Friday, November 16, 2012

Risk and Retirement Finances

In my last blog post, I described a recent article by Paula Hogan and Rick Miller about different approaches to financial planning. 

I'd to come back to an issue from that article related to risk management for retirement finances. They make a clear distinction between two risk concepts:

Risk tolerance: comfort in dealing with portfolio volatility (not being stressed out and losing sleep over the day's market events) and an ability to “stay the course” and not panic after a market drop.

Risk capacity: the ability to experience portfolio losses without suffering a major life setback or a major reduction to one's standard of living

These ideas also relate to other terms related to risk, such as the ability, willingness, and need to take risk. A variety of sources talk about this, and the source I have in front of me while writing this is Larry Swedroe's The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments (Bloomberg).

Ability to Take Risk: This is risk capacity. Larry Swedroe indicates that this relates to four factors: investment horizon, stability of earned income, need for liquidity, and alternative options available if things go bad.

Willingness to take risk: This is risk tolerance.

Need to Take Risk: This one can get a little confusing. Simply, the higher expected return one needs to meet their goals, the higher amount of risk is needed. One clear implication is that, as William Bernstein says, if you've already won the game then stop playing. That is, if you are at the point where you are satisfied with your lifestyle, then the possibility of increasing your lifestyle by another 50% is not worth the risk of being forced to reduce your lifestyle by 50%. At some point be satisfied with what you have and don't be greedy. 

The confusing part is when you haven't won the game. A strict interpretation is that you must increase your risk... make a Hail Mary pass in an attempt to achieve your financial goal. This would be more in line with probability-based approaches in which the probability of failure counts more than the magnitude of failure. 

But the safety-first approach would suggest that you revise your goals (save more, retire later, spend less in retirement) so that you do not need to take so much risk to achieve them. Even if you "need" more risk, you shouldn't take more risk than justified by your risk tolerance and risk capacity. In terms of risk capacity, it is not wise to put essential needs at risk.   

Applying Risk to Retirement

In applying these ideas to retirement, what becomes increasingly clear is that risk capacity starts to diminish rapidly. Having "pensionized" sources of guaranteed income help to increase the risk capacity, but as returning to work becomes less of an option, so does the ability to take risk. The investment horizon is shorter, the ability to generate new income sources reduces, more liquidity may be needed for health expenses, and alternative options to reduce expenses or change lifestyle may decline with increasing age.

As risk capacity reduces, risk tolerance can really come to smack a retiree in the face. What risk tolerance really comes to mean for a retiree is understanding how well one can deal with the prospect of reducing their lifestyle. Being more aggressive in this case means understanding and accepting that lifestyle may have to be reduced if things don't go well. Aggressiveness can be manifested both by spending at a higher rate (in order to enjoy early retirement more) and by using a more aggressive asset allocation (to obtain more upside potential). Having larger amounts of guaranteed income sources to fall back on also supports greater risk tolerance. 

For those with greater risk tolerance, spending well above the "safe withdrawal rate" could be perfectly acceptable. For those with less risk tolerance, spending conservatively, investing more conservatively (without overdoing it), and considering partial annuitization into guaranteed income sources are all alternatives.


  1. Great post, Wade. I just finished re-reading Bernstein's "Investor's Manifesto". While he makes a good point about quitting risk after you've won the game, another perspective might be that you can afford to take higher risks with assets that you don't need. The challenge is limiting yourself to a portion of your portfolio, say 10% for "testosterone-poisoned investing strategies".

    Of course this may also be analogous to an alcoholic deciding to have "just one drink". I don't have any easy answers to this conundrum.

    1. Thanks Doug.

      Yes, if you've got more than enough, you can play around with the excess, but fight the temptation to put everything at risk.

  2. Your article makes me think of two points, one of which you have covered before.

    1) If it's wise to take risk off of the table once you've "won the game," then this may speak to the stock/annuity mix which you recently wrote about ( If you purchase an annuity with the funds you need to match the income necessary to "win the game," then you take that risk almost completely off of the table.

    2) Unless you've experienced the actual risk scenarios (such as a long-term hospitalization, job loss, etc.), it's very hard to actually say what your risk tolerance truly is. I liken this to military training (something Nords will understand) - you can train all you want to simulate teh effects of a battlefield, but until you're deployed downrange into a hostile or potentially hostile environment, you really have no idea how you'll react. You hope the training makes your responses automatic, but there are some people who, no matter how much training they receive, panic when they hear the first gunfire (or, in the case of one of my soldiers, hears someone hammering nails 1/2 a mile away and *thinks* it's gunfire!). I'm a fan of using the IFTTT approach for scenario planning to reduce the mistakes which could happen (such as overtrading) in the event of a rsky event actually occurring.

