CE Course: Stress Testing Your Retirement Plan: “How Big is My Cushion?”

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“Stress Testing Your Retirement Plan: ‘How Big is My Cushion?’” is eligible for CE credits, see Accreditation details for more information

The single most important question of a client close to or in retirement is, “Do we have enough money to retire?” To measure the financial capacity of a client, I categorize him into one of the three zones: Red, green and grey. For more information on the Zone Strategy, see our CE Course, Lifelong Retirement Income: The Zone Strategy.

Once you figure out your client’s zone it becomes a lot easier to suggest the right retirement income strategy. Usually, clients in the red or grey zone have tough choices to make: keep working or spend less; save more or rent out part of your house; and so on. However this article is not about the red-zone or grey-zone clients. It is about those who have made it successfully to retirement and are already deep in the green zone.

Green-zone clients are mostly high-net-worth. During retirement, they might have ongoing income from other sources such as rental income, royalties, and business or consulting income. Typically, they only need to take out small percentages of assets, well below the sustainable withdrawal rates. If this happens to be a RRIF portfolio, they take out the minimum mandatory withdrawal amount, pay the income tax on it, and reinvest some or all of the remaining money.

If a client is in the green zone by virtue of a retirement plan, tell him not to worry about retirement income. However, to distinguish yourself from other run-of-the-mill advisors, you need to go beyond soothing words. Many worry about black-swan events and want a precise answer to, “Do I have large enough cushion in my retirement assets to overcome unexpected or unforeseeable events?” They deserve better than, “Hey! Don’t worry about it. You’ll be all right.”

And this is where the concept of stress test comes into play. For my green-zone clients, I run a series of stress tests. I tell them exactly how much “cushion” they have in their portfolio for different stress factors. Often, I get a “wow” in response. These tests are not only educational, but they also increase clients’ confidence in me as their advisor.

There are many different types of stress events. This lesson will cover the most important ones:

• Sudden and permanent loss of assets
• Need to increase the income taken from the portfolio
• Future inflation higher than historically experienced
• Living longer than planned for
• Future equity returns lower than historically experienced
• Future conventional bond yields lower than historically experienced

Our process is simple—for each stress factor, calculate the maximum allowable number which still allows the client to remain in the green zone. For example, if a client has $2 million in assets and he needs to withdraw $30,000 from his portfolio each year, he can suddenly lose half his assets and still remain in the target area. Or, he can increase his periodic withdrawals by 100% and still fall within green-zone parameters. Or, he can live until age 108 instead of 95 and still be within the green zone.

We define this collection of numbers as the “Stress Envelope.” Let’s use an example to demonstrate how the process flows: My new clients, Bob and Jane, are both 65 and have just retired. They need $125,000, indexed to CPI, annually from their investment assets. Their asset mix is 40% equities and 60% fixed income, rebalanced annually. We use the TSX/S&P index as our equity proxy. As for the bond portfolio, they hold conventional bonds which pay a 1% premium above the historical 6-month GIC rates. Their total investment assets are $5 million.

Question 1: “Do we have enough?”

First, draw an aftcast chart to show the portfolio value over the entire retirement time horizon (see Figure 1). Aftcasting reflects the sequence of returns exactly—as well as the volatility of returns—as it happened in history. Aftcasting, as opposed to forecasting, is a method that has been developed for analyzing investment outcomes. It includes the actual historical equity performance, inflation and interest rates, as well as the actual historical sequencing of these data sets. It displays the outcome of all historical asset values of all portfolios since 1919—the earliest year for which the TSX index history is available—on the same chart, as if a person starts his plan in each of the years between 1919 and 2000. It gives a bird’s-eye view of all outcomes for a specific time horizon. It is not a simulation; it provides success and failure statistics with exact historical accuracy, as opposed to man-made simulation models.

