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Roth Optimization not as good a manual result

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Issues and Potential Errors

Last Post by Gaby Hecht 3 years ago

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Bob James

(@bo3b)

Trusted Member Customer

Joined: 5 years ago

Posts: 43

November 13, 2023 6:14 am

@smatthews51 I Fully appreciate the efforts put into the existing PRC UM but frankly every use seems to result in more frustration than better understanding. Certainly helpful in some cases but overall just something about the style, content seems to miss the mark.

Realize this is not a great response to your request for improvement suggestions. Good documentation is certainly about technical coverage of features but to be effective, "How" the information is presented can also be critical - It can be an art as much as a science.

Just one person's opinion - Might be a worthwhile exercise to start a dedicated thread to ask the Forum for feedback, suggestion...

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Stuart Matthews

(@smatthews51)

Member Admin

Joined: 6 years ago

Posts: 618

November 13, 2023 7:41 am

@bo3b OK, thanks. One of the things I'm doing with the manual for the on-line tool is to organize the information more along the lines of how to use the tool to accomplish a particular thing rather than just a page-by-page explanation. Plus, it'll be integrated into the tool. Also, I think I'm going to develop a companion document with use cases that may replace the examples in the current manual. I like your suggestion of a dedicated thread on the Forum, too, so will get that going soon.

Thanks again,

Stuart

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Louis Molino

(@lmolino)

Eminent Member Customer

Joined: 4 years ago

Posts: 16

Topic starter January 10, 2024 4:53 pm

@smatthews51

This issue has come back with the 2024 version of the software. I am getting a much better Roth conversion result manually than from the Optimization algorithm. See attached pdf. The top figure is the manual conversion compared to no conversion. The bottom graph show the manual conversion compared to the optimization run for a 20 year duration. I ran the same data with 2023 v4.1.1 and the optimization seems to be working correctly, as it yields essentially the same result as the the manual method. Can email the files if needed.

Thanks

Attachment : Compare.pdf

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Stuart Matthews

(@smatthews51)

Member Admin

Joined: 6 years ago

Posts: 618

January 10, 2024 5:25 pm

@lmolino Please email me an export file so I can investigate. Thanks.

Stuart

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Robert Wallace

(@wallace471)

Trusted Member Customer

Joined: 6 years ago

Posts: 52

January 11, 2024 4:07 pm

@smatthews This topic is also recently discussed in the thread topic "Asset Allocations in Tabular Projections" by @ricke and @rrkaushik. @ricke notes that performing the optimization in Asset Allocation Mode 1 vs. Mode 2 produces very different results due to the math from asset allocation shifts over time. If true, @ricke further notes that using Mode 1 may lead to "terrible decisions". Therefore, doing a conversion using allocation Mode 2 is suggested.

I do indeed get very different optimization targets in Mode 1 vs Mode 2, with Mode 2 providing similar estimates to a (crude) manual method of estimating Roth conversions. (For example, see: http://www.youtube.com/@NumberCrunchNerds )

Stuart: Any comment on which allocation mode is preferred (more accurate) for Roth Conversions? If there is a preferred Mode, should that be mentioned in the manual?

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Richard Eaton

(@ricke)

Trusted Member Customer

Joined: 6 years ago

Posts: 58

January 11, 2024 6:18 pm

Doing studies to optimize things like Roth Conversions when using Mode 1 while holding different asset allocations in various types of accounts is the issue. It is not a Pralana problem, it's just a bad science experiment, where you failed to control the relevant variables. You end up measuring the mixed effect of Roth Conversions and an asset allocation shift to more stocks. That will make it appear to the bad scientist that there is an enormous benefit to Roth Conversions and that's where the "terrible" part comes in, if you do a bad comparison, you get a bad result. You are free in reality to hold differing allocations in different accounts, but don't expect to be able to make meaningful comparisons that way.

Using Mode 1 when the asset allocations in all accounts is equal (often called "mirrored" allocations) is the gold standard of knowing your overall asset allocation and therefore your risk. Pralana allows you to reset the allocation 4 times in the model so you can even approximate a glide path.

