Episode #26: Stress Testing Your Financial Plan

Wealth Decisions Podcast Transcript for Episode #26: Stress Testing Your Financial Plan

Listen to this episode on Apple Podcasts or Spotify

Welcome to The Wealth decisions Podcast, where each week I take 15 minutes or less to discuss crucial wealth decisions and mindset hacks to help you live a richer life.

I'm your host, Brian Muller, and I've been in the financial services industry for over 25 years, and I'm also a certified life and health coach.

And I have a passion for helping people make better decisions around their money and their life.

So for the sake of time, let's dive right into it.

In today's episode, we're going to be discussing an essential, but overlooked aspect of financial planning, and that's stress testing your financial plan.

Today, I'm going to talk about this crucial process that I think can help ensure your financial stability and peace of mind.

So let's just first define what stress testing your financial plan means.

It's a process of evaluating how well your financial strategy and your financial plan would hold up under various challenging scenarios.

Just like engineers stress test buildings to ensure they can withstand earthquakes or severe weather, you need to stress test your financial plan to make sure that it can withstand economic shocks and personal setbacks, as well as different things out of our control.

It's important to do this because the financial landscape is constantly changing.

You know, market conditions fluctuate, personal circumstances change, and global events can have an unforeseen, you know, impact on our finances.

And by conducting a stress test, we can identify potential weaknesses in our financial plan and make any necessary adjustments before any real crisis hits.

So some of the benefits of stress testing your plan is just detecting problems, weak spots.

Regular testing helps you identify these issues before they become major problems.

Number two, it increases your financial resilience.

You know, by addressing some of these weaknesses, you can make your financial plan more, you know, robust and better to able to withstand any major shocks.

It also helps you make better decisions, you know, understanding how your plan is going to perform under stress tests can help you make better financial decisions.

And of course, number four, peace of mind, knowing that your plan has been thoroughly tested can potentially just reduce some financial anxiety that you may have.

First of all, a solid financial plan is going to give you some idea of your probability of success.

I use Right Capital and there's many other financial planning software systems out there that advisors use, but Right Capital, as well as a few others that I know of, will assign a probability of success.

And it will run your financial plan through a thousand different scenarios called Monte Carlo Analysis.

And it's going to look at good, bad and ugly different market environments and assign a probability.

And you want to be usually in what is called the confidence zone, a probability of somewhere between 75 and 90% probability of success to give you peace of mind that your plan will hold up.

But you can also run a lot of different stress tests on your financial plan.

You can look at what if the equity markets or the stock market was to drop immediately 20% as soon as you retire.

You can stress test Social Security.

If Social Security benefits were reduced, how would that affect the probability of your plan?

You can stress test inflation.

You could look at what if inflation is 1% higher or 3% higher.

You can look at stress testing against returns and expected returns.

What if your returns were not what you expected?

What if they were lower by 1% or 2% during an extended period of time?

What if tax expenses were higher?

What if your tax rates went up by 20% or 30%?

And what if you lived longer or healthcare costs increased?

You can stress test your plan against all these different scenarios to see how the probability of success of your plan will hold up with different types of stress tests.

A solid financial plan is going to also look at your tax allocation.

Where do you have money?

How much percentage-wise do you have in taxable investment accounts, tax-deferred investment accounts, and tax-free investment accounts?

It's going to give you a balance sheet of your net worth.

It's going to look at potential withdrawal rates and how that would impact your plan.

It'll show you what withdrawal rate you need to take to meet your income needs and what would change if that withdrawal rate went up.

You can run stress tests or what-if scenarios that show kind of your wiggle room.

What if you needed, instead of $6,000 a month, you needed $8,000 a month to live comfortably after tax?

Will that work and how will that affect the probability of your plan?

So let's talk just a little bit about how to get ready to dive into this process of stress testing your financial plan.

First, you just want to review your current financial situation.

You know, take some stock of where you are financially.

Review your income, expenses and savings.

Make sure you have a good solid budget of what you need to live comfortably now and what that might look like in retirement.

Assess your debt levels.

Check in on your asset allocation.

Evaluate your insurance coverage.

And make sure you have enough in some type of emergency fund.

This step just kind of gives you a baseline to work from and helps you identify any changes that you might need to make.

Step two is to identify some of the potential risks.

You know, what could go wrong?

And this can include some of the things I discussed of things that may be out of our control, but also could include some personal risks and broader economic risks.

You know, some personal risks might be a job loss or reduced income, how that would impact your ability to save, to reach your financial goals, major health issues or unexpected major expenses.

And economic risks, like I talked about before, you can stress test your portfolio against potential market downturns, higher inflation or even rising interest rates.

It's just really important to consider both, you know, any type of short-term setbacks and maybe longer-term stresses and don't, you know, shy away from imagining worst-case scenarios.

The point is, is to be prepared for anything.

And step three is just to run some different scenarios.

This is where the actual stress testing happens.

You know, for each risk you've identified, imagine how it would impact your financial plan.

Some scenarios, you know, might include, like I mentioned before, what if the stock market dropped 20% right when you retire?

