Planning for expected events in Retirement is easy. Planning for the unexpected is wise. These are the top four stress tests to put your Retirement Plans through to see if you are as bullet proof as you need to be.
Planning for expected events in Retirement is easy. Planning for the unexpected is wise. These are the top four stress tests to put your Retirement Plans through to see if you are as bullet proof as you need to be.
How to stress test your retirement plan
Kevin Lao 00:11
Hello everyone and welcome to the Planning for Retirement Podcast. I am your host, Kevin Lao and today we’re going to be talking about how to stress test your retirement plan.
Now most people think about stress tests when they’re going to the doctor, they’re getting hooked up to some monitors, putting a treadmill and doing a little bit of exercise. And you know ultimately, the doctor was monitoring your blood pressure, your heart rate, your fatigue level, all sorts of things. Really, their goal is to see how your heart performs or responds with a little bit of stress. And I like to take that same concept into my financial planning practice to see how my clients’ portfolios or retirement plans or other long term objectives respond with a little bit of stress. And the reason I do this probably is obvious. But really the idea is that we’re planning for a 15, 20, 30 or even a 40 year window, and things are inevitably going to happen. We just don’t know what those things are. And we don’t know when they’re going to happen exactly. So what I like to do because people worry and they are concerned about different things. And I like to flush those things out in the financial planning process to see what’s keeping up keeping them up at night. And ultimately stress test those scenarios to make sure that their long term objectives are still holding up, and still have a high probability of achieving them with a little bit of stress.
So there are a lot of different stress tests that I’ve run in my career. But what I found is that there are four major stress tests that I put all my clients through. And if they can pass these four stress tests, they are sleeping really, really well at night. They’re enjoying retirement, they’re freed up to spend their own money in retirement, which is an interesting thing. But people that are retired, they have this concern of running out of money. And so there’s always this fear of… you’re spending too much because you don’t know how long you’re going to live or what’s going to happen. So I found that people are enjoying lives more in retirement by stress testing these scenarios up front. So without further ado, the four stress tests has that I run for all of my clients to make sure that they have a bulletproof plan are number 1, Great Recession loss. Number 2, long term care costs. Number 3, prolonged low returns. And number 4, living longer than expected.
So we’re going to dive into each of these in a little bit more detail. I hope everyone finds this helpful. I hope you take something away from it. You can all always reach out to me directly you can email me at [email protected]. You can also go to my website and contact me there www.imaginefinancialsecurity.com. You can also subscribe to our podcasts that’s always very helpful. And you can be informed of new episodes that drop etcetera, etcetera. But always love to hear from you to let me know what you think. And if you have any questions as it relates to your situation, always happy to answer and be a resource. So let’s dive in.
Alright, we’re going to start with talking about the Great Recession loss test. Some may call it the bear market tests. And you know a bear market is quantified as a 20% drop in the stock market from its previous high. I like to use the Great Recession loss test because it is the biggest drop in the stock market that I’ve seen in my lifetime. Not bigger than the Great Depression, which was an 86% drop from previous highs and the 1920s, 1929. So that is extreme. But in 2007 or 2009 from its peak, the market dropped about 56%. And it took about 49 months for the market to get back to that previous high that it hit in 2007. A normal bear market will last on average about 22 months. And typically you know they happen every five years. So they’re fairly common. So I want to make sure that if my client goes through one of these types of bear markets and if it’s as extreme or close to the Great Recession… I want to make sure that they’re prepared and we have a plan and we have a high probability of achieving ultimately that retirement income goals or other legacy goals that they might have.
So how do we do this? Okay, so the first thing is prioritizing the objectives into needs, wants and wishes. This is important because obviously if we go through a serious recession or a depression you know my clients may not be buying boats or taking their bucket list travel… you know they might be but they’re probably not they can probably make some of those cuts. So we would quantify those as maybe wants or wishes, whereas you know your basics like food, healthcare, water, shelter, those types of things are needs. So we want to make sure that we have three categories of objectives: needs, wants and wishes. And this is all part of the process upfront. Once we have this quantified, we run it through a simulation to see what is the probability of success and achieving those goals if we go through a great recession in their life expectancy.
