The title of this story makes it sound like it’s about portfolio management, but it’s really about a far more important issue: the risk that a portfolio doesn’t meet expectations, and the domino effect on your financial independence.
Stress testing, or scenario testing, is an important part of any comprehensive financial plan. By adjusting assumptions regarding rates of return, career outlook, inflation, tax rates and other areas, you can attempt to determine the key factors to focus on, and design a plan that meets your individual needs.
Here are a few scenarios for financial plans to test the probability that your money is there when you need it.
Rates of Return
The first test is to determine the baseline, or required, rate of return. All other assumptions held equal, what is the lowest possible rate of return that provides a good chance of maintaining your lifestyle through retirement?
If the rate of return required is low, you may want to consider a conservative portfolio. If it’s high, the risk associated with that aggressive portfolio may also be uncomfortably high and you and your financial advisor will look at other ways to close the gap (such as deciding to work longer, spend less, or make similar changes).
Bear Market at Retirement
Before signing on the line to retire, make sure you can, even under a worst-case scenario. While long-term rate of return assumptions are important, the sequence (timing) of these returns is even more so. The order of returns is out of our control, but it is important to be cognizant of how these sequences can affect your portfolio.
These concerns may vary for investors at various stages in their lives, but can make a new retiree very nervous. While bear markets are an inevitable part of the cycle, you would wish for the highest return years when you have the most money in your account, and losses to occur when you have the least amount of money in your account.
A bear market early in retirement, without a thoughtful cash flow management strategy, can devastate a retirement outlook. While far worse things have happened in the past, advisors typically test using a 15% annual decline in the market for each of the first three years in a client’s retirement.
Inflation & Income Tax Rates
In addition to the impact of higher inflation and income tax rates on your portfolio, you may want to run some scenarios showing the impact of higher inflation and taxes on your total financial plan. While we all want to defend against the erosion that comes with inflation and higher tax rates, we have to be cognizant that there may be unintended consequences of doing so.
If you invest too conservatively, you may run the risk of not out-pacing inflation on an after-tax basis. If you invest for growth to try to solve this problem, you’ll have to be able to live with the ups and downs that could go along with that strategy. As always, balance is the key.
Everyone is unique, and therefore risks need to be defined on an individual basis. How secure is your employment? What if you can’t sell your home for what you expect? What if a spouse dies unexpectedly? What are the cash flow and long term planning implications, and what should you do? How are your children faring in these challenging times?
You have your own individual risks that must be considered in every case. When you have an understanding of how you may be affected by unexpected events, you can take steps to guard against more of the risks of life. -CL-
Securities and Advisory Services offered through Royal Alliance Associates, Member FINRA/SIPC. Advisory services offered through Key Financial, Inc. A Registered Investment Advisor who is not affiliated with Royal Alliance, Associates. The views expressed are not necessarily the opinion of Royal Alliance Associates, Inc. This information is not intended to be a substitute for specific individualized tax, or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a tax or financial professional.