6 Reasons Financial Advisors Should Stress Test Their Clients’ Financial Plans

May 19, 2023

By stress testing financial plans, Financial Advisors can help retirees identify potential risks, make informed decisions, and optimize their financial strategies to achieve their objectives and maintain financial security in retirement.

Here are 6 of the top reasons it benefits clients to have their projections stress tested.

1. Purchasing power is gradually eroded by inflation.

Over time, inflation eats away at the ability of portfolios to purchase goods and services. Even if clients may not fully grasp the intricacies of stocks, bonds, or financial markets, almost everyone can relate to now paying more for the same things as before.

Inflation can also impact savings and investments. If the rate of inflation is higher than the interest rate earned on savings or investments, the real value of the money saved or invested decreases over time. For example, if the inflation rate is 5% and the interest rate on a savings account is 3%, the purchasing power of the money in the account is effectively decreasing by 2% annually.

Moreover, inflation can affect different goods and services unevenly, leading to changes in relative prices. Some products or sectors may experience higher inflation rates than others, which can alter the affordability of specific things. This can disrupt consumer spending patterns and choices, as individuals may need to allocate more of their income to items with rapidly increasing prices.

Overall, the gradual erosion of purchasing power due to inflation highlights the importance of considering inflation when making financial plans, investments, and budgeting decisions. Individuals and businesses need to account for inflation to ensure their money and assets maintain their value and meet their long-term financial goals.

Stress Testing with Randomized Scenarios: How are your client’s projections impacted if they experience variable rates of return based on the 20th worst case from a set of 101 potential outcomes?

2. Adjustments may be necessary for withdrawal rates.

As previously mentioned, inflation erodes the purchasing power of money over time. If the rate of inflation exceeds the return on investments, the real value of the portfolio decreases. To account for inflation and maintain the desired standard of living, individuals may need to adjust their withdrawal rates upward.

But, there are plenty of other reasons changes may be required. Unforeseen or unexpected expenses, such as medical bills or home repairs, can arise and put a strain on retirement savings. In such cases, individuals may need to adjust their withdrawal rates temporarily or consider alternative sources of funding to cover these expenses.

Changes in lifestyle or goals, such as relocating to a different area or pursuing new hobbies or interests, can also impact the overall financial plan. Life events, such as becoming Grandparents, could require adjustments to withdrawal rates to align with the new circumstances and priorities. Having to retire earlier than expected, or an unexpected illness, can significantly impede expected income.

Furthermore, investment returns may deviate from projections. While we enjoyed a period of high returns in the past, many investors may now be seeing lower returns than anticipated. If investment performance falls short of expectations, individuals may need to lower their withdrawal rates to avoid depleting their portfolios prematurely. Financial markets can experience periods of volatility, which can impact the value of investment portfolios. During market downturns, individuals may choose to lower their withdrawal rates to preserve capital and ride out the volatility.


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3. Assets may be vulnerable to a bubble.

The concept of assets being in a bubble refers to a situation where the prices of certain assets, such as stocks and real estate, experience a rapid and unsustainable increase, often driven by speculative behaviour rather than fundamental value. When these asset bubbles eventually burst, prices can decline sharply, leading to significant financial losses for investors.

For Canadian retirees, asset bubbles can have several implications when it comes to stress testing their financial projections.

Portfolio value and retirement income: If retirees have a significant portion of their investment portfolio exposed to assets experiencing a bubble, the bursting of the bubble can lead to a substantial decline in portfolio value. This can directly impact their retirement income, as the income generated from their investments may decrease, potentially requiring adjustments to their spending plans.

Asset allocation and diversification: Stress testing financial projections involves examining different scenarios, including the possibility of a market downturn or asset bubble bursting. Retirees who have a well-diversified portfolio that is not heavily concentrated in assets experiencing a bubble may be better positioned to weather the storm. Diversification across asset classes, regions, and sectors can help mitigate the impact of an asset bubble on overall portfolio performance.

