How Do You Know Your Financial Plan is Accurate? Give It a Stress Test

hand pointing at tablet showing financial projections
Written by akobylski, chuggins on March 11, 2021

Andrew Kobylski | Wealth Planner and Callie Huggins | Wealth Planner

For a variety of reasons, if your financial projections look too good to be true, they might well be. 

When the pandemic hit home in March 2020, the stock market crumbled, and many people saw their investment portfolios drop. Fortunately, the markets eventually recovered; but the sudden drop caused many people to review their investments and projections.

At the time, while reviewing a new client’s portfolio, we learned that his previous advisor projected his net worth as double our estimate by age 70. Naturally, the client was confused by the different scenarios. We discovered that the former advisor's underlying growth assumptions used were far too optimistic – and gave the client an unrealistic view of his financial future.  

It’s easy for any advisor to make a financial plan look unbreakable when using unrealistic assumptions. The true value of a financial plan comes from testing its resistance under difficult conditions.

To do this, financial advisors typically conduct a “stress test.” The test typically examines how a financial plan will fare during a future, unexpected event, such as a recession or major geopolitical event, and allows you to adjust accordingly. For example, if you are near retirement and your portfolio is heavily weighted in stocks, an unexpected recession may send it plummeting by double digits. Although there may be no recession in sight, stress testing would allow you to adjust your portfolio in advance to safeguard it from potential future harm. 

It’s a good idea to consider asking your financial advisor to conduct this test.  Here are four areas to discuss to ensure your plan will hold up:

How Much Growth is Projected? Most financial advisors build a conservative growth rate into their projections – five percent annual growth is a common rate.  While changing the growth by even a couple percentage points may seem irrelevant, it can monumentally alter the trajectory of your projection.

Take this scenario:  A person is 45 person years old, has $1 million in investments, and saves $20,000 annually. If we omit taxes and assume a realistic 5 percent annual rate of return, his portfolio will grow to around $4.3 million by age 70. However, if this person’s advisor assumes a higher return, the projections show a scenario that is likely unrealistic:  For example, at a 9 percent annual growth rate, his investments at age 70 to be valued at $10.3 million. Our research shows that the average investor loses 4% of their annual returns from simple mistakes stemming from investment selection, fee management, and emotional trading. Not accounting for this principle in your plan’s growth rate assumptions may inflate your projected future assets. 

Our advice: Lean toward conservative growth assumptions to ensure your financial plan can withstand the unpredictability of future market returns.

Inflation. It’s not surprising $100,000 had greater spending power in 1950 than it does today. This can be seen in something as simple as the price of milk, which in 1950 was 83 cents. Today, the average price per gallon is around $3.60.

As we know, some expenses can have higher cost-of-living adjustments than others, such as health care or even education costs. Due to the ever-growing cost of living, accurately depicting inflation is necessary when developing your financial projections. Otherwise, your projections may misrepresent your future reality. 

Our advice: Since the cost of living will rise in the future, account for this growth in your financial projections.

Annual Spending Plans in Retirement. While working on a plan with another client, we determined she was spending around $120,000 annually, or about $10,000 per month. When asked to map her annual expenses for one year, she realized she was spending closer to $140,000.

This difference is significant. Compounded over time, this spending rate will affect her income in retirement. Rather than lasting through age 95, her assets would be depleted around 80 years old. Using this information, we were able to get her back on track towards meeting her financial goals.  

Taking the time to map out and track your annual expenses. And, even with a budget in place, unaccounted for expenses are bound to appear. The stress test can account for additional expenses that are typically overlooked such as home upgrades, car repairs, or any other unanticipated one-off costs.

Our advice: It’s a good idea to partially overstate annual spending level to account for future, unknown costs.  

A Whole Array of Other Uncertainties. Whether it’s a forced early retirement or a bear market, stress testing your financial plan will help account for other uncertainties in the future. It will not only test the plan’s strength, but also your individual financial flexibility.

Knowing a plan can withstand a 30 percent market dip provides a peace of mind. A test can also simulate the financial impact of taking a dream vacation or providing gifts to your favorite charity, giving you more freedom to spend your money in retirement. Navigating from your expected financial plan to these “Plan B” scenarios can display the robustness of your financial plan against unforeseeable risks.  

Our advice: While it’s fine to look at the most likely financial scenario, consider a worst-case scenario, too. People often make their best financial decisions when they understand the potential consequences when a plan doesn’t work out. 

There is no doubt that future events will have an impact on our financial future.  It could be an unexpected job loss or even another pandemic. By using realistic assumptions and mapping out all relevant scenarios, make certain your plan can still deliver on your goals once these difficult conditions occur.