An interesting article released this summer as a working paper for the Pension Research Council at the University of Pennsylvania is Paula Hogan and Rick Miller’s “Explaining Risk to Clients: An Advisory Perspective.” (downloading the paper requires registering with an email address and password, but is otherwise free)
Hogan and Miller both operate their own financial planning firms, and their views are informed by the academic theories of lifecycle finance.
I recently made a table summarizing two schools of thought for retirement income, and their article sets out to do something similar: they define four paradigms for financial planning, and they describe the views of each toward risk management. Something I particularly like is that they aim to help bridge the gap between practitioners and academics, or how to combine the theory (models where people are rational, understand their preferences, and take the appropriate action to maximize their outcomes) and real-life experience.
I will summarize these four paradigms, though it is hard to give the article full justice. It’s full of good insights. This is definitely an article which is worth reading if the topic sounds interesting to you.
The Traditional or Accounting/Budgeting/Modern Portfolio Theory Paradigm
This one is most similar to what I called the “probability-based” school of thought. This paradigm focuses on saving, diversification, managing costs, and using insurance for non-financial purposes. It developed from the perspective that those seeking financial planning guidance primarily want help with their investing portfolios. It is based on using modern portfolio theory to choose investments, and budgeting so that one’s portfolio will outlive them.
Financial risk is evaluated with Monte Carlo analysis to investigate the probability that things may turn out bad. They make the interesting point that this paradigm generally recommends full insurance for non-financial risks (life insurance, disability insurance), but will accept something like a 5-10% probability of failure as being acceptable for financial risk. That doesn’t seem internally consistent.
The model doesn’t make a clear distinction between risk tolerance (which is defined as comfort in dealing with portfolio volatility and ability to “stay the course” in the event of market drops) and risk capacity (ability to experience losses without a major life setback). The model holds that with reversion to the mean, stocks are less risky in the long run, and so a more aggressive stock allocation is suggested for those who can “stomach it.”
Retirement income advice: systematic withdrawals based on a safe withdrawal rate
The Life Cycle Paradigm
This model is based on economic theory and supports a stronger role for comprehensive financial planning, rather than just asset management. Human capital management (managing the career path, integrating the financial portfolio with human capital characteristics) plays a much stronger role in this model, as it is the major asset that people have and the primary determinant of their standard of living.
For the next point, it is worthwhile to just quote the article:
Another insight from the Life Cycle paradigm is that people care more about their lifetime standards of living than about their wealth. This shifts the advisory focus from return management to risk management: from building the largest possible portfolio constrained by risk tolerance, to arranging lifetime consumption in the safest way possible given finite lifetime income.
From this quote, we can see that this model corresponds to what I called the “safety first” school of thought.
Goals-based investing is an important element of this model. Moving away from a total returns perspective, each goal is financed with a distinct asset allocation based on both risk capacity and risk tolerance (the two terms have different meaning here). Risk capacity is important. Goals which are really important and can’t be sacrificed (such as meeting basic living expenses) should be matched with low risk investing strategies (what Modern Retirement Theory calls ‘secure, stable, and sustainable’). Goals which are less important (such as discretionary expenses) can be matched with more volatile strategies to reflect the increased risk capacity (of course also keeping risk tolerance in mind).
Retirement income advice: TIPS or I-bonds or inflation-adjusted annuities for basic needs, and more volatile assets for discretionary expenses
The Behavioral Paradigm
This model questions the rationality of people. Prospect theory, loss aversion, the use of heuristics (rules of thumb), and other behavioral economics ideas play a larger role. This approach emphasizes greater communication between advisors and clients, as advisors must help clients to understand what actually makes them happier. Advisors must understand behavioral biases (framing, anchoring, overconfidence, mental accounting, etc.) to help clients make better decisions.
This model is linked to the ‘life planning’ school, as a role of advisors is to help clients to discover their values and goals and make the necessary life changes to reach these goals.
Risk tolerance is a more complex issue in this model. Stated views about risk tolerance could be based on framing or anchoring, and may not really reflect one’s true underlying preferences. Risk capacity is quite important, then, since getting a grip on actual risk tolerance is hard.
Retirement income advice: To help with loss aversion, focus on strategies with both downside risk protection as well as upside potential. For example, a variable annuity with a guaranteed living benefit rider
The Experienced Advisor Paradigm
This is the newest paradigm, focusing on comprehensive or holistic planning. The focus moves from portfolio management to helping clients to clarify their values and to provide personal coaching. The advisor is a counselor. More emphasis could be placed on working with both members of a couple, as each may have different values, goals, and views about risk.
It is understood that clients may not be able to accurately explain many details about their finances, unlike what is generally assumed in the more theoretical approaches (the first two paradigms). In particular, clients may not be able to differentiate between essential and discretionary spending, or even know their budget.
Retirement income advice: Before even discussing this, make sure client has realistic expectations about the aging process, the need for custodial care, and other matters