What’s a Retirement Stress Test, and Why Do I Need One?
If you follow the financial news, you may have heard about annual “stress tests” at the major banks. These tests help determine whether banks have the financial stability to get through a major problem, like a market crash or economic downturn.
It’s a worthwhile undertaking, but for the average person these tests might seem a little abstract. Oftentimes, banks will incorporate possibilities like a rising interest rates, a collapse in emerging markets, or an economic boom leading to higher inflation.
You might even be falling asleep just thinking about it!
But stress tests are useful for individuals, too – especially pre-retirees
Think about all the risks you’re facing down as you get closer to retirement. You might fall ill, get laid off, or happen to retire right as the markets drop.
Do you know what you’d do in any of those situations? Well, you can do a stress test and figure out what type of contingency planning could help you get through a bad situation.
The basics of stress testing
Just like the banks, you’ll have to make key assumptions about the cost of these scenarios and the effect they could have on your retirement. And just like a stress test, it’s important to remember that it won’t be perfect: you could face several negative events at once, or the magnitude of those issues might be worse than (or not as bad as) you expected.
So why bother?
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Because at the end of the day, it’s always better to plan as best you can than to wing it and hope for a good outcome.
Even if you’re wrong about the magnitude of any given problem, the fact that you’ve made some plans around it can help make it less of a problem.
Let’s walk through two scenarios that often keep pre-retirees up at night: an un-planned early retirement and a fall in the markets a la 2008.
Scenario 1: An unexpectedly early retirement
What would happen if you were to get laid off 5 years before you planned on retiring? Would you be okay, or would you have to quickly rethink your whole financial plan?
You might be surprised to know that almost 50% of people end up retiring before they planned to, and most don’t necessarily want to be. Health scares, layoffs – any unexpected change can prompt this kind of sudden transition.
Those years of lost savings and potential expenses can also do a number on your financial plan.
Here’s how to test your readiness:
Whatever your planned retirement date, pretend you’re 5 years out and suddenly out of the workforce.
Ask yourself these questions:
- What does your nest egg look like (assuming all else is the same)? How much money do you have for retirement?
- What are your possible income sources right now?
- What assets do you have available to help finance your retirement?
- Would you be able to maintain the lifestyle you have now (or that you were expecting to have as a retiree), or do you need to scale down your expectations?
Once you have a sense of your assets and income, it’s time to think about how to adapt your long-term balance of income and expenses. In this type of situation, would you need to downshift to a more modest lifestyle? Take Social Security early? Sell your home?
If you’re concerned about how on earth you’d weather an early retirement, it’s time to start rethinking your plans. Every situation is different, but you might consider saving more, rethinking your long-term investment strategy, or even giving some thought to your lifestyle expectations – both now and later.
Whatever you do to prepare, the idea is to provide yourself with a little bit of flexibility, and ideally a little more peace of mind.
Scenario 2: A serious drop in the markets
If you knew anyone who was retiring in the 2007 to 2010 period, you probably remember stories of stress, worry, and grave concern about the future.
Even after the worst of the financial crisis, many pre-retirees and retirees were uncertain whether they would ever recover their asset base – and about whether they would be causing themselves further damage by relying on their savings for income in the meantime.
Unfortunately, you can only do so much to time your retirement, and the markets might not cooperate. One study found that 80% of “success” in retirement – how long your money lasts – can be attributed to what’s going on in the markets in your first decade after retiring.
In other words, even with the same great habits and the same consistent planning, individuals can experience vastly different outcomes depending on nothing more than what’s happening in the markets when they retire.
Are you prepared?
It’s very useful to test how resilient your plan would be in extreme market situations.
For example, let’s imagine that the stock market loses 25% of its value in the year before you plan to retire. Take your expected asset allocation (that is, your expected mix of stocks, bonds, and other investments) and calculate the effect of that market drop on your portfolio as a whole.
Now, ask yourself the following questions:
- What does your nest egg look like (assuming all else is the same)? How much money do you now have for retirement?
- How does that amount translate to an annual income?
- Would you be able to hold off on using your savings if you needed to? In other words, what are your other income options, and how much flexibility do you have to allow your account to grow?
If a severe market downturn would spell catastrophe for your retirement, it’s time to revisit your plans. Maybe you need to be saving more, or perhaps you could reconsider your investment mix.
Every situation is different – including yours
As with most things in personal finance, there’s no one-size-fits-all answer for how to prepare for these kinds of challenges. But you can do yourself – and your retirement – a huge favor by thinking through them in the context of your personal and financial situation.
By understanding the impact of different types of risks, you’ll be better able to plan ahead to help avoid them, or at least to reduce their potential effect on your retirement.
Learn more, plan better
Talking to an advisor can be a big help in making these kinds of plans: not only can we help you run the numbers, we can help you figure out what to do about them.
But if you’re looking to get started on your own, download our free retirement stress test guide. It’s an easy-to-use workbook that will walk you through some key retirement risks and how to test your personal retirement readiness.
Don’t let the unknown scare you into analysis paralysis: take charge of your retirement by downloading our stress test guide, and start making progress today!
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