Sequence of returns risk: Retirees who are relying on their investment portfolios for income face a unique risk known as sequence of returns risk. This risk refers to the order in which investment returns occur. If a significant portion of the portfolio experiences substantial losses early in retirement due to an asset bubble bursting, it can significantly impact the long-term sustainability of the retirement plan. Stress testing financial projections can help retirees understand the potential consequences of adverse sequencing and explore strategies to mitigate the impact.

Rebalancing and risk management: Stress testing financial projections provides an opportunity for retirees to reassess their asset allocation and risk management strategies. Retirees may need to rebalance their portfolios, reducing exposure to assets experiencing a bubble and reallocating to more stable investments. This proactive risk management approach aims to reduce the potential negative impact of asset bubbles on financial projections.

By incorporating the possibility of asset bubbles and their potential consequences into stress testing, Financial Advisors and Planners can provide their retiree clients insights into the resilience of their financial plans. It allows them to evaluate different scenarios, make informed decisions about asset allocation and risk management strategies, and potentially take steps to mitigate the impact of asset bubbles on retirement income and long-term financial security.

Stress Testing with Historical Scenarios: Could your client still achieve their goals if the next 40 years replicated the investment returns and inflation rates that we saw from 2000 to 2010?

4. Longevity amplifies risk.

Longevity, or the length of time an individual is expected to live, plays a significant role in financial planning and stress testing.

Increased life expectancy means that individuals may spend a longer time in retirement than originally anticipated. This extended retirement period introduces additional risks, such as the potential for higher healthcare costs, inflation eroding purchasing power, and the need for a larger nest egg to sustain lifestyle needs over an extended period. Stress testing financial plans helps evaluate the potential impact of longevity by assessing whether the available funds will be sufficient to cover expenses throughout the retirement years.

With longer lifespans, individuals may face a higher probability of encountering healthcare issues as they age. Healthcare costs tend to rise with age, and stress testing financial plans takes into account the potential impact of increased medical expenses. By factoring in potential healthcare costs and considering scenarios where these costs may escalate, retirees can better plan for and mitigate the financial risks associated with longevity.

Longevity amplifies the importance of managing market volatility and sequence of returns risk. A longer retirement horizon means retirees are exposed to a greater number of market cycles and potential downturns. Stress testing financial plans incorporates different scenarios to assess the impact of market volatility and adverse sequencing of investment returns over an extended period. It helps retirees evaluate how their portfolios may perform under various market conditions and determine if adjustments are necessary to ensure long-term sustainability.

The risk of outliving one’s savings and income sources is heightened with increased longevity. Stress testing financial plans helps retirees assess whether their existing assets, such as retirement savings, pensions, and other income streams, will be sufficient to support their lifestyle throughout their extended lifespan.

Longevity can also impact legacy and estate planning considerations. Individuals may wish to leave a financial legacy for their loved ones or support charitable causes. Stress testing financial plans enables retirees to evaluate the potential impact of longevity on their ability to fulfill their legacy goals. It helps determine whether adjustments in investment strategies, asset allocation, or estate planning techniques are necessary to ensure that their desired legacies can be achieved.

Overall, longevity amplifies the risks associated with financial planning, particularly in retirement.

Stress testing financial plans provides retirees with a comprehensive analysis of the potential risks and challenges they may face due to increased longevity. By assessing different scenarios, retirees can make informed decisions, adjust their strategies, and take proactive steps to mitigate the risks associated with living longer.

5. Assessing if clients are still on track to meet their objectives.

Assessing whether clients are still on track to meet their objectives is a crucial aspect of financial planning.

Financial objectives can vary widely among individuals and may include goals such as retirement planning, saving for education, purchasing a home, starting a business, or achieving specific investment targets. The first step is to clearly define the client’s objectives and establish measurable criteria to track progress.

Regular reviews of the client’s financial situation, portfolio performance, and progress towards their objectives are essential. This can be done annually or at predetermined intervals to ensure that any changes or adjustments are timely and appropriate.

Assessing a client’s risk tolerance is crucial in determining the appropriate investment strategy. Market fluctuations and unexpected events can impact the client’s ability to achieve their objectives. Regular risk assessments can help identify potential vulnerabilities and adjust the investment approach accordingly.

