As we approach the end of a very tumultuous year, I’d like to take a few moments to send one of my takeaways as well as provide our guidance going forward into the new year. I will be brief with any discussion around COVID-19 as it has been well covered by other analysts/managers and feel that I am not alone in becoming weary of superfluous phrases like “unprecedented” and “new normal” that surround us. 

Instead of speaking directly about the effects of COVID-19 that we are all aware of, I want to discuss what has been highlighted as a result of the market changes and where we can go from here. While it’s impossible to foresee the pandemic’s long-term effects, it is our goal to position ourselves in a way to best take advantage of the situation while at the same time continuing to manage risk. This leads to the takeaway I will focus on today, the importance of ongoing stress testing.

Stress Testing

When we help people construct their retirement plans, we highlight the importance of stress testing different factors that could have a negative impact on financial estimates. I have included a screenshot below showing the primary factors we monitor to:

1) Help protect our clients, and

2)Aid in our investment selections. 

Stress Testing a Retirement Plan

This chart shows the impact to a retirement plan’s success measured by the following factors:

-A stock market crash of 30%

-Tax expenses go up by 20% 

-Health care costs increase by 20%

Inflation increases to 4.5% (our base assumption holds inflation at 2.5%)

-A 20% reduction to Social Security benefits

-Living 5-years longer than we planned for 

While the combination of these items is not likely to occur simultaneously, each one individually has a relatively high likely hood to happen to some degree during our lifetime.  Here are a few of my thoughts on these variables.

Stress Testing Variables

Equity Markets Crash by 30%:

Stock market crashes are very rare, but as this year highlights, they DO happen. Drawing down on a portfolio during depressed levels can have a negative long-term impact because you could be forced to sell positions at the worst time and miss out on the opportunity of recovering that decrease in value. 

Tax Expense Higher by 20%:

With congress continuing to spend like there is no tomorrow, I think it’s a safe bet to assume taxes will go up in the future. As tax expenses increase, the investment portfolio is stretched further in terms of what it can provide. 

Health Care Cost Increase by 20%:

This is a complicated problem that is likely to get worse before it gets better. Right now, the average retiree spends between $5,000 and $8,000 a year on health care costs. Would an increase in 20% put more strain on a budget? Yes. 

Inflation Increases to 4.5%:

Monetary Theory 101 teaches us that increasing the money supply through quantitative easing will lead to an increase in prices (inflation). The example I used shows this to be a significant risk for this particular plan because the majority of assets are uninvested and just sitting in the bank. If inflation increases to 4.5%, these dollars lose this value every year in terms of purchasing power which has a devastating impact over the long-term.

Social Security Benefits Reduced by 20%:

The social security system is underfunded and at some point, will have to be modified to avoid a default in payments owed to people who have paid into the system. Politicians have thrown out ideas like pushing the full retirement age to 70 from 66, reducing benefits paid, or increasing the taxation of those benefits. Whichever way the system is changed, it will not likely be an increase to the benefits people get today. 

You (and your spouse) Live 5 Years Longer:

Obviously, none of us know how long we will live, so the best we can do is estimate our planning timeframe based on family history and life expectancy averages. Living longer than expected can put additional stress on a portfolio and increase the risk of outliving our money.

These variables each have the potential to negatively impact a retirement plan which is why we monitor this continuously and stress test our models at least annually. This year particularly highlighted this need as the markets did drop 30% and we got to live through this impact. Our team at Bauer Wealth Management discuss this often and always come to the conclusion that risk management is our primary objective. We believe that by managing risk we can produce smoother returns over the long-term and maintain a dedication to using hedged models as a portion of our client investments, especially if they are nearing, or in, retirement.

That said, we also believe in being opportunistic in times of uncertainty and have implemented strategies to benefit from where we currently stand. This is outlined in our 2021 Guidance section below.

2021 Guidance

We have expanded our portfolios with additional positions to capture further growth in the mega-cap technology space but also benefit from a cash-flow rotation out of that sector to more cyclical areas of the economy that are typically coined as “value”. 

We have also increased our exposure to small cap companies as they usually follow behind the wake that large and mega cap stocks create. This will position us well to take advantage of gains in international and emerging market stocks which are looking very appealing from a valuation standpoint. 

So in short, we are still being vigilant with keeping our hedged models intact with a continued focus on downside protection, but have expanded our strategy to be opportunistic on the upside. With COVID-19 not going away, and for all intents and purposes getting worse, we expect the next few months will be challenging in the markets.

But that is why we are here. I wish each and every one of you a happy holiday season, success in your financial planning, and most of all a wonderful life.

Stephen

References

Picture Credit: Marius Venter from Pexels.com

Financial Planning Software Used for Illustration: Right Capital

Published by stephenheitzmann

Stephen Heitzmann, MSF, CRPC® is an investment advisor, blogger, and avid sports enthusiast. He is managing partner and CEO of Bauer Heitzmann, Inc.