So what’s cool about this is if clients pass the test and great you know there’s not a whole lot of changes we need to make if they fail the tests or if some of their objectives need to be cut out… we can then make decisions on what should be done you know whether that’s changing the investment strategy or saving more before retirement or if they’re already retired, maybe it’s reducing expenses or working you know doing consulting part time. There are a number of different things that we can do. The biggest controllable is obviously the investment strategy.
So with this, what I like to make sure happens is that we have a significant amount of non-correlated assets to stocks in the portfolio. So typically you know clients would refer to this as bonds you know I would call it fixed income or other alternatives. And it’s crazy. I recently saw an article from a major publication that said, bonds are terrible investments, which is insane because you know that’s a very blanket statement, and you’re talking to a audience that is all different ages. So yes… bonds may be terrible for some but they’re amazing for my clients that are approaching or in retirement because they serve as that hedge if the stock market does go through a great recession type of scenario. So let’s say for example, the stock market dips 20% or more or like in 2007, 2009 it dropped 56%. If 100% of our portfolio was in stocks, we would have to liquidate stocks to generate income right… so we’d be selling stocks at a loss.
Now, you’ve probably heard the notion you want to be buying low and selling high not selling low. So in order to alleviate this concern, we need to make sure we have a certain dollar amount in the Fixed Income Cash or alternative asset classes to make sure that if we go through a bear market or recession like 2007 2009, where it took 49 months to recover… we have enough in those asset classes so we don’t have to sell stocks low. So if I’m using that benchmark of 49 months of full recovery that’s roughly 4 years of income that we would want to have in fixed income types of investments that we can pull from in those types of bear markets or recessions. What this does is that alleviates the pressure on doing anything within stock… the stock side of the portfolio, let those asset classes recover because historically speaking, stocks do come back and they do perform way better than bonds. I do agree with that. But it allows us to put less pressure on those equity investments, allow them to recover and still generate that income that my clients need to enjoy their lifestyle and have that peace of mind.
So again, hopefully the takeaway here is let’s see if the portfolio holds up. And the goals hold up if we go through a bear market scenario like a great recession. And then secondly, let’s make sure we have a well thought out investment strategy to ensure that we have other asset classes in the portfolio that are non-correlated to stocks. So we can weather those storms when we go through them because on average these happen every five years. If we have a 30 year retirement, you’re going to be lucky enough to live through about six of those bear markets.
Our next we’re going to talk about long term care costs. And this is a topic that has been pretty much at the forefront for my clients since I’ve been in the business and it’s only gotten more prevalent as people are living longer. You know and one thing I saw… a study that was done on life expectancy, which I thought really was staggering to me is that someone who is 65 today has almost a 70% chance of needing some type of long term care services in their lifetime. And what’s even more staggering is that 20% of those aged 65 or older who would need long term care will need it longer than 5 years. And if you think about the cost of long term care, the fact that Medicare does not pay for long term care. It’s concerning for most people and you know, as a practitioner you know doing… we’re specializing in retirement planning. It’s something I need to assume every single person I work with has a long term care plan.
I’m not saying they need to own insurance but I need to make sure they have a plan. And what I’ve found is the best way to start that planning discussion is to stress test to see how their retirement goals how their other long term objectives how their investment portfolio holds up. If we put one or even both individuals if they’re married through a long term care stress test. Now how we do this is challenging because you might need care for a year, you might need care for 10 years if it’s something that’s more cognitive like dementia. And it’s obviously impossible to run all of those scenarios. So what I do is I take the average, for women it’s 3.7 years of care for men it’s 2.2 years of care. And I multiply that by the average cost of a private nursing home, which right now is about $105,000 per year in today’s dollars. So someone’s 65 you know that’s today’s dollars, we want to build in a reasonable rate of inflation for 5 maybe 6%, depending on the state and depending on the type of care we’re going to stress test is a prudent inflation rate for this type of service. And so if we’re looking out 15, 20, or even 30 years down the road in doing the stress test… the numbers are going to be quite staggering.
