You can test your retirement plan so that your doctor can challenge your cardiac function or that the bank can implement scenarios that may cause it to fail. Retirement plans are as good as their ability to survive financial storms, such as shocks to the stock market. A good stress test also predicts whether there is a risk that could run out of money or whether it needs to be brought to avoid money problems during retirement.
Of course, financial stress tests are nothing new. In response to the 2008 financial crisis, the Federal Reserve has launched stress tests for the nation’s largest banks to see if they have enough capital to absorb losses during a stressful economic situation and maintain lending for borrowers.
Performing stress testing in your retirement plan is a way to assess your ability to withstand the volatility of the stock market and other financial shocks, such as the stock market and economic recession, unemployment, occupational health, long-term care costs, or periods of high inflation that reduces electricity purchased.
Subscribe to Kiplinger’s personal finances
Be smarter, better informed investors.
Save up to 74%
Sign up for Kiplinger’s free e-newsletter
Remember profits and prosperity with expert advice on investments, taxes, retirements, personal finances and more – directly to email.
Profit and prosperity with the advice of the best experts – directly to your email.
What is a retirement plan stress test?
“Stress testing is an exercise to see how your portfolio withstands the outcomes of different markets,” said Cassandra Rupp, senior wealth advisor and certified financial planner at Vanguard.
Stress testing is a way to model uncertain futures that are impossible to predict. The goal is to run your portfolio through various markets and economic scenarios, and see if you can retire and maintain your spending across your lifestyle, and leave money at the end of your life.
“We are committed to providing financial planning services to our customers,” said Ryan Viktorin, certified financial planner and VP of Fidelity Investments. “But given some of the risks we face, we need to make sure our plans and numbers still work.”
Stress testing requires considering average market return scenarios, below average returns and above average profit margins, Viktorin says. “Most people look at the average market returns over time and think things look pretty rosy,” she added. “But we want to show them what it looks like in a significantly below average return period.”
Three big unknowns
Roger Young, director of thought leadership at T. Rowe Price, says there are three major uncertainties that retirees must consider:
Investment performance and associated market volatility are significant. Earning a return lower than the expected or suffering portfolio loss at the wrong time can reverse your plan. Collapsed into this category are a sequence of market challenges similar to return risk.
The lifespan, or how long we live, is another thing. Some people will spend 30 or 40 years or more than they have spent on work. “Living a long, healthy life is positive, but it puts additional stress on your finances,” Young said.
The third unknown is how much money a retiree will spend or need to be drawn from savings. This is because initial spending forecasts can change due to later unexpected healthcare costs and sudden increases in inflation. “In stress testing, most people think about the investor side, but we want to think about the stress testing across all the uncertainties that are unique to you,” Young said.
How do you stress test your retirement finances?
Financial professionals use computer-generated Monte Carlo simulations to highlight test retirement plans for many different investment outcomes. “It’s a great tool,” Young said. “This financial forecasting method or probability modeling, which implements retirement plans through thousands of different financial simulations and bakes with assumptions such as starting portfolio balance, return on investment, investment time, longevity, savings, inflation, spending, and more.
However, unlike basic investment or retirement calculators that allow you to plug in fixed annual forecast returns such as 10%, when determining portfolio balance growth over the long term, Monte Carlo analysis takes into account market volatility. Stress testing your retirement portfolio by examining different patterns of return is more realistic and provides better insight into how planning is done under the most disadvantaged economic circumstances.
The results of the Monte Carlo simulation are numerically expressed from 0 to 99. After running 1,000 different simulations using current plan assumptions, 750 points indicate a positive outcome of missing money and a lack of 250 simulations and money is gone. A Monte Carlo simulation score of 75 indicates that there is a 75% chance of achieving retirement goals.
Most financial experts prefer a success score of 85% or more, but the higher the likelihood of success, the larger the wavy room will be if the situation changes over time. “If the chances of reaching their goal are 70% and 84%, we think we’re a bit off course,” Rupp said. “If they’re under 69%, we’ll consider a course from that course.”
When running a client simulation, Vanguard assumes a life expectancy of 100. Planning your lifespan is important as no one knows for sure when they will pass.
For example, Monte Carlo simulations can help you answer questions such as, “What is the chance of running out of funds by the age of 85?” If the probability of that negative outcome is too high, Monte Carlo simulations can help you change your plan of success. For example, you can determine whether you need to invest monthly to make your risk scores a more acceptable level.
For most people, working with a financial advisor who specializes in retirement planning is probably the easiest way to test your portfolio.
This is an illustration of 1,000 simulations and related reliability scores for T. Rowe Price.
How to improve your score
A recent whitepaper from T. Rowe Price shows how mutual funds can improve the way in which you infuse your retirement into a “trust score.” In a hypothetical example, the 56-year-old named Lee is in a suitable state to retire at the age of 65. A $100,000 salary and $500,000 retire with a 60% medium risk portfolio, with a 10% savings per year, or odds of success are just 68%.
However, a few tweaks have brought Lee back to a much better shape. His decision to increase his annual retirement contribution to 15% of his wages increases his chances of success to 76%. He also chooses to cut his retirement spending by 6%, resulting in a much more attractive 84% confidence score. So simply by promoting savings and reducing spending, Lee was able to return to what T. Rowe Price infuses a “zone of trust.”
If your score is low, you can pull the lever to increase your chances of successful retirement, says Young of T. Rowe Price. You can reduce your retirement spending at any time, postpone your retirement, and increase your equity exposure for your asset allocation.
Young adds that many people are too focused on having a nearly 100% chance of success. But it is often costly. “I mean you’re sacrificing,” Young said. “You may be doing other things during your life to make your life better. Take the slightly lower odds of success and consider enjoying retirement a little more.”
Other prediction methods to consider or DIY stress tests
If you are not working with a financial advisor who can run a Monte Carlo simulation, a simple back envelope analysis may give you a general sense of security for retirement. According to Viktorin, see if your expenses percentage is covered by guaranteed income. If you can cover all your expenses with guaranteed incomes like Social Security or pensions without tapping on your investment portfolio, your chances of success are good.
Another basic forecasting method is to assume a constant rate of return (e.g. 8%) of your account balance over time to estimate future portfolio values. For example, if you have $250,000 currently saved and your future value has swelled to $750,000 for over 20 years, and you estimate that it is the number you need to save to retire comfortably, there is a baseline to follow.
You can also plug in an annual return quote to look at the base case, best case and worst case scenarios and determine if your plan can reach the finish line under the worst economic and market scenarios.
Resignation account stress testing adds Viktorin instead of one process. Things change. Therefore, if your personal financial situation changes, it is important to update your ability to withstand market stress.
