Stress testing your retirement corpus is an important part of retirement transition.
One of the greatest fears for potential retirees is running out of money when they need it the most in their later years.
This is more so if you choose to retire early as you need your retirement corpus to support you for a greater number of years once you leave your job.
That brings us to the concept of doing a stress test for your retirement corpus to check its sturdiness.
What is a Retirement Corpus Stress Test?
A retirement corpus stress test is an exercise to help you gauge the financial resilience of your retirement corpus.
To conduct this test, you do a what-if analysis.
This will determine how well your retirement nest-egg can cope with any future economic or personal shocks.
On your journey to financial independence, you learn the cardinal rule of personal finance. What you spend each month should always be less what you earn.
Sticking to this rule month after month is what allows you to build up your retirement corpus.
The purpose of your retirement corpus is to generate income that will be equal to your spending needs during your retirement years.
Some adverse developments in the economy or your personal life can however lead to the following scenarios:
A) Your retirement corpus may not be able generate the monthly income you desire.
B) Your spending could end up being higher than what you had planned for.
Or a combination of both the above conditions
Should something like this happen, you run the risk that your retirement corpus may get depleted much before you expected it to.
A stress test for your retirement corpus can help make your corpus strong enough to withstand any such adverse developments in the future.
None of us can predict what will happen in the future.
If you have tested your retirement portfolio for potential future shocks you will be able to cope with them much better.
The Sources of Financial Stress on Your Retirement Corpus
The potential stress on your retirement corpus can come from two areas:
This kind of stress comes from happenings in the economy that are not unique to you.
If tomorrow if the stock market crashes, the rupee tumbles or the real estate market implodes it will impact you as well as everyone else around you.
This is the stress that impacts your retirement corpus due to developments that are unique to you.
If you contract an illness and run up a huge medical bill this impacts only you.
The risk to your retirement corpus is coming from you as an individual.
The market may still be doing well but these unexpected medical bills can strain your retirement corpus.
Therefore, the stress test for your corpus needs to cater for unfavourable developments in both external as well as internal factors.
What-If Analysis for Stress Testing Your Retirement Corpus
The crux of the retirement corpus stress test is a what-if exercise.
You need to assess WHAT will happen to your retirement corpus IF an unfavourable development takes place.
Externally Induced Stress
There may be a severe downturn in the financial markets at any stage during your retirement.
The earlier you retire, the greater the chances that you will experience multiple downturns in the market during your retirement.
Will you still be able to maintain your standard of living during a prolonged market downturn?
One way to test for this is using a back-testing exercise.
Here we use the historical data in financial markets to see how your portfolio would have performed in those conditions.
Given that we only have limited historical data available for Indian markets, we can use data from other markets to test a variety of market scenarios.
You can use the FIRECalc calculator to stress test your retirement corpus.
Even though it uses data for the US market, it can still provide a good guideline for our testing purposes.
Secondary Source of Income
A lot of retirees take up part time assignments after leaving their full-time job.
This allows them to lower the retirement corpus they need to plan for before pulling the plug on their full-time job.
A secondary assignment like this can supplement any income stream getting generated from your retirement corpus.
If you are in this situation, you will need to consider what if the financial markets collapse and you lose your secondary income at the same time?
Often these do happen at the same time.
As economic conditions worsen and stock markets collapse, companies too end up cutting contractors and part time consultants.
How well are you prepared to cope with the loss of this secondary income combined with a drop in income from your retirement corpus?
Internally Induced Stress
The what-if scenarios here will be unique to you.
I outline below some common sources of internally induced stress that can impact the strength of your retirement portfolio.
While ideally you would have paid off all your financial debts even before thinking of retirement, some retirees quit their paid employment even with some debt yet to be paid off.
For example, you may have bought a second home to get some rental income. The property may still have a housing loan that is yet to be paid off.
What if your income takes a dip tomorrow?
What if you can no longer get a tenant to pay rent on that property?
You may be able to lower your spending in other areas of your life, but debt can be sticky.
There may not be much you can do about it.
This is a common but also the most unpredictable risk to your retirement corpus.
You may be eating well and staying fit.
That is no guarantee that a major illness cannot strike you at any stage of your life.
Have you taken out adequate health insurance or put aside a separate corpus to take care of any medical issues that you may experience?
The number of dependents you have can drastically increase the stress on your retirement corpus in case you need to take care of their varied financial needs.
If you have parents, children, relatives, or anyone else who is not financially self-sufficient then you need to be prepared to support them.
There can be adverse developments in their lives that will indirectly subject your retirement nest-egg to unexpected stress.
Yup, this one is important.
It can ruin your best laid plans if you are forced to split your assets at a later stage.
Hopefully, your relationship will stay strong so this never becomes an issue but a what-if analysis may be in order.
Your assets may drop by half should this happen, but your expenses will only drop marginally or not at all.
How well will your corpus be able to deal with this possibility?
While I have outlined a few common sources of stress, do take the time to figure out other potential areas unique to you that may pressurise your retirement corpus.
Any development that has the potential to lower your income or increase your spending is a potential source of stress for your retirement portfolio.
How to Use the Results of Stress Testing Your Retirement Corpus?
This exercise of subjecting your retirement nest-egg to what-if scenarios is only useful if you take action to counter the risks identified as part of the stress tests.
Once you have been through the various external and internal risks to your portfolio you are ready to take the next step.
You will have identified some risks that you can easily cope with while there may be others that have left you worried.
Some of the potential actions could include:
Reviewing your asset allocation to make it less exposed to market downturns.
Prioritising Debt Repayment.
Having a conversation with your dependents.
Reviewing your insurance coverage.
Delaying your retirement date to boost the corpus size.
Building up alternative income streams.
Will Stress Testing Your Retirement Corpus Guarantee Anything?
The short answer is NO.
A retirement corpus stress test is an exercise to check the strength of your retirement corpus, but it cannot guarantee that you retirement corpus will never fail.
The intention of stress testing your retirement corpus is to subject it to risk scenarios which have a high probability of happening during your retirement years.
We can neither predict the severity of these risks nor the sequence in which they will occur.
In addition, a number of these risks can hit your retirement corpus at the same time.
One of the biggest fears that any retiree has is running out of money during his or her lifetime.
What makes this especially challenging to cope with is the sheer uncertainty of it.
Since your retirement corpus will be impacted by things in the future, it is almost impossible to guarantee any outcome.
We all crave for certainty when making decisions about our financial future.
When it comes to your retirement corpus you can only work based on assumptions on what the future may hold.
No one can offer a guarantee.
Therefore, the next best alternative is to stress test your retirement corpus for several potential outcomes in the future.
It is a fire drill to prepare for a fire that may or may not actually happen.
Hope for the best but prepare for the worst.
Dushyant Choudhary is the founder of dushyantnomics, an early retirement blog for professionals. Dushyant retired early from his 9-5 corporate life after a successful international career. He brings his knowledge and experience to his current role where he’s dedicated to helping professionals achieve a fulfilling retirement.