What if your investment returns are lower than planned for an extended period of time?

What if inflation were to go up 2% or 3% for several years?

And also, what if you were faced with the major unexpected expense, whether that's 20,000 or 50,000 or 100,000?

You know, one type of unexpected expense that could happen sometime later in retirement is the need for long-term care.

You can stress test your plan against a potential long-term care need.

I usually put that in a client's plan somewhere later in retirement for 3 years.

And we look at obviously inflating that out with health care costs, which the inflation rate on health care costs is much higher than the normal inflation rate.

And we can see how your plan would hold up during some type of unexpected medical expense like long-term care.

And if your plan doesn't hold up and your probability drops significantly, then that's where a discussion of maybe a long-term care policy to protect you against something like that down the road might come into play.

You know, for each of the scenarios that you run, you know, how would it affect your income and expenses?

How would it affect the probability of your plan?

You know, would you be able to meet your financial obligations?

And would you be able to sustain your current lifestyle?

You know, many financial advisors have very sophisticated software to help you with this process of stress testing your plan.

And now at Momentous Wealth Advisors, I have the ability to do this on a one-time basis.

So if you're looking for a financial plan or a financial plan and portfolio analysis, you can hire me to do this on a one-time basis.

If you're comfortable managing your investments on your own, but just want a second opinion on your portfolio and your financial plan, I have the ability to do that for you to give you peace of mind knowing that your plan will hold up in different stress test environments and we'll be able to show you on a Zoom call how each one of those types of stress tests will affect the probability of your plan to give you peace of mind knowing that your plan will hold up through the thick and the thin.

And step four of this stress testing your financial plan is to evaluate your plan's performance in all these different scenarios.

For instance, did your emergency fund cover expenses during periods where you had to maybe reduce your income?

Were your investments diversified enough to withstand market volatility?

Do you have the right amount of insurance coverage to adequately protect you?

Were you able to maintain your basic needs during your entire retirement?

And if your plan held up really well in all these different stress test scenarios and didn't drop below the confidence zone, that's fantastic and you don't have to worry.

And that's exactly why you should be doing some type of stress test with your financial plan.

But if the plan doesn't perform well, then step five is you're going to have to make some adjustments.

You know, identify some areas where your financial plan needs to be strengthened.

And this might involve, you know, increasing your emergency fund, adjusting your investment allocation.

Maybe you're taking on too much risk currently, especially if you just retired or are about to retire.

You might want to review and possibly increase your insurance coverage.

You might find ways to reduce expenses or maybe even increase your income.

And you may want to look into developing other additional income streams while you're planning for retirement.

You remember the goal isn't to plan for every possible scenario, but to make your overall financial plan more resilient.

And step six of stress testing your financial plan is just to document your findings and the actions that you took.

A good financial advisor is going to take notes and document those findings for you and the actions that are needed to bring your plan into a better probability of success situation.

But let's just talk just a little bit about some best practices in stress testing.

The key is to be consistent.

You don't have to do this every quarter, but this should be something that you do at least once a year when you're updating your financial plan.

And keep it consistent.

You want to, number two, stay objective.

It's easy to be overly optimistic about your finances.

You should never use unrealistic rates of returns in your financial plans.

We typically use anywhere from six and a half to eight percent rates of return depending upon the client's asset allocation and risk tolerance.

But you want to be objective as possible when assessing risks and evaluating your plan performance.

Number three, you want to consider different time horizons.

You know, look at what would it look like if you wanted to retire earlier, or what would it look like if you retired a little bit later?

And look at how the plan performs over those different periods.

And postponing retirement may be what you have to do or increasing contributions to make sure that your plan holds up in all those different stress test environments, and you still have a good probability of success to retire when you want to on your terms.

Number four, you want to update your scenarios.

You know, as your life circumstances change, maybe new economic realities come about, you want to update your stress test scenarios accordingly.

And number five, you know, don't forget just to be positive.

You know, I'm not a doomsday person.

While I think it's important to focus on risks, also we need to consider the positive scenarios.

You know, how would an unexpected windfall or an inheritance or a significant raise affect your plan?

There's positive things that can happen throughout your financial journey that we can add to a financial plan to show you how it affects your probability.

And number six is just to seek professional advice.

You know, if you're unsure about how to conduct a thorough stress test, consider working with a financial advisor, either on a one-time basis or hire a financial advisor for an ongoing financial planning and wealth management type of agreement.

You know, they have all the tools and expertise to model this type of stress testing for you and give you solid objective advice.

And remember, the goal of stress testing isn't to make you anxious about potential financial disasters or your future.

It's just about being prepared and confident that your financial plan can weather all types of storms.

So that's it for today's episode.

Stress testing your financial plan.

Listen to this episode on Apple Podcasts or Spotify


-Brian D. Muller, AAMS® Founder, Wealth Advisor

Momentous Wealth Advisors in a fee-only fiduciary advisory firm

Disclaimer: This material is for informational purposes only and should not be construed as investment advice. Past performance is not indicative of future results. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Always consult with a qualified financial professional before making any investment decisions.