  3. Wade,
    Good discussion here.

    I do feel compelled to push back on one point, though: "Having "pensionized" sources of guaranteed income help to increase the risk capacity..."

    I'm not certain why that is necessarily true? I certainly agree that the rest of the factors you mention have direct bearing, from the shortening time horizon to the inability to return to work (or more broadly, the depletion of any human capital reserve).

    I'd grant that all else being equal, having a pension is clearly superior to not, as it simply represents more assets and/or income. But the implication of your statement - that converting liquid assets TO "pensionize" them (e.g., buying an annuity or inflation-adjusted annuity) is less clear.

    First, simply because of the ongoing debate about whether a pension is really any substantively more secure at producing an income stream than a comparable conservative portfolio under a safe withdrawal rate approach (since the tail risk of both is highly correlated).

    But second, simply because it seems to me this still relates back to the goal. If my goal is a 2% payment stream, arguably pensionizing income may be safer. If the goal is 4%, it's less clear. If the goal is 6%, pensionizing assets is clearly the inferior strategy, as it has no probability of success, while a portfolio-based strategy still has at least "some" chance.

    Which is really just to say from the broader perspective, I'm not sure that risk capacity can be entirely separated from the need to take risk, as capacity itself seems dependent upon the need?

    - Michael Kitces

  4. Jason and Michael,

    Thanks to both of you for writing.

    I'm writing from Toronto, as I'm here for Moshe Milevsky's conference.

    Michael, thank you for the chance to clarify. In this case, I didn't mean to suggest that one should annuitize for this reason. This was more of an "everything else being the same" type of argument that having more pensionized income allows for greater risk capacity, though this is notwithstanding your concern that annuitized income sources may be vulnerable and the guarantees should not necessarily be accepted at face value.

    As Jason brings up with his first point though, in terms of annuitizing, I think this does get back to the point that with partial annuitization in place, remaining assets can be invested more aggressively. Risk capacity just means that should financial assets be depleted, the severity of harm is lower because annuity income will still be coming (again, notwithstanding your concerns about the safety of annuities).

    Jason, it's a good point too that one may have a lot of trouble determining their true risk tolerance without actually experiencing the event. I think that would imply more of a "safety first" approach than a "probability based" approach.

  5. I generally reject the traditional definition of "risk tolerance" that you used. Most people admittedly use the word in the sense that you do - a reference to market volatility and ability to say the course. But where my personal risk tolerance is low would be taking the "risk" of knowing that my portfolio is not even growing at the rate of inflation in debt instruments that are paying just over 0% nominal these days - much less growing in real terms. To me, that is FAR more scary than buying equities at relatively attractive prices (especially foreign stock), and simply having to "tolerate" volatility where it is largely irrelevant in a long-term retirement portfolio anyway.


    1. Thanks. I agree with you. I should have explained it better, but this is partly what I was getting at when I wrote:

      What risk tolerance really comes to mean for a retiree is understanding how well one can deal with the prospect of reducing their lifestyle.

      But you have a good point that I overlooked when discussing this. Thanks!

    2. Yes, I was primarily referring to a retirement portfolio, in the accumulation phase. I only read the article once, but you seemed to be including both pre and post retirement portfolios. With the post retirement portfolio, my same concerns still apply, but there is obviously greater stakes for portfolio volatility and the chance of failure.

  6. As others have said and written, including Moshe Milevsky, the notion of risk tolerance as a psychological state that one should take account of in deciding what to do is very slippery and changeable. My risk tolerance goes up when things are going well, down when things are bad, up when the sun shines, down when my dishwasher breaks, up (or is it down?) when I've had an argument with my wife etc. As a self-managed investor, how am I supposed to measure myself anyway? At least risk capacity is fairly well measurable. I'm leary of risk tolerance. A better formulation is that of Ron Dembo and Andrew Freeman in their book The Rules of Risk. Their notion of Regret, as in "how much will you regret a wrong decision?" to determine how much you are willing to pay to cover the downside or how much will you self-insure, merits a lot more attention.


    1. Thank you for all your valuable comments recently. My inbox got away from me for a while. Thanks for the book suggestion. I just ordered it. Happy Holidays! Wade