And you know personally… I think there’s probably some sort of bubble that’s going to burst with long term care costs going up the way they have been over the last couple of decades. And I think technology and the industry will evolve to help alleviate some of that inflation. But for now, it’s quite staggering. So once we run through the stress test… I will then share with my client if they have a high degree of success and self-insuring and this assumes they don’t have any long term care insurance. And if they have a high degree of success, self-insuring you know they really have one of two options, they could self-insure, meaning use their own assets whether that’s investment portfolios 401ks, IRAs, individual stocks or bonds, mutual funds whatever it might be, they can use their own assets to self-insure or they can decide to buy insurance to hedge their portfolio. And what I mean by that is instead of liquidating investments that are going to generate potentially 5, 6, 7 8% a year in returns, they simply buy insurance so that if they ever need care… they can keep those assets on their balance sheet to essentially work for them and for future generations or maybe their spouse, and essentially allow the insurance to pay the costs of long term care. So or they can do a combination of you know and that’s what I see a lot of people do is they’ll get some insurance but then they’ll self-insure for the rest.
And you know there’s no magic number but I think the stress tests will give us an idea of… Hey, are you successful self-insuring? And if so, we have some options. If you’re not successful then really, there’s one of two things. Number 1, we can change the goals. Meaning you can work longer, you can spend less, you could change your investment strategy, you could do consulting, or work part time, or you can buy some insurance to hedge against this risk. And you know from my experience, you know if you are in your 50s or 60s or even your 40s you know long term care insurance is relatively affordable. But the older you get… you know once you get into your mid to late 60s or 70s, it gets more expensive. So you know in those scenarios… you know you’re going to want to look through many different carriers. And you’re going to want to work with an agent that can look at many different carriers to see what is the best fit for you based on your age and health profile. And there’s a lot of different flavors of insurance. You know there’s hybrid policies, there’s pay as you go, there’s one lump sum payment policy.
So there’s a lot of flavors out there. I don’t personally sell insurance you know as a fee only planner… I work with my clients to give advice on these policies. But ultimately what I will do is I will work with my clients with their insurance broker to come up with the best solution. And you know, ultimately, what I found is that having a decision is probably the most important thing because I’ve had people brush it off and not doing it… do anything. And ultimately they leave it to their loved ones whether it’s their spouse or children to make the decision or even find out if they have insurance or not. And so another key takeaway is once you have a plan for paying for your care, is making sure your financial powers of attorney, making sure you’re your healthcare powers of attorney, making sure they are aware of what that plan is. So if God forbid something happened tomorrow, they know where to go. They know what assets to utilize to pay for your medical costs and things of that nature. And they’re not scrambling at the last minute. So again, stress test the plan, see if you’re successful with a long term care event, if you need insurance or if you want insurance, there are a lot of different flavors you can go and making sure you’re consulting with the right individuals, the right advisors is extremely important in my experience, and then obviously let the loved ones know let the people know your friends or family. What your decision is on that front so they can essentially follow suit. When or if something were to happen.
Alright, the third stress test we’re going to talk about is prolonged low returns in the stock market. And I’m not going to go into too much detail because I think it’s pretty obvious what it is we’re going to assume lower than expected returns in the portfolio over the next 10, 20 or 30 years, and see how the portfolio reacts. You know, the goals react. But I think why we do this is relevant and I think it’s a few pieces of data that I want the listeners to… to know about is important. If you look over the last 10 years… okay let’s take the S&P 500 [phonetic 15:38], which is a benchmark for U.S large cap stocks. The S&P 500 over the last 10 years from 2011 to 2020 has returned 11.96% per year. So we’ll call it 12% a year. If we look over a longer period of time let’s say 50 years the S&P 500 has returned 6.8% per year.
