In early 2009, the Federal Reserve put the balance sheets of 19 financial institutions through an examination to ensure that they had adequate capital to endure the continuance of a global recession, declining real estate prices, and heightened financial market volatility. The program was officially known as the Supervisory Capital Assessment Program, but it will likely always be known as the “bank stress tests” because SCAP doesn’t roll off the tongue like TARP does.

The stress tests involved two projections—one with reasonable baseline assumptions about the future and another with more dire assumptions. For example, the baseline case assumed that residential housing prices would decline -17.4% in 2009 and 2010 while the more adverse scenario assumed a -27.5% two-year decline. By going beyond the most likely scenario and looking at a reasonably adverse scenario, federal regulators could ascertain which financial institutions would likely survive, even if financial conditions continued to deteriorate. For those that didn’t survive the adverse scenario, their balance sheets were shored up with enough additional capital to pass the stress test.

Here at Bell we go through a similar process with the retirement and education plans we design for our clients, and we recommend that any investor planning for his or her own retirement or their kids’/grandkids’ education adopt a similar practice to ensure the health of their financial plan in even the most unfavorable conditions.

As with the bank stress tests, retirement plans should begin with baseline assumptions, which are reasonable expectations about future asset returns and inflation. Unfortunately, that’s where many planning processes end, leaving the plan vulnerable to more adverse conditions. No matter how much you plan, luck plays a big role in the ultimate success of your financial goals. It is inevitable that some people will have the misfortune of retiring at the outset of a bear market. This is the time when their plan is most vulnerable as the present value of the plan’s funding liability is at its highest.

For example, a 30-year retirement plan, with annual income requirements of $50,000 adjusted annually for inflation, has a funding liability of just under $820,000 at the outset of retirement assuming an 8% return, 3% inflation, and no legacy. However, if in the first two years of the plan a -30% bear market occurs, the 28 remaining years in the plan still require a funding liability of nearly $842,000, but the portfolio assets have dropped to under $500,000. Unless more capital is infused, the plan projects to run out of money after just 14 years. Unfortunately, unlike the banks, retirees don’t have investors lining up at their door to provide an infusion of additional capital.

This is exactly why we assume that all of our clients’ financial plans experience an ugly bear market at the outset of the plan. For our conservative growth asset allocation (Class 3-4 in our parlance), this stress test translates to a -30% two-year bear market as described above. For more aggressive allocations, we increase the severity of the decline.

Once we know that a client’s plan can withstand a severe and extended bear market at its most vulnerable point, we then have the necessary confidence to provide our stamp of approval, knowing that even the bad luck scenario of retiring at the worst possible time won’t jeopardize their plan. For our clients, this stress test provides peace of mind along the bumpy road to their financial goals. Even in nerve-racking corrections like we have experienced the past two summers, they take comfort in knowing that their plan has been stress tested against much worse conditions.