Monte Carlo Simulation

Monte Carlo Simulation
How well do you understand risk when it comes to your client's money? How well does your client?
Some trial lawyers, financial planners automatically reject the guarantees and unique tax advantages inherent in a structured settlement when interest rates are low or there is the perception that they (their clients) can do better in the stock or bond markets. Some assume that the client would not be interested in a structure because they are not a minor, unsophisticated, incompetent, needy for income or dependent on complex medical support. The decision to go with 100% cash by a Plaintiff may be borne from the reasons above or other reasons such as fear of the unknown, misperceptions about flexibility; sometimes simply the perception to get rich or even the dignity of wealth. 

In the financial section of practically every newspaper, financial journal or bank window and find advertisements touting historical returns of mutual fund portfolios, trust companies or money managers. Typically these are quoted as an average annual return for a given time period (i.e. from Point A to Point B) and are described as such in the fine print of a mutual fund prospectus. However, investments in the real world rarely perform on a straight-line basis and therefore decisions solely made on the basis of achieving said returns on a straight-line basis could prove to be flawed. An average rate of return of 8% does not mean that 8% was achieved in each and every year in between or will be in the future. In the table below you will see a series of 4 hypothetical returns on money achieved each year over a 10 year period that show a virtually identical 10 year mathematical average. However if you invested along the way (instead of at the beginning) your average might have been markedly different as you can see from the mathematical averages for the first, last and middle 5 year periods
        Year             10y 1 st
5y
2 nd
5y
Middle
5y
Illustrative 1 2 3 4 5 6 7 8 9 10 Avg Avg Avg Avg
Percent 1 2 3 4 5 6 7 8 9 10 5.5 3 8 6.0
Return 2 1 4 3 6 5 7 10 9 8 5.5 3.2 7.8 6.2
  -20 8 6 -5 18 -2 6 10 13 22 5.6 1.4 9.8 5.4
  35 18 -20 -25 5 7 -12 12 9 27 5.7 2.6 8.8 -2.6
  5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5
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The greater the fluctuation in returns brings a greater range of variation in projected values. Thus a projected investment return that employs a static or deterministic approach is bound to be inaccurate because of the failure to recognize the implicit volatility.

In most personal injury settlements, the calculation involves more than a simple lump sum future value or present value; there are multiple cash flows to consider, varying rates of inflation on multiple items, such as cost of medical items, timing of income streams and unknown mortality. If you take two historical periods with the same hypothetical settlement amount, the same distribution amounts and dates and the same returns, but the returns were achieved in a different order there will be a considerable difference in the ending balances.

Monte Carlo analysis or simulation employs what is known as "stochastic" analysis using multiple variables, thus permitting us to account for such factors as health care inflation, general inflation, mortality factors, investment rate of return and others. Armed with a sophisticated program run on a desktop or laptop a simulation of 1,000 to 10,000 trials can be run. The simulation randomly draws values for each factor for each year based on their probability distributions, accounting for an appropriate standard deviation, thus providing a better display of the risk of a 100% cash decision.  It shows how long the money will last based on the set of assumptions. The allocation of settlement proceeds in an important decision. For many it's a once in lifetime decision because they have no means to earn back their mistakes. Structured settlements offer guarantees and unique tax advantages not available to other investors.

If you have been solicited to sell your structured settlement payments, beware of the slick "sales pitch" that claims better investment opportunities for the discounted lump sum they want to pay you. 
  • First, many of the folks promoting this theory may not be properly qualified or licensed to tell you this and you should always check first.
  • Second, without a clear understanding of risk your chances for disappointment increase . Monte Carlo analysis, or Monte Carlo simulation can also be applied in this situation and may be very useful. The same concepts apply as they would at the time the structure was created. With Monte Carlo simulation the many variables of your stated needs can be projected and weighed with a statistical sample of hypothetical returns on the discounted "cash now" lump sum, in a statistical trial as described above. Thus you can have a better understanding of the chances of success or failure. You are then in a better position to make an informed decision as to whether the risk is worth the price you pay (the discount).

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