So essentially over the last 10 years the markets outperformed 5% per year. So you know there was there was a lot of factors there. And you know if you think about the Great Recession, 2007 and 2009, we were just coming out of that in 2011. You know, so that’s a factor. You know anytime you come out of recession, the stock market booms… you know we had quantitative easing… we had prolonged low interest rates. So there’s not a lot of places to go for yield naturally, people invest in stocks to get yield and low interest rate environments. But if we believe in the law of averages and looking at the idea that the market is cyclical you know… I’m going to venture that we could experience some lower expected… lower than expected returns over the next 10, 20 or 30 years. So if we believe that it’s prudent to stress test how the portfolio is going to react to those types of scenarios. And you know the way we do this, if a client has a more aggressive appetite, meaning they have a higher exposure in stocks in their portfolio and their strategy… I would argue that we would want a stress test closer to 1.5 or 2% per year less in returns over the duration of the life expectancy. The client’s more balanced if they’re more conservative, they have a higher percentage in fixed income with a portfolio. We could probably lean more towards 1% per year less from a return standpoint.
But you’d be surprised at the results you know if you are a… you know on the edge of being successful or if you’re on the verge of being unsuccessful versus successful. You know it’s one of those things that you’d want to know. And if we enter that scenario of being in a lower than expected return type of market for a 10 or 15 year period you know it’s probably good to know like… hey, what can I reasonably expect from an income standpoint? And more importantly, from a goal standpoint, you know what do I need to prioritize as my needs versus wants versus wishes.
So I hope that’s helpful. And again, this is one of those things that I think everybody should do especially not even just the folks approaching retirement especially those folks that are 20 years away from retirement or even 30 years away. Because you know in that scenario, we’re assuming a… let’s say a 20 year or a 30 year savings rate window as well as another 30 or 40 year retirement phase. So the return that you build into the analysis, which will then determine how much you need to save for retirement is extremely important. Because you know if we assume a 7 or 8% return every year but we’re only getting 5 or 6 you know that makes a big difference in terms of how much you to need save. And then much rather those younger clients that are that have the time to be more aggressive on savings as opposed to having that false sense of security. So again, this exercise is not only important for those that are in that retirement age but if you have kids or if you’re listening and you’re in your 30s or in your 40s you know think about using a more conservative targeted return in your model to see what kind of savings rate you need to come up with to get to that targeted… targeted goal that you set forth in your plans.
Alright the final stress test we’re going to talk about is longevity risk or living longer than expected. Now obviously nobody has a crystal ball. And as a financial planner, I have to look at statistics when I’m dealing with clients whether it be individuals or couples you know as we approach potentially a 20 or 30 year retirement window or even longer. And one statistic that always jumps out to me is that a 60 year old female, a nonsmoker, has a 30% chance to live until 94 and a 20% chance to live until 96 and actually a 10% chance to live until a 100. So if that 60 year old retires at let’s say 65 and they live until, let’s say 96, which there’s a 20% chance… that’s a 31 year retirement window we’re planning for. So that’s a lot… a lot of variables can change there you know inflation, interest rate changes, tax law changes, other legislation changes, rates of return, etc. Another thing to think about is that males or females live longer than males. And if you look at that same 60 year old and let’s consider this to be a male, also, nonsmoker has a 30% chance to live until 92 instead of 94, a 20% chance to live until 94. And then a 10% chance to live until 96. So if you look at that scenario you know two healthy individuals… you know that are approaching retirement, there’s a pretty good likelihood that the female is going to outlive the male. And you know if you ever go to a nursing home or a long term care facility… you know majority of them are women.
