Stress Test Your Retirement Income Plan

When it comes to our financial futures, the one thing we’re most scared of is uncertainty. It would be great if we could look into a crystal ball to see what the future will hold. When you devise your retirement plan a lot of assumptions have to be made because we just don’t know what will happen.

Many assumptions are based on average best guesses – what the markets will do in ten years, where interest rates will be in twenty, how much your expenses will be in the future, and what your health and life expectancy will be.

But what if your life turns out to be not so average? What if you hit retirement and there’s a downturn in the markets, or the inflation rate starts to soar, or you have an unusually long life span?

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Your plan might look reasonable and achievable, but you can’t cling to a false sense of security that you’ll know where you will be in twenty or thirty years. What will happen if your plan doesn’t work out?  Will you have enough?

Stress test your retirement plan and find out.

Worry #1 – Outliving your money

Reliable retirement income for life is your primary goal.

The biggest worry with retirement savings is known as the sequence of return risk, or in other words, your withdrawals could be greater than your investment returns during your lifetime.

Some retirees unnecessarily adopt too frugal of a lifestyle out of fear of facing financial ruin.

Simulate your future retirement income with a Monte Carlo simulation.  Since no one can predict what actual portfolio returns will be, running Monte Carlo simulations can be useful. You can see how long your investment pot can provide retirement income by subjecting it to a series of random circumstances.

To be honest, I’m not really a fan of these.  There are too many unknown variables and a percentage probability of different outcomes doesn’t really comfort me but you may find them beneficial.

Plan for a sustainable and a safe withdrawal rate from your savings. The 4 percent rule of thumb is a good starting point if you retire at age 65.

Since longevity is uncertain, build a cushion into your calculations. Assume you will live ten years longer than you expect. 

You could also consider allocating a portion of your retirement portfolio to a pension-like income stream with one or two annuities, thereby insuring income for life.

Worry #2 – Poor investment decisions

Let’s face it. Most of us have made terrible investment decisions at some time in our lives – the over-hyped stock; mediocre high fee mutual funds; bailing out when we should have stayed the course; overall poor investing behaviour when we let emotions get in the way. 

You may feel the pressure to make up for mistakes. Investment losses are especially devastating later on in your career, or when you’re already retired.  That’s when you have the most to lose, and the least time to recover.

That pressure can often lead to investing in a dubious “high-return” products hoping they will solve your problem.

What would be the impact if your most risky investment took a dive? How confident are you that you’ll at least get close to market returns?

The best plan is to invest in well-diversified investments based on your individual profile and circumstances, either on your own or with the help of an investment advisor. If you already have a good strategy in place, there is no need to make major changes when you retire. Predictability is more important than sky-high returns.

So, the next time you’re tempted to attend a seminar touting “low-risk, high return” investments such as real estate development shares, foreign currency futures and precious metal mines, go ahead and take advantage of the free lunch and the prize for attending, but leave your credit cards at home.

Worry #3 – Inflation starts rising fast

A low inflation rate like we’ve experienced lately may not be noticeable in the short term, but it can have a big impact on the purchasing power of your savings over a lengthy retirement.  Trying to estimate inflation over a long period of time is bound to result in some inaccuracies.

Include investments that are resistant to surging inflation, such as real-return bonds (which are indexed to inflation) and dividend paying stocks.

Retirees are especially vulnerable to rising interest rates because they tend to rely heavily on fixed-income investments. Assess the impact of potential interest rate increases on your fixed-income investments by looking at their duration, which measures a bond fund’s sensitivity to changes in interest rates. The longer the duration, the more the price will fluctuate when interest rates change.

For example, if your bond fund has a duration of 6 years, that means its value will drop by roughly 6% for every 1% increase in interest rates. Broad-based bond funds and ETFs typically have a duration of around 6 or 7, while short-term funds have a duration of around 2.5 to 3. You can get duration estimates for Canadian fixed-income mutual funds and ETFs from their individual websites.

Worry #4 – Your expenses are more than expected, especially in your later years

Unexpected expenses could relate to any number of matters, including health and long-term care needs, rising prescription costs, a need to help other family members, changing housing needs, changes in public policy, and fraud and theft.

It can cost $1,500 to $3,000 a month for a single senior to rent a studio apartment in a retirement home, and $5,000 or more if sharing with a spouse. Costs vary greatly across Canada and also depend on the type of accommodation.

Private extended care facilities can be even pricier. Government run facilities cost less but may have long waiting lists. You also have the option of remaining in your home and paying for home care.

How will you get the money to pay for that? It’s important to research the costs in the area you wish to live in, so you’ll be financially prepared.

You may want to consider long-term care insurance.  Another option is to use the proceeds from selling your home, or refinancing to pay for in-home care.

Worry #5 – Death of your spouse

You may have planned, saved, invested and done everything right during your accumulation years.  But many couples fail to address an inescapable truth – a husband and wife rarely die at the same time.

The household income you have planned for can be cut by nearly 40%. First there’s the loss of one Old Age Security payment.  Plus, the surviving spouse may only be entitled to 60% of a company pension and the Canadian government caps the amount of CPP a survivor can receive.

Income tax can actually increase with the loss of the income splitting provision.  Combined RRIF withdrawals can cause a significant claw back to the surviving spouse’s own OAS.

Consider this when you plan how much to draw from your retirement assets to avoid this reduced cash flow.

The bottom line

It’s called “retirement planning,” but you need to accept that plans change and the unexpected can occur.  You should be working towards a range of different possible outcomes.

Retirees must have the flexibility and liquidity to manage unplanned expenses. Consider stress testing your retirement income plan.  Consider some of the things that could go wrong and figure out how much impact that could have on your spending.

You may be fortunate and not incur any of the above risks, but it’s still prudent to have a Plan B. It’s important to allow for contingencies and give yourself some wiggle-room.

If you can get a handle on the risks and make any necessary changes to get yourself back on the right track, you’ll have gone a long way toward increasing your chances of having a secure and comfortable retirement.

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4 Responses

  1. Kristian says:

    Great post. Keep em coming.

  2. Vince P. Mayne says:

    Seniors’ living expenses in their final years has been severely impacted by the recent COVID-19 situation. Ontario & Quebec homes for the aged monthly costs are dictated by the provincial governments. Both governments have discovered that the homes do not offer a safe refuge from infectious diseases owing to substandard operations.

    I think we can expect an increase in the cost of homes for the aged. Older boomers are likely 5-10 years away from their first stay in one of these homes and unlikely to tolerate the current conditions.

    • Marie Engen says:

      Hi Vince. The Covid-19 pandemic has highlighted the appalling way we treat our elders both in government run facilities and private for-profit institutions (and yes they are institutions). There are no standards = or if there are – no oversight at all. Many elders have no family close by to advocate for them and are left on their own.

      You are probably right that in the future costs will be higher. As they age boomers will demand improved conditions, especially competant longer-term staff who are not paid minimum wage for long hours. We are all getting older and time goes by fast. It’s up to our large cohort to work on making these changes.

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