Stress testing your personal balance sheet

'Stress testing' has been a media buzz term related to banks ever since the onset of the Financial Crisis, but have you ever carried out a stress test on your personal balance sheet?

One of the most overlooked yet vitally important elements of financial planning centres on expenditure. No one knows exactly what they spend so it can be a helpful exercise to explore the cost of your lifestyle; it also makes stress testing your personal balance sheet possible.

Fixed expenditure such as mortgage payments, insurance premiums, and school fees are easily identifiable. However, it is the estimated costs of variable expenditure that poses the biggest challenge. Variable expenditure is much harder to track and represents your discretionary spending such as holidays, cars, boats, clothes and houses. These items are broadly the cost of you maintaining your standard of living.

Why is this so important? In order to conduct a cash flow planning exercise and stress test the sustainability of your income and asset pools (both liquid and illiquid) throughout your assumed lifetime, the cost of you maintaining your current or desired lifestyle is an important starting point. Moreover, carrying out a detailed expenditure analysis can form the bedrock of a cohesive financial plan as well as inform and educate future investment discussions.

Whilst we cannot predict the future a Cash Flow Planning exercise allows you to make use of financial projections to assess what your financial position may look like at different points in time. This exercise is based on pre agreed assumptions and is able to illustrate if it is likely that your liquid assets will run out, and if so at what point in time?

In addition to providing a guide to your future financial position, this exercise will also bring to the surface other facts that you may not have previously considered, such as:

  • Will your net business sale proceeds be sufficient to match the salary and dividend drawings that you were taking pre sale?
  • If liquid assets run out, which illiquid assets will need to be realized and how long will they last for?
  • What level of cash flow is sustainable?
  • What is the likely value of your estate at death?
  • Can you afford to gift large capital sums to loved ones and still maintain enough liquid assets to support your lifestyle?
  • Can regular gifts be made to children?
  • If you die, or contract a critical illness, will there be enough income and assets to sustain your family’s standard of living for the remainder of their lifetimes?

Outcomes

Once we have carried out a full expenditure analysis and stress tested your current situation, you will be better able to understand whether your income streams and assets will be able to support your lifestyle over your projected lifetime. At this stage clients generally fall into three categories as follows:

1. More than enough assets to support desired lifestyle;

2. Not enough to support lifestyle – projected to run out of money in year XXXX;

3. Just enough assets to support lifestyle

After carrying out the initial cash flow and stress testing analysis we will be able to provide financial planning advice based on all of the issues and touch points identified – whether this be investment structuring advice, protection, estate planning, school fees planning or, as is common, a combination of all elements.

The outcome may be more or less as predicted or it may turn out to be very different from the projection. For this reason it is advisable to periodically test the projections against reality and to ‘recalibrate’ where necessary.

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