And so oftentimes what happens you know, if you’ve ever had personal experience in dealing with a loved one… you know that needs care is that if the male of the household needs care. Oftentimes, their spouse is still living and is able to help with some of the care at home. And if that male were to pre deceased, the female… then the female’s left to their own devices to get care at their end of life. And so oftentimes, the female is relying on some sort of professional help whether that be in home or in a nursing home etc. So the first issue that I deal with when we’re talking about longevity risk is sort of piggybacking off the long term care planning that we talked about a few segments ago is we need to make sure that there is a long term care plan for the surviving spouse in most cases, the female. And so oftentimes, if we’re deciding on who to buy insurance for long term care… I will oftentimes and if there’s a decision you know whether it be budget or other factors or maybe health, oftentimes, I will advocate for the female be the one to buy the insurance because they’re much more likely to rely on professional care. So they’re not a burden on their other loved ones whether it be children or grandchildren. So that’s the first thing.
The second thing we always have to address is with longevity risk is providing some kind of guaranteed income that my clients can never outlive. And you know… so the first source of this and the largest source of this type of guaranteed income, and I’m using quote to [unintelligible 22:34] quotes when I’m talking about guarantee is Social Security. And you know the reason I’m using [unintelligible 22:39] on this one is because you know right now, it provides for roughly 40% of all income received by individuals 65 and older. And actually I looked at a report recently, and it said that Social Security represents approximately 20% of the entire federal budget. So it’s a big number. And other estimates… I’ve seen other studies that I’ve seen done for Social Security estimates is that by 2041 if nothing changed, there’s going to be a deficit in funding Social Security, which is not a surprise you know. So for those that are you know 60 to 65, are in their 70s or 80s already collecting Social Security, they’re very close to it… they’re not as much of a concern. But the clients that are maybe in their 40s or 50s definitely more of a concern there of… hey, is Social Security going to be there at the same capacity when I get to retirement than it currently stands? And there’s a there’s obviously a big question mark to that.
And so many times you know when we’re dealing with this type of scenario, we’re looking for their privately funded sources to provide that guaranteed income. And you know the natural… the natural answer for guaranteed lifetime income is to purchase some kind of privately sold annuity. And so annuities by design are meant to provide that guaranteed lifetime income that one can never outlive.
So essentially you’re putting that longevity risk on the insurance company. The bet is that you outlive what the insurance company how long they think you’re going to live. So you know they have their actuary tables, and they run all the statistical model you know based on your age and your gender and they figure out… okay you know what… I think this client is going to live until certain age and if you live past that, and then you pass that breakeven point and you’ve made out ahead, if you pass away earlier or prior to that obviously the insurance company, quote-unquote [phonetic 24:29], wins. But there’s definitely something to be said, for that peace of mind where you know a client is entering retirement with no concerns about that income source ever going away… you know unless the insurance company obviously goes belly up, which is a different conversation.
So you know the caution I would throw out there is that these are oftentimes sold sort of as a you know… I would call it a fear-mongering type of solution you know where, you know, folks that are entering retirement, they’re obviously concerned about market volatility, they’re concerned about income. And so oftentimes these are pushed by you know… the insurance agents that purchase these annuities. And the question is do you buy one? Do you not buy one? If you want to buy one how much of it do you purchase? And frankly you know my personal experience with this is that these annuity products in these contracts are very complex. And so with that obviously… I’m biased given I am a fee only planner, I don’t sell annuity products. I always recommend clients that are looking at purchasing some type of annuity product to consult with a fee only practitioner to get that second set of eyes when you’re working with your insurance agent to figure out what makes sense, what type of flavor of the annuity makes sense. And then ultimately, how much of your money should be put into that type of product.
So just personally within my practice… I like a scenario, if my clients have a certain amount of fixed expenses that they never want you know they never want to be concerned about meeting… okay and let’s say Social Security makes up 50% of those expenses. And then the rest is made up of all of their other investments you know there’ll be a 401k plan or an IRA or other stock portfolio. And that scenario, we might look at back backing into how much they would need to put into that annuity to get that other 50% for their fixed expenses. Okay… so that’s kind of a very simplistic way to say that we want guaranteed income sources to fund most of the guaranteed expenses that my clients have.
