How to Stress-Test Your Retirement Plan
by Gabriel Lewit
“Am I ready to retire?” is a question that millions of people ask themselves. Yet, for better or for worse, only some people will ever have a fully satisfactory answer.
One of the reasons that retirement planning can be so difficult is future uncertainty. In addition to not knowing where the economy might be ten, twenty, or thirty years from now, it is almost impossible to forecast how long you will live or whether any unexpected expenses are likely to emerge.
However, while knowing the exact amount of money you’ll spend in retirement is impossible to forecast, there are still quite a few things you can do to ensure that your retirement plan is ready to go. Investing in assets that will generate a perpetual income (such as annuities), building a portfolio that can withstand a sudden economic downturn, and being conservative with your cost of living estimates are just a few of the things you help ensure that your golden years are actually golden.
Stress-testing a retirement plan involves carefully examining each component of the plan and seeing how you would fare under extreme—or “stressful”—circumstances. Both the 2007-08 housing crisis and the COVID-19 outbreak, if anything, have taught many aspiring retirees that financial turbulence can quickly emerge.
When trying to determine whether your retirement plan is ready for the long-haul, be sure to keep the following things in mind.
Be Conservative with Every Estimate
As you begin preparing for retirement, there are many different figures that you will need to estimate. The value of your home, the future value of all financial assets, and the expenses associated with retirement are just a few examples. If you retire hoping that your current home can sell for $1 million but eventually discover that the home can only sell for $800,000, you might find yourself facing an unexpected financial challenge.
As a general rule of thumb, it is a good idea to consider that all assets you own are worth (at least) 25 percent less than what you assume them to be. Additionally, you should also assume that all expenses will be 25 percent greater than what you assume, even accounting for base-line inflation.
In fact, inflation is one of the primary reasons that future values can be so unpredictable. Over the past decade, inflation has hovered around 2% in the United States. But while inflation (as measured by the CPI) was 3 percent in 2011, it was only 0.5 percent in 2020. Even just one year at the extreme ends of this range can have a major impact on costs and values. As uncertainty is multiplied over a greater period of time, your exposure to the risk of the unknown will increase.
Conduct a Monte Carlo Analysis
In finance, a Monte Carlo Analysis is a form of analysis that helps people see how a portfolio might perform in a wide range of possible circumstances. Usually, a Monte Carlo analysis begins by taking a set of things that you currently know (or can estimate), such as your current net worth. From there, your retirement plan is tested against randomly generated market circumstances, some of which will be favorable, and some of which will be unfavorable. Because the world itself is unpredictable, this particular form of analysis makes it easy to see just how ready for uncertainty you really are.
When conducting this sort of analysis, you will see that 20 years from now, your wealth will have increased in most simulations. In some simulations, your wealth might remain about the same. But in other retirement planning simulations—and this is really what you’ll need to protect against—you might find that your wealth is expected to significantly decrease, perhaps even moving towards zero.
Take a look at how your portfolio performs during the best 25% of simulations, the worst 25% of simulations, and how it performs under various specific circumstances (such as a steady return). If the worst quarter, or even the worst tenth, of simulations, cause you to go bankrupt, then you may want to consider either reallocating your wealth or waiting a few more years before retiring.
Hope for the Best, Prepare for the Worst
The Monte Carlo analysis, along with other simulative strategies such as the Historical Audit, is great for quantifying how well your portfolio can withstand future sources of stress. But in addition to doing a quantitative stress test, you should also consider doing a qualitative stress test. One of the most important aspects of the retirement planning process is that you simply don’t know what the future has in store. Before answering the question “am I ready to retire?”, ask yourself the following what-ifs:
- What if the stock market were to suddenly lose 50 percent of its value? In 2020, the Dow Jones Industrial Average, the S&P 500, NASDAQ, and most other major indexes dropped by about 30 percent in a very short amount of time. It is seemingly impossible to predict when such an event might happen again.
- What if I can only sell my home for 60 percent of its estimated value? It is not uncommon for many people to have half (or even more) of their wealth in their home—something that is notably an illiquid, highly speculative asset. Make sure you aren’t depending on simply downgrading your home to get you all the way through retirement.
- What if I receive way less social security than projected? Contrary to what some people assume, your social security payments are not in a special fund, waiting for you to retire. Though social security currently helps many people, current issues with the social security system mean you should not count on it to be your sole source of income.
- What if I were to suddenly become sick or injured? Since 1966, Medicare has helped many Americans above the age of 65 pay for their medical expenses. However, there are many things that Medicare does not cover, just as there are many Americans who hope to retire before the age of 65. Be sure that you will be in a position (whether with insurance or with wealth) to handle unexpected medical expenses—the likelihood of needing medical help only increases with age.
- What if I were to live to be 150? While it is unlikely you will actually live this long (in fact, nobody ever has), this question can help people recognize the need for a perpetual income. You don’t know how long you will live. “Planning” to live to be 90 and living to 100 instead can create an array of financial challenges. Make sure your age will never be what affects your ability to be financially secure.
By asking these questions, it will be much easier to see whether or not you are actually ready to retire. While there will be some things you might be able to do if sudden expenses do arise (such as going back to work or using a reverse mortgage), you should be conservative with your estimates and prepared for anything the future might have in store.