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May 01

How to Stress Test Your Financial Plan

How to Stress Test Your Financial Plan

So, you have some semblance of a financial plan, but do you know if it’s built to withstand an unexpected setback?

We have a saying around here that you will never know how good your financial plan is until it’s put to the test. It’s not until the market takes a dive or you’re faced with an impossible circumstance that you find out what your financial plan is really made of.

There are a set of scenarios every person can stress test his or her financial plan against in order to find out just how much staying power your financial plan has to secure your financial future. Once you go through this exercise, you’ll not only know how your financial plan stacks up against potential threats, but you’ll also be alerted to any areas that require extra attention.

Does your financial plan pass the stress test? Let’s find out.

  1. Simulate your future retirement income

Let’s start with the nerdy scenario, since we are analytical financial advisors after all. If we just look at your investment portfolio that has been built based on your personal circumstances and short and long-term goals, there are a series of tests we can run on the likelihood of you achieving a certain level of income through retirement.

These tests are known in the financial services industry as Monte Carlo simulations. These simulations take a close look at your investment portfolio size, how your assets are allocated across asset classes, the projected amount of income you will need in retirement, adjustments for inflation increases, and how long you will need your retirement income.

Since no one can predict what actual portfolio returns will be, running the Monte Carlo simulations are useful because it allows you see your retirement income outcome under a series of different possible circumstances. Adjusting for varying market returns, your spending needs, healthcare costs, and how long you will need your retirement income to last.

Most financial professionals will run some version of a Monte Carlo simulation for you as part of their financial planning process. However, you can also find out on your own by using Flexible Retirement Planner – a free online tool that allows you to run these simulations.

  1. Double check your debt-to -income ratio

If your income can’t keep up with your debts, that’s a strong indication that your financial plan is under stress. Ideally, you want your debt-to-income ratio to sit somewhere below 36%.

So, after you tally up all your outstanding debts, including your mortgage, and you divide that number by your gross monthly income – what percentage do you get?  If it is higher than 36%, now you know you have some work to do to pay down your debts.

  1. Make sure you have enough emergency reserves

Unexpected expenses aren’t an “if” they happen, they are a “when” they happen. And a financial plan is only as good as its ability to overcome the “when it happens” in life.

We often recommend that you have three to six months of your expenses or income set aside for a rainy day. The exact figure you should have available to you in case of an emergency largely depends on how long you believe it would take you to secure other employment in the event you were to lose your source of income.

For some of you with in-demand skills, you may only need three months. Others of you may require more, because you know the types of positions you qualify for are few or not as prevalent in your current city.

If you don’t have an emergency fund of any kind, your financial plan is at risk of being compromised at the first financial bump you encounter. If you do have an emergency fund, be sure to re-evaluate your needs every year to ensure you are adequately covered when funds are needed unexpectedly.

  1. Review and update your insurance coverage

For the same reason you have an emergency fund, you also have insurance – homeowners/renters, car, health, and life insurance. As you advance in your life, you will want to make sure you are updating your insurance coverage accordingly to make sure you are fully covered.

Nothing can derail a financial plan faster than massive expenses as a result of not having insurance coverage when you need it most.

[RELATED ARTICLE: A Quick Guide to Life Insurance for Every Generation]

When you are busy living life and working towards reaching your financial goals, the last thing anyone ever anticipates happening is a home burglary, car accident, devastating diagnosis from the doctor, or sudden loss of a loved one. Yet, we know that these sorts of things happen to people every single day.

When you have adequate insurance coverage, you can more easily weather the storms that life may hit you with without it completely annihilating your financial situation and your dreams for retirement. Make sure you review your coverage every year before it renews. And if you are without certain coverage altogether, now is the perfect time to sit down with your financial advisor and determine what you need and which insurance brokers may be best-suited to provide it.

 

When your financial plan includes a cushion, it has the ability to withstand the stressors placed on it over the course of your lifetime. Expect the unexpected, anticipate that life may cost more than you think, and don’t procrastinate on taking action where action is necessary. Build your financial plan on a firm foundation of thoughtful preparation, and you will be thankful you did when life applies pressure to it.