Ready Your Nest Egg for the Worst Case

EDITOR'S NOTE: This article was originally published in the February 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

As many of you already learned, retiring as the market moves into bear territory is a case of terrible timing. It's tough to recoup losses that occur in the first years of retirement or in the years leading up to it. Would you have planned differently if you knew a severe recession was imminent?

Moshe Milevsky, associate professor of finance at York University in Toronto, believes financial advisers should test whether a client's portfolio can withstand a market event that has a 1% chance of occurring. In a Journal of Financial Planning article, Milevsky calls these market events "black swan" scenarios, a term applied to rare, often devastating, episodes, and explained by Nassim Taleb in his book The Black Swan: The Impact of the Highly Improbable.

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An adviser who finds that a client's portfolio is particularly vulnerable to a worst-case scenario could perhaps advise the investor to reduce spending or buy an annuity that locks in guaranteed income, Milevsky says. Without changes, the investor would have little hope of having enough income to last a lifetime.

He compares a "retirement-income sustainability" test to car insurance. "It enables you to plan well and reduce your exposure to risk," he told Kiplinger's.

Gambling With Monte Carlo

Many financial advisers use a computer to run Monte Carlo simulations to determine the odds that a client's portfolio will last through retirement. Based on an investor's age, income, asset mix and contributions, the software puts the portfolio through hundreds of thousands of "what if" market-condition scenarios. A portfolio's success rate is based on the percentage of cases when an income and spending target is met.

But there are shortcomings. A typical Monte Carlo simulation may predict, for instance, ten loss years out of 70, but it won't put several of those loss years together. Nor does it usually test for when loss years occur at certain times, such as early in retirement.

Milevsky says many planners already can conduct stress tests. For those who need help, he developed software to test for 1-in-100 market events.

To illustrate how such a stress test would work, Milevsky describes two hypothetical investors. In November 2007, at the start of the bear market, Robert, 62, and Sandra, 78, met with their financial planners. Robert had a portfolio of $950,000, with 90% allocated to stocks. He planned to spend $37,116 a year. Meanwhile, Sandra had $330,000 of investment assets, from which she intended to spend $25,777 a year. Only 25% of her portfolio was allocated to stocks.

Using Monte Carlo simulations, both investors had an 80% chance of having enough money to last their lifetimes. Fast-forward two years -- a period that included the bear market. The 80% sustainability rate for both portfolios plunged.

If the advisers had instead run two different tests in November 2007, they would have been better able to help their clients avert much financial harm, Milevsky says. First, planners would have conducted the standard Monte Carlo. The second test would have assumed that three years had passed and that both portfolios had undergone a 1-in-100 market event. Advisers would have found that Robert's portfolio had a 29.6% chance of lasting through retirement, compared with 53.7% for Sandra's nest egg.

Then, Milevsky would have had the advisers determine what he calls the Sequence of Returns Downside Exposure ratio, or Sordex. In layperson's terms, the higher the ratio, the more risk an investor faces.

Thomas Cochrane, founder of AnnuityDigest, believes that such a test would be right for people who have $1 million to $3 million of investment assets. Cochrane says if a black-swan analysis raises concerns, it would "trigger a conversation" between adviser and client. "If someone is still working, maybe he can increase savings," he says. "If someone is retired, he can dial down spending. You can change asset allocation. Hedging with insurance products is certainly a discussion point."

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Susan Garland is the former editor of Kiplinger's Retirement Report, a personal finance publication whose subscribers are retirees and those approaching retirement. Before joining Kiplinger in 2006, Garland was a freelance writer whose work appeared in the New York Times, the Washington Post, BusinessWeek, Modern Maturity (now AARP The Magazine), Fortune Small Business and other publications. For 12 years, Garland was a Washington-based correspondent for BusinessWeek, covering the White House, national politics, social policy and legal affairs. Garland is a graduate of Colgate University.