Stress test your financial life
In Volume 3 of What Would Dad Do? and in the Retirement Yearly Plan spreadsheet, I discuss stress testing as a necessary step in retirement planning. In Volume 1, when I wrote about essential money management, I covered the purpose and necessity of emergency savings. In Volume 2, when discussing investment risks, I mentioned steps such as diversification and rebalancing to mitigate risk. But I didn’t tie those actions together as an overarching task for all of us to stress test our entire financial life. Let me explain.
On any day of the month, we may face a financial emergency, such as an unexpected expense or unemployment, so emergency savings are there to serve that purpose. But the crucial task in determining the size of the savings needed is to imagine the worst-case scenarios: a new HVAC system, being out of work for 9 months, or short-term disability that lasts for many months. As you think through the likelihood and magnitude of such scenarios, you’ll probably give up and conclude that your small emergency fund needs to be quite a bit larger to cover your expenses for, say, 6 months of unemployment. This exercise was a good start, but it didn’t stress-test your entire financial life. There’s much more to consider.
The subject of life insurance will come up when thinking about scenarios. Being young, married, and with children creates a whole set of scenarios, including the unexpected passing of one of the parents at any time. It also includes scenarios of major illness or disability, which should be evaluated. The results of this stress testing shouldn’t make you run out and buy five additional insurance policies tomorrow, but you should do the work to insure your life, health, automobile, and home properly until your wealth is sufficient to offset the impact of financial loss. The same goes for disability insurance. A necessary future benefit to address several risks.
Next, consider the task of stress testing a retirement plan: you’ll consider negative investment returns, higher inflation, or higher expenses. You’ll also consider living longer and dying young, leaving your spouse what’s left. You might consider unexpected, larger expenses for old-age care or even higher taxes. Your scenarios will show whether your money lasts long enough to support a “plan to age.” Most people do this stress testing near or in retirement to make decisions about the existing pile of money. But well before retirement, stress testing a retirement plan would include: if I wasn’t working, would my savings grow sufficiently or fall way short? Or, if I’m forced into a job change at lower wages and can’t save 12% anymore but only 6%, is that sufficient? In other words, evaluate the risks of getting to retirement.
Stress testing starts with three indisputable facts: your age, your wealth, and your future benefits. If you’re 48 and have almost enough money to stop working and live modestly, your future benefits don’t matter much. If you’re 48 and have little money in the bank but good insurance (health, disability, life, etc.), your benefits matter much more because you have so little wealth. Those benefits would help you through many challenging financial situations in ways your meager savings won’t. The thing about those three indisputable facts is that you can only change one immediately (future benefits), one over time (wealth), and one you cannot control (age).
Our current wealth is usually thought of as a number: the sum of savings, retirement account balances, and home equity, minus debts. But wealth is much more. It includes the value of everything in the future. If you’re younger, with a steady job, $100,000 in the bank, and no college debt, you might think you’re doing okay and will have greater wealth in the future. But that’s only possible if (a) you stay employed and cover your living expenses, (b) you invest your wealth to exceed the rate of inflation, and (c) you don’t need any of that wealth for an emergency. Now wealth doesn’t seem so certain. A stress test is to know your bare-minimum expenses so you can evaluate the impact on your wealth if you're unemployed for 2 years, a job change results in 30% less income, or your job, or rather your job category, goes away due to technological change. What is needed to minimize the impact on your wealth in each scenario?
While job loss is often unpredictable, the forces shaping job categories are not. The number of long-haul truck drivers will decline as self-driving rigs become a reality over the next 20 years. Journalists, lawyers, architects, and software engineers will face increased automation and reduced demand. These once-stable, lifetime employment choices are no longer as stable. Anyone in a job category at risk should take stock of their skills and education and plan for a likely career change. As with nature, adaptation is how you survive.
Stress-test your finances, career, health, and family to spot what needs improvement and where to lower risk across your financial life. Understand and evaluate your benefits. Assess the risk to your wealth and how to protect and improve it. Remember to factor in your age when evaluating scenarios. How much effort you spend on this stress-testing is up to you. One way to do this is to list 12 scenarios (not easy after the first few). Then do back-of-the-envelope math to estimate or plug numbers into a spreadsheet. Return to the list in a few days after thinking about them. Then identify the several that need work to mitigate risk and make a plan to get that done.
After reading this, you may conclude that having more wealth sooner is what’s necessary to lower risk, but that’s not the message here. The point is that when you don’t have the wealth, it’s even more important to protect what you do have, with the understanding that as you get older, your age and wealth will change the calculus. Stress testing your entire financial life is really the sum of all the proper actions and decisions one must make to ensure financial success throughout life.
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