Would your Financial Plan cope if life changed?

Most of us hope that our financial lives will follow a reasonably predictable path. Our income will continue to arrive each month and our mortgage will gradually reduce. Our investments and pensions will grow over time, we will save for the things that matter to us and eventually, reach retirement with enough money to enjoy the lifestyle we want.

But life rarely moves in a perfectly straight line.

Interest rates change. Investment markets fall. Jobs disappear. Businesses experience difficult periods. Families face unexpected expenses. And occasionally several things go wrong at the same time. This is why, from time to time, it can be useful to stress test your personal finances.

What does financial stress testing mean?

Stress testing simply means asking:

“What would happen to my financial plan if things didn’t go according to plan?”

Rather than assuming everything will develop exactly as expected, we deliberately explore some less favourable scenarios. For example:

• What happens if your income falls significantly for a period?

• Could you cope with a major unexpected expense?

• What if mortgage or borrowing costs rise?

• What if investment markets fall sharply just before you retire?

• What happens if you have to retire five years earlier than expected?

• Could your family maintain its lifestyle if you were unable to work?

• Would your retirement plan still work if you lived considerably longer than expected?

The objective is not to predict that any of these things will happen. Instead it’s to understand what would happen if they did.

A good financial plan should have some margin for error

One of the dangers in financial planning is creating a plan that works beautifully provided every assumption turns out to be correct. Perhaps investment returns need to average exactly 6% every year and your income needs to continue uninterrupted until age 65. Inflation needs to remain under control and there can be no major unexpected expenditure.

While on paper, such a plan might work, in real life, it is probably too fragile.

Good financial planning should generally include some room for uncertainty. The aim is not necessarily to protect yourself against every conceivable financial problem. That would be practically impossible. Instead, you want to make sure that an unexpected event does not automatically become a financial catastrophe.

Start with your emergency reserves

One of the simplest stress tests is to ask how long your household could operate if your regular income suddenly stopped. Could you comfortably meet your mortgage or rent, household bills, food, insurance and other essential spending for three to six months?

The appropriate level of emergency savings varies considerably from one household to another. A family with two secure salaries and relatively low outgoings may need a different reserve from a household that relies on a self-employed individual whose income fluctuates significantly.

The important point is that your emergency fund should reflect your circumstances, rather than an arbitrary number.

Stress test your protection

Another important exercise is considering what would happen if illness, disability or death affected your household. If one person's income disappeared permanently, could the family continue meeting its commitments? Would the mortgage be cleared and could children continue through school or college?

Life assurance, income protection and specified illness cover are not particularly exciting parts of financial planning, but they can become extremely important when something goes wrong. Protection should therefore be reviewed periodically, particularly following significant life events such as marriage, buying a home, having children, taking on additional debt or becoming self-employed.

Stress test your retirement

Retirement planning is another area where stress testing can be extremely valuable. Imagine you plan to retire at 65, but then are forced to finish work at 60? Or suppose investment markets fall just as you retire – would you still have enough?

And perhaps one of the most important questions of all: what happens if you live into your 90s?

Retirement can potentially last 25, 30 or even 35 years. A good retirement strategy therefore needs to consider not only the amount you have accumulated, but also the sustainability of your future income.

Your investments need stress testing too

Investment markets inevitably experience difficult periods, so a financial plan should not be built on the assumption that markets will rise steadily every year.

Would you still be comfortable with your investment strategy if your investment portfolio temporarily fell by 20% or more? Maybe the core important question is; would you have sufficient cash available so that you were not forced to sell investments at an unfortunate time?

Understanding these scenarios in advance can also help you avoid emotional decisions during periods of market volatility.

Stress testing is not about becoming pessimistic

There is an important distinction between prudent planning and constantly worrying about what might go wrong. The purpose of stress testing is about knowing that your financial plan can withstand some difficult circumstances, giving you added peace of mind.

Yes, you might discover weaknesses that need attention. But equally, you may discover that you are in a much stronger financial position than you realised.

Financial plans should evolve with your life

Your financial position at 35 will likely look completely different at 45, 55 or 65. Income changes and  families grow. Mortgages reduce, while investments accumulate and financial priorities change.

That is why financial stress testing should not be something you do once and then forget about. Every few years, or following a major change in your circumstances, it can be worthwhile revisiting the assumptions behind your financial plan and asking some uncomfortable but valuable questions.

What if my income fell? What if markets performed badly? What if I retired early? What if I lived longer than expected?

You cannot remove uncertainty from life. But good financial planning can make sure that when the unexpected happens, your finances are better prepared to deal with it.