Until recently, stress tests were associated with medical exams in which patients run on a treadmill to elevate their heart rate so doctors could observe how their heart works while under strain.
In the past few months, stress testing has assumed a different meaning, as markets hung on the results of "stress tests" ordered by the Obama administration to ensure U.S. banks would remain solvent should the economy behave worse than projected and cause loan losses to increase.
This principle of conducting stress tests to ensure that we'll survive unanticipated problems doesn't just apply to the financial system - it's also relevant for Canadians contemplating retirement.
After all, given the level of uncertainty today, many are unsure if we'll hit our long-term goals and feel our financial future is out of our control.
A few years ago, doing the complex calculations to explore different scenarios and tradeoffs leading to retirement would have been impossible. Today, sophisticated financial planning software lets investors run projections and test what-if scenarios. This can be done with a skilled financial adviser, although those who are technically proficient could try this themselves using planning software.
You need to stress test three things - how much you'll spend in retirement, how much you save for retirement and the risk you take in investing those savings. For each, you create a base case and then examine the impact of different scenarios.
The first step is to stress test how much you'll need in retirement, adjusted for inflation.
Calculating your retirement needs is often done by taking a percentage of income before retiring - 70 per cent of preretirement income is common. But this figure has come under attack as being both too high for many Canadians (actuary Malcolm Hamilton of Mercers is the most prominent proponent of this view) and too low for others (a Fidelity Investments report makes this case).
A better way to forecast needs is to develop line-by-line estimates of spending for each major budget category, adjusting for inflation and factoring in wish-list items like travel and spending winter in warmer climates. To clarify your options, create low-, middle- and high-spending scenarios for each type of expenditure.
Then conduct the first stress test: Consider the impact of higher-than-expected inflation (a growing concern due to the record government spending) and unanticipated expenses such as an extended stay in a long-term care facility.
The second step is to stress test how much you'll save before retiring.
Last year's markets have caused many to cut back spending to increase savings and to rethink their retirement age. January surveys by Sun Life indicated that half of Americans have decided to postpone retirement by a year or more and a quarter plan to work five years longer; in Canada, half of those aged 30 to 65 expect to work past age 65.
The age at which you plan to retire and whether you'll work part time are key variables in the cash you'll generate to live on. Another factor is the amount of equity you'll free up by downsizing your home.
Here's the second stress test: Look at the impact of being laid off. Also examine what happens if that post-retirement part-time income is less or if health issues make part-time work impossible.
The final stress test is to look at the risk you take in investing your savings.
Returns are primarily driven by the amount of risk you take. Given what's happened to the markets, many Canadians would prefer to avoid risk entirely. So, start by stress testing your retirement plan for the impact of the 2-per-cent return currently available on GICs.
For most Canadians without a guaranteed company pension, a risk-free return means they're almost certain to run out of money in their 80s, especially if inflation rises. If there's a shortfall at 2 per cent, you can do further stress tests at 4-, 6- and 8-per-cent returns - looking at the greater risk that comes with each higher return level. A financial adviser can help look at the tradeoffs between risk and return.
Note that given longer lifespans, it's not just before retirement that Canadians need to look at taking on more short-term risk. If you're 65 and in reasonable health, chances are your money will need to last you 25 years or more - and your investment time horizon needs to be pushed out to match.
For this stress testing to remain accurate, it needs to be updated every year or two. The underlying rationale behind stress testing our retirement is borrowed from the military axiom that in war you should hope for the best but prepare for the worst. By preparing a base-case scenario and then looking at the impact of negative events, you can get a handle on where you stand, clarify the tradeoffs and options to close any gaps, and create a buffer against unforeseen events, in the process ensuring you're in control of your financial future.
Special to The Globe and Mail