Stress Testing a Boomer's Retirement Plan

Your advisor should balance “best case” assumptions with “worst case” to give you solid information about what to expect as you enter retirement.

Stress testing is a way to analyze and project someone’s retirement circumstance under extreme conditions. Traditionally retirement projections have been made using assumptions that may have been “best case” assumptions. For example; that investment return will be fairly steady over many years, or that you do not retire at the beginning of a severe bear market. Unfortunately the real world is not always so nice and predictable. Ask your advisor to run projections showing you how bad the “worst case” can actually be.

Why is it so important now?

Stress testing is more important as life expectancy increases and people retire at younger ages – the exact scenario for the baby-boomer generation. They may spend as many years in retirement as they did earning and working. The longer the time spent in retirement, the greater the demands on their assets intended to provide most of their income in retirement. Stress testing is less important for those who have large pensions -- something most baby-boomers will not have. The longer people spend in retirement, the greater the odds that they will experience many different economic conditions including periods of high inflation and low investment return.

The issue of retirement planning under more realistic assumptions has been addressed to some extent over the last decade by the adoption of a technique from the fields of science and engineering called Monte Carlo analysis. Most practitioners are now familiar with this approach and better ones routinely use it. Monte Carlo has helped the field move away from the erroneous assumption that investment return and inflation are the same year in and year out.

Unfortunately while useful Monte Carlo analysis has some problems:

• Since it is statistically based, a key assumption is that the pattern of occurrence of investment return and inflation can be adequately modeled using a normal distribution. Under this assumption extreme events have a very small likelihood of occurring, for example a three-year bear market where equities lose 49% of their value. Sound familiar? Or a 27% decrease in the Dow over 1-2 days.
• Monte Carlo techniques do not usually associate investment return with inflation in a fashion that reflects the real world, since both are generated randomly. For example during the 1970’s we experienced high inflation combined with very poor investment performance for several years. This correlation between high inflation and poor return on equities is something unlikely to be generated randomly using the Monte Carlo approach.
• Monte Carlo also does not adequately model the serial correlation exhibited by inflation year to year. Since it randomly picks inflation figures using the normal distribution it is unlikely to generate patterns such as seen in the 70’s where high inflation continued for several years in a row, something that can decimate someone’s living standard.

Event Analysis or Scenario Creation

Including event analysis in your portfolio modeling is something you may want to ask if your advisor offers. To properly model someone’s retirement years you need to consider the worst case scenarios that Monte Carlo cannot model. As one example, consider that studies consistently show the worse thing for a retiree might have been to retire in January 2000 just before the awful bear market. Even a well-diversified portfolio may have decreased 15-20% over the next three years. That combined with what is considered a safe rate of withdrawal from the portfolio of 4% annually means that in three years the retiree’s portfolio may have decreased by 35%. Studies show that even after several years of decent returns the retirees’ portfolio may never recover, greatly impacting their lifestyle for the remainder of their retirement.

There may not be any way to adequately and completely protect against a “worst case” investment occurrence. The possibility, though, should be modeled and discussed so you can be prepared. You may need to generate a game plan if it happens -- a plan that includes part-time work for a few years or a lower expectation of your monthly spending. Put your advisors to work modeling “worst case” scenarios in your portfolio. Your goal is to enter retirement with realistic expectations and not be faced with a nasty surprise.