Figure 1: Aftcast of portfolio values for Bob and Jane – Current Scenario

The aftcast shows, based on actual market history, that the portfolio never runs out of money. If Bob and Jane are lucky (top decile), their original $5 million grows to about $26 million by age 95. On the other hand, if they are unlucky (bottom decile), it grows to about $6 million. The median portfolio grows to about $18 million. Historically, no portfolio runs out of money and they are definitely in the green zone.

Question 2: “How big is my cushion?”

In order to do the stress test, there is one prerequisite: The client must already be in the green zone. If he is in the red or grey zone, the portfolio is already under stress from market, inflation and longevity risks and therefore has no room for any additional stress factors. In the above example, we know that Bob and Jane are in the green zone. Thus, we can proceed with our series of stress tests.

Sudden and Permanent Loss of Assets:

What if there was a sudden and permanent loss of assets? This can happen as a result of market risk or behavioral risk—their portfolio loses money, they switch everything to cash just before markets start recovering, and lose any opportunity to recover from that loss. It can also happen as a result of a catastrophic event. They might need a large chunk of money from their assets as a result of an unforeseen, un-budgeted catastrophic event in their lives. Regardless of the reason, they want to know how much they can lose permanently and still remain in the green zone.

The following chart can help you estimate this number (Figure 2).

Figure 2: How much can you lose permanently and still remain in the green zone?

Bob and Jane plan to withdraw $125,000 annually from their $5-million portfolio. Therefore, their initial withdrawal rate is 2.5%. Starting at the horizontal axis at 2.5%, draw a vertical line all the way to meet the green line (age 65), then from their intercept, draw a horizontal line, as indicated with dashed lines. On the vertical scale, read the maximum loss that they can have and still remain in the green zone. We read 24% sudden loss, or in dollar amount, a loss of $1.2 million. Their assets can go down to $3.8 million, and, all else being equal, they would still be in the green zone.

Keep in mind that portfolio fluctuations do not count as sudden and permanent loss in the green zone. As long as the asset mix is kept the same, Bob and Jane’s portfolio will eventually recover from fluctuations. However, if a client panics and moves all his investments to cash (or near cash) after a large loss, the opportunity to recover from that loss is forfeited and you would then have a permanent loss.

Need to increase the income taken from the portfolio:

What if they need to increase their withdrawals permanently? This can happen for many reasons, but the usual suspects are: home or facility care, permanent disability, and need to take care of children or grandchildren.

Figure 3 can help you to estimate this number. Use the exact same process: Starting at the horizontal axis at 2.5%, draw a vertical line all the way to meet the green line (age 65), then from their intercept, draw a horizontal line, as indicated with dashed lines. On the vertical scale, read the increase in income they can have and still remain in the green zone.

We read that Bob and Jane can increase their withdrawal about 32% to $165,000 per year, indexed to CPI. At that rate, all else being equal, they would remain in the green zone.

Figure 3: How much more income can be taken while remaining in the green zone?

Future inflation higher than historically experienced:

In our aftcast, we used the actual inflation for each year since 1919. What if the future inflation turns out to be higher than what we have experienced during the 20th century? If that happens, Bob and Jane would need larger COLA adjustments to their withdrawals during retirement.

Figure 4 can help you figure how much higher the inflation can go without moving Bob and Jane out of the green zone. Following the same process as before, we read from the chart that, even if the inflation were 2.1% higher than what was experienced during the last century, all else being equal Bob and Jane would remain in the green zone.

Figure 4: How much higher can the inflation be and you still remain in the green zone?

Living longer than planned for:

In Bob and Jane’s aftcast we used 95 as the age of death. Mortality tables indicate there is about 7% chance that Bob will live beyond age 95, and Jane has about a 14% chance. Both of their parents lived until their late 90s, so they are worried about outliving their assets.

Figure 5 can help you estimate how much longer they can live and still reside in the green zone. We read from the chart that if they live 24 years beyond age 95, until age 119, with all else being the same Bob and Jane would still remain in the green zone.

Figure 5: How much longer can Bob and Jane live and still remain in the green zone?

Future equity returns lower than historically experienced:

What if the future performance of equities turns out to be worse than what we have experienced during the 20th century? In that case, Bob and Jane’s assets would not grow as much as was aftcasted in their plan.

Figure 6 can help estimate how much lower equity returns can go before one moves out of the green zone. We read from the chart that even if equities underperformed the index by 4.9% each and every year, all else being equal Bob and Jane would remain in the green zone.

Figure 6: How much lower can alpha go and still remain in the green zone?

Future conventional bond returns lower than historically experienced:

In our aftcast we used historical 6-month GIC interest rates plus 1% as our bond yield. On the current yield curve (at the time of writing), this approximates a bond portfolio with roughly a six-year term until maturity. What if the future performance of bonds turns out to be worse? What if North American bond markets exhibit a similar pattern to Japanese bond markets of the last 20 years or so?

Figure 7 can help you estimate how much lower conventional bond yields can go relative to the current one, before Bob and Jane will move out of the green zone. We read from the chart that even if bonds were to have a 3.2% lower yield, each and every year, compared to the last century, with all else being equal Bob and Jane would remain in the green zone.

Figure 7: How much lower can conventional bond yields go and still remain in the green zone?

Now, let’s summarize our findings. We present Bob and Jane their stress envelope:

• They can lose up to $1.2 million permanently and remain in the green zone.
• Total periodic withdrawals can be as large as $165,000, indexed to CPI, and remain in the green zone.
• The future inflation can be up to 2.1% higher than historically experienced and they would remain in the green zone.
• They can live until age 119 and continue to occupy the green zone.
• Future equity returns can be up to 4.9% lower than historically experienced and they would remain in the green zone.
• Future conventional bond yields can be up to 3.2% lower and they would remain in the green zone.

Each of the numbers indicates the limits of that stress factor alone and not in combination. Furthermore, if the asset mix is different by more than 10% either way from this near-optimum asset mix, the stress envelope will be less favorable.

After the presentation, Bob and Jane might decide on the following combined stress envelope:

• A sudden and permanent loss of $500,000 (10%)
• An increase of their withdrawals by 5% to $131,250
• An inflation that is 0.5% higher than historically experienced
• Live until age 98 (additional 3 years)
• Future equity returns 0.5% lower than historically experienced
• Future conventional bonds yielding 0.5% lower.

When combined, the stress factors do not add up linearly because of the interactions between them. To model that, I use my aftcast software. Figure 8 depicts the resulting income carpet, including the stress envelope.

Figure 8: Income Carpet and Stress Envelope for Bob and Jane

In conclusion, when preparing a retirement plan, use your client’s expected budget to generate a base case without padding a “cushion” into the aftcast. After that, if it turns out your client is in the green zone, add the combined stress envelope into the plan as we did in the example above.

Bob and Jane were happy to see that their outcome is “Good,” even under their choice of various stress factors. They have a big cushion, as numbers attest. They are impressed with the logic, depth and coverage of your analysis. Now, you look a lot more credible than if you were just to tell them, “Hey! Don’t worry about it. You’ll be all right.”

Now that you’ve finished reading, complete the exam to receive your CE credits. If your score is 85% or higher, send an e-mail to jim@retirementoptimizer.com with your name and proof of your score to get a one-time-per-advisor free retirement calculator, and a free pdf copy of Jim Otar’s 525-page book, “Unveiling the Retirement Myth.”

Jim Otar, CMT, CFP is a financial planner, a professional engineer, a market technician and a financial writer. He is also the founder of retirementoptimizer.com. His past articles on retirement planning won the CFP Board Article Awards in 2001 and 2002. He is the author of “Unveiling the Retirement Myth – Advanced Retirement Planning based on Market History,” and “High Expectation and False Dreams.” Your comments are welcome: jim@retirementoptimizer.com

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