Mode 2 (many writers call it "tax efficient asset location") allows you to hold different allocations in different accounts and many writers recommend it. This reduces current taxes by putting bonds in your IRA instead of taxable or Roth and increases growth by putting stocks in Roth.

When we do this and use a constant projection of returns, we see that we end with more money using Mode 2 than the same allocation using Mode 1 - Hooray, it's magic! However, if you test a bad historical sequence (Analysis-Run Analysis-then click the button to enable a historic sequence and choose a poor one such as 1966 as the starting year.), then you end up with less money than Mode 1 - Uh-oh, not magic, more risk!

That extra risk is the source of the extra return. When we load our IRAs up with bonds, we are effectively foisting a portion of them on the government (since we owe some fraction of that account in taxes). Meanwhile the stocks we hold in Roth are all ours, so it's effectively an asset allocation shift towards stocks. We could get exactly the same final estate value using Mode 1, equal allocations in all accounts, with some higher allocation to stocks. That equivalence actually holds up pretty well in both bull and bear markets. Pralana is such a powerful tool that you can actually check this yourself.

I happen to currently hold something in between equal allocations in all accounts and the "tax efficient" Mode 2. So I check Roth Conversions with equal allocations in Mode 1 (which will generally favor more Roth Conversions) and with "tax efficient" Mode 2 (which will generally favor smaller conversions) and make the current year's conversion somewhere in between.

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Robert Wallace

(@wallace471)

Trusted Member Customer

Joined: 6 years ago

Posts: 52

January 12, 2024 5:43 am

@ricke Thanks for your explanation and insight/experience on this important aspect of PRC! Your approach looks very reasonable. I must admit that I would not have appreciated this just based on the manual text. Perhaps a paragraph in the manual on "Roth Conversions and Allocation Mode" would be appropriate to explicitly point out the compromises between the allocation approaches and an example of their application (along the lines of your approach mentioned in the last paragraph above)?

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Stuart Matthews

(@smatthews51)

Member Admin

Joined: 6 years ago

Posts: 618

January 12, 2024 8:02 am

@wallace471 I will take it as an action item to elaborate on this topic in the user manual (and may reach out to @ricke to write it!).

Stuart

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Stuart Matthews

(@smatthews51)

Member Admin

Joined: 6 years ago

Posts: 618

January 12, 2024 8:04 am

@lmolino This case did indeed uncover a failure mode in the new algorithm which has since been resolved in v1.3.

Stuart

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Greg Golich

(@golich428)

Trusted Member Customer

Joined: 6 years ago

Posts: 88

January 12, 2024 9:32 am

@ricke, @smatthews51, Richard, Thanks for pointing that out and the explanation. I have struggled with that the past few years and ended up going to Mode2 for the reasons you point out. We need to keep in mind that we all may have different goals for our Roth accounts. I look at them from a legacy perspective and want to have it 100% invested in equities. Others may view it as a future way to manage tax brackets and may not want all equities. These are such personal topics that it is hard to make blanket statements. Thanks again - I have thought about starting a thread on just modeling ideas, pitfalls and tips. Maybe that is something you could start.

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Gaby Hecht

(@hecht790)

Eminent Member Customer

Joined: 6 years ago

Posts: 30

January 12, 2024 12:11 pm

We should be careful here and not make Mode-1 an equivalent option to Mode-2. I believe that mode-1 exist in PRC just because of historical reasons. Initially it was easier to implement Mode-1 than a real Asset Allocation across all accounts (mode-2) which is the common industry understanding for Asset Allocation. Once Mode-1 established in the tool and people used it, it was difficult to remove it when Mode-2 introduced.

I do not see value in Mode-1 in real life. Keeping the same Asset Allocation in all accounts will eliminate Asset Location which is an important tax tool. Not keeping the same Asset Allocation in all accounts in Mode-1 may cause PRC users to make critical financing mistakes, change their investment risk without them knowing and be less tax efficient.

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