Clients’ personal circumstances may change over time. Factors such as marriage, divorce, birth of children, career changes, or health issues can impact financial goals. Assessing how these changes affect the client’s objectives and adjusting the plan accordingly is essential.

Stress testing involves simulating various scenarios to assess the resilience of a financial plan. This helps identify potential risks and evaluate whether the plan can withstand adverse market conditions, unexpected events, or changes in financial variables.

Effective communication between the advisor and the client is crucial in assessing progress towards objectives. Regular discussions, updates, and sharing of relevant information enable both parties to evaluate whether adjustments are needed and ensure alignment between the client’s goals and the implemented strategy.

By regularly assessing whether clients are still on track to meet their objectives, Financial Advisors can proactively make necessary adjustments, provide informed guidance, and help clients navigate changing financial landscapes to enhance the likelihood of successful outcomes.

6. Fluctuating interest rates can have a major impact in multiple areas.

Fluctuating interest rates can have a significant impact on financial planning for Canadian retirees.

Retirement income and cash flow: Fluctuating interest rates affect the income generated by fixed-income investments, such as bonds, certificates of deposit (CDs), or savings accounts. When interest rates rise, retirees holding fixed-rate investments may see an increase in income. Conversely, falling interest rates can lead to a decline in income. Stress testing financial plans helps retirees evaluate the potential impact of interest rate fluctuations on their retirement income and cash flow. It allows them to assess whether their income sources are resilient enough to withstand changing interest rate environments.

Bond prices and portfolio values: Fluctuating interest rates have an inverse relationship with bond prices. When interest rates rise, the market value of existing bonds typically decreases, which can impact the value of a retiree’s bond holdings. Stress testing financial plans helps retirees understand the potential impact of changing interest rates on the value of their bond portfolios. By considering various interest rate scenarios, retirees can assess the sensitivity of their portfolios to interest rate fluctuations and make informed decisions regarding their fixed-income investments.

Mortgage and debt management: Interest rate fluctuations also affect mortgages and debt obligations. Rising interest rates can lead to higher borrowing costs for individuals with variable rate mortgages, lines of credit, or other loans. Stress testing financial plans allows retirees to evaluate the potential impact of increasing interest rates on their mortgage payments or debt servicing obligations. This analysis helps retirees assess their ability to manage debt and make adjustments if necessary.

Annuities and retirement income products: Interest rates play a crucial role in determining the income generated by annuities and other retirement income products. When interest rates are low, the income provided by these products may be less attractive. Stress testing financial plans enables retirees to evaluate the impact of changing interest rates on the performance of annuities and retirement income products. It helps retirees assess whether their chosen products remain suitable and whether adjustments need to be made to optimize their retirement income strategy.

Asset allocation and investment strategies: Fluctuating interest rates can influence investment performance and asset allocation decisions. For instance, when interest rates rise, bond yields increase, which may make fixed-income investments more appealing relative to other asset classes. Stress testing financial plans allows retirees to assess the impact of changing interest rates on their investment portfolios and consider potential adjustments to their asset allocation strategy.

By stress testing financial plans, Financial Advisors can give their clients insights into the potential risks and opportunities associated with changing interest rate environments. It allows them to make informed decisions regarding income sources, investment strategies, debt management, and overall financial sustainability throughout retirement.

Stress testing financial plans is critical for Financial Advisors to ensure the success of their clients’ objectives, especially for Canadian retirees. By incorporating factors such as the erosion of purchasing power due to inflation, necessary adjustments to withdrawal rates, the vulnerability of assets to bubbles, the amplification of risks with longevity, and the impact of fluctuating interest rates, advisors can provide comprehensive analyses that address potential risks and challenges.

Through stress testing, Advisors can help retirees make informed decisions, adjust strategies, and mitigate risks, ultimately enhancing the likelihood of achieving long-term financial security and meeting their objectives. Regular assessments and effective communication between advisors and clients further contribute to successful outcomes in financial planning.

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The Financial Advisor’s Marketing Guide

Learn how to build an online presence, create and share valuable content, and engage with prospects and clients through email marketing.