Now, if my client has a Social Security Plan you know for them or them and their spouse, and they also have a pension you know whether it be through military or federal government or private pension… I may not really even consider an annuity in that case you know because we may have most of the fixed expenses being met by those fiscal fixed income sources. But that’s a real simple way to sort of figure out okay… hey, here’s my fixed expenses, how much do I need to back into putting into this type of annuity to get those the fixed expenses met by fixed income?
Now another caution I would throw out there aside from the complexity is that interest rates are historically low. You know the 10 year treasury… I mean was next to nothing you know just within the last few months and frankly, interest rates have been historically low really since [unintelligible 27:16] you know since the Great Recession… you know they had a lot of several series of rate cuts, and they’ve stayed like that for a long period of time. What’s happened is that these insurance companies, the models that they ran, to assume the longevity piece of the pie as well as what they could earn on their general portfolio to pay out the income sources, their way lower than expected. And so the result of that now is that these annuity rates are extremely low. And so it’s very important to look at those types of products and kind of look under the hood to make sure that the annuity is what you think it is because many times it’ll be dressed up you know it’ll say a certain thing. But really, if you look at the fine print, it’s really going to be performing a different way and have liquidity restrictions or substantial upfront costs. So again I get… I’m biased but always consult with a fee only practitioner that understands these types of products but does not actually earning a commission from recommending that particular solution.
So we’ve talked about the long term care planning, we’ve talked about that risk there addressing later in life expenses for the surviving spouse, we’ve talked about guaranteed income. What I will say about guaranteed income and the final note here you know before I close out this segment is that we can replicate a very well designed portfolio we can replicate the guaranteed income sources that my clients need to get that fit that extra 50% to get to their fixed expenses with a well-designed investment portfolio. And you know… I say that obviously you know, there’s volatility involved, there’s always risk involved. But for my experience… I am a big fan of using the endowment model. And the endowment model you know essentially being the notion of creating a really well diversified portfolio and creating a targeted withdrawal rate on that portfolio to where you have an extremely low risk of ever dipping into principle or at the very least outliving your assets.
And I and I’m definitely more of a fan of that type of strategy really for two reasons: Number 1, you maintain all of that liquidity on your balance sheet. And so whereas the annuity once you give that money out to the insurance company you know that’s a, you know that’s gone… you know that’s an irrevocable decision, the insurance company has your money. And then secondly, it’s very… it’s essentially impossible to leave those assets to the next generation you know so that is important to you and not only to maintain liquidity for those long term care expenses down the road or to leave those assets to let’s say… kids or grandkids you know the annuity oftentimes provides a lot of limitations there. So for that reason… Again, if we’re well discipline, we can design a strategic investment policy statement. Again, consult with a practitioner that understands income when it comes to investing portfolios that’s very different than accumulating assets. You know again… I always lean towards that route because it gives my clients flexibility. It keeps the assets on their balance sheet for the emergencies. And then ultimately, they’re able to leave those assets for legacy whether it’s to their family or to charity.
So I hope that’s helpful to get an understanding of how we’re addressing those longevity risks… how our clients are alleviate some of the concerns around social security? How our clients are using the longevity statistics when it comes to planning for things like long term care expenses? And then ultimately how to create that replicate that guaranteed income streams like Social Security have with your own assets?
I hope everyone enjoyed this episode and hope you have some takeaways that you can apply to your own situation. If you would like help stress testing your retirement plan and want to speak to me, you can reach me directly at [email protected]. You can also go to my website at www.imaginefinancialsecurity.com. There’s a book now link that goes directly to my calendar. So you can book a 30 minute free consultation, always happy to have those discussions and see how we can help you directly and I can assure you that if you can pass these four stress tests. You will be sleeping better at night and you will retire with a high degree of confidence and have that financial peace of mind that you will never have to be have to go back to work or be forced to go back to work which is there’s a lot to be said for that. So until next time… signing off. My name is Kevin Lau, your host of Planning for Retirement and hope everyone enjoys the rest of your day.