portfolio at different percentile levels within the distribution of the runs.
Results are presented at the 10th, 50th (median), and 90th percentile levels for the target allocation, and the 50th percentile level for the current allocation. Percentile levels are the inverse of confidence levels. The 10th percentile represents a scenario in which the performance of the allocation is much lower than expected. The corresponding confidence level for the 10th percentile would be 90%. In other words, you should expect to meet or exceed the performance of the 10th percentile forecast about 90% of the time.
Wealth Table
The Wealth Table presents, for a specific percentile level, the beginning balance, total additions, withdrawals, investment growth, and ending balance for each year of the simulation. It is important to note that because of the way the individual simulation runs are sorted separately each year, that the values displayed for a particular percentile level for one year are likely from a different run from the previous year. For example, when viewing the 50th percentile, the values for year 2024 might be from run #372 because that was the run that fell in the middle when the runs were sorted by year 2024 ending balance. The values for year 2025 might be from run #148. Because of this, the beginning balance for one year, as displayed in the Wealth Table, will differ from the previous year’s ending balance.