Retirement is a big deal when it comes to anyone’s financial life. These are the years when, after saving and investing for decades, the retiree has to deploy his or her wealth to support his or her lifestyle in those golden years. An essential aspect of managing it revolves around understanding and assessing risk tolerance.
It is the degree of variability in investment returns that an investor can tolerate. To a retiree, it means something else entirely. Limited earning potential and a minimal investment horizon involve a delicate balance between the need for your investments to grow and to preserve one’s capital.
This thorough guide will explain the nuances of assessing retirees’ risk tolerance. We shall explore why it’s important, how it is measured, what influences it, and how one might align their investments with risk tolerance. Understanding your risk tolerance is crucial to creating a sustainable, comfortable financial future if you are retired or nearing retirement.
Why Risk Tolerance Matters for Retirees
Understanding risk tolerance is essential for retirees given the following reasons:
- Constrained Recovery Time: Unlike younger investors, retirees have less time to recover from significant market downturns. Correctly gauging one’s risk tolerance will avoid assuming more risk than can be withstood.
- Income Dependence: Many retirees depend on an investment portfolio for periodic income. Excessive risks run the risk of dismantling such income flows if market conditions become inopportune.
- Emotional Well-being: When investments are aligned with a person’s risk tolerance, there is usually less stress and anxiety about finances, which adds to the enjoyment of one’s retirement.
- Legacy Planning: When retirees are concerned about leaving an inheritance, understanding their risk tolerance helps them balance that goal with their own financial needs.
- Shift in Financial Landscape: As life spans lengthen and traditional pension plans become the exception rather than the rule, retirees find their money necessary to last longer. Therefore, today’s retirees must take risk management more seriously than ever before.
Elements of Risk Tolerance
Risk tolerance is made up of two elements:
1. Risk Capacity
The risk capacity represents the amount of risk an individual can take. Retirees may have the following:
- Overall wealth and possessions
- Expected retirement duration
- Income needs from investments
- Other sources of income, such as Social Security, pensions
- Health and related probable medical expenses
2. Attitude to Risk
Attitude to risk is the emotional or psychic ability to bear risk. This may be a function of the following factors:
- Past experiences with investment
- Outlook on life and attitudes toward money
- Understanding of financial markets
- Personality traits such as optimism, anxiety levels
It is also emphasized that the capacity for risk and attitude toward risk do not always coincide. A retiree may have a high capacity to take risks because of abundant wealth but a low attitude toward risk due to personal conservative views. A thorough assessment of risk tolerance focuses on these two aspects.
Methods of Assessing Risk Tolerance
The risk tolerance of a retiree may be ascertained through various means, including but not limited to:
1. Questionnaires and Surveys
Most financial institutions and numerous financial advisors have developed some form of standard risk tolerance questionnaires. These typically cover the following:
Investment goals
Response to market volatility
The time horizon for when the money is needed
Income needs
Again, these may be useful for obtaining a general idea, but they should not be relied on exclusively to determine risk tolerance.
2. Scenario Analysis
This is a method where retirees are subjected to multiple simulated market scenarios and then asked to respond as to how they would feel. For example:
- “If, in one year, your portfolio became 20% less valuable, would you sell, hold, or buy more?”
- “Would you rather have an investment that would give you a certain 4% return or one that had a possible 8% return but where you could also actually lose money?”
These can uncover emotional reactions to risk that may not be as quickly discovered with questionnaires.
3. Financial Modeling
Advanced financial planning software models various market scenarios and their impact on retirees’ economic plans. This can be used to illustrate real-world implications associated with different levels of risk.
4. Behavioral Assessment
Some use psychological profiling techniques to understand the retiree’s underlying attitude to money and risk. It uncovers subconscious biases that drive risk tolerance.
5. Risk Capacity Analysis
This involves a detailed assessment of the retiree’s financial position to determine that they can sustain the acquisition of some level of risk. This encompasses issues such as the requirements for income, other capital, and contingency expenditures likely to be incurred in the future.
Determinants of Risk Tolerance in Retirement
A retiree’s risk tolerance may be affected by numerous factors, including:
1. Age and Health
Generally speaking, risk tolerance declines with age. However, with increased life expectancy, some retirees may be forced to accept a higher level of risk tolerance to make the money last.
2. Level of Wealth
The wealth of retirees can allow those with bigger wealth to bear higher risk capacity, though this does not necessarily imply that their risk attitude is correspondingly high.
3. Sources of Income
People with guaranteed income sources, like pensions, may enjoy a higher risk tolerance in their investment portfolios.
- Family Situation
Retirees with financial responsibilities for family members, like adult children or grandchildren, would have lower risk tolerance.
- Market Conditions
Recent market conditions may also affect risk tolerance. Bull markets may raise retirees’ risk tolerance, while bear markets may make them more conservative.
- Financial Knowledge
Retirees’ levels of understanding of the financial markets and investing principles are more likely to give a realistic sense of their risk tolerance.
- Past Experiences
Past experiences with financial gains or losses can