Stress Testing Retirement Plans

by Paul A. Ruedi

 Though the average annualized return of a diversified stock portfolio has been in the ballpark of 10% based on data going back to the 1920’s, lurking within that average are periods of significantly worse performance. This makes funding a multiple decade retirement quite complicated, because although we would like to expect average returns, we simply have to anticipate the possibility of returns that are much worse than that.

As retirement planners, we have to recognize the uncertainty of returns and make sure our clients’ financial goals are not derailed by something like a perfectly normal bear market. For this reason, we have to “stress test” any financial plan we build against a wide range of possible outcomes. Instead of assuming average returns, we use what we know about markets to anticipate thousands of possible outcomes, and make sure our clients’ financial plans remain intact.

This may sound technical, but we use stress tests in our everyday lives. In his book The Flaw of Averages, Sam L. Savage uses the example of shaking a ladder. When someone is about to climb on a ladder, they don’t simply look at how the ladder is standing and take comfort that it is standing where it is. Everyone feels compelled to shake the latter first, testing a lot of different forces and positions and making sure the latter still stands.

We do the same thing with our financial plans. Though it would be nice to look at the average return of a portfolio and just assume a client will receive it, that just isn’t reality. Even if they do receive that average return over the long-term, the path their portfolio takes to get to that return matters greatly. Much like shaking a ladder, we must test any financial plan against an array of forces and stressors that could be placed upon it.

Though you cannot predict when bear markets will occur, we know they happen, and we can account for them in our retirement planning process. Lurking within our stress tests are not just bear markets like we have seen in recent history, but stressors that are much worse in terms of magnitude and duration. Retirement plans have to stand up to a range of outcomes before we feel comfortable putting a client on that particular path. If you aren’t sure if your retirement plan has been stress-tested, you may want to seek the help of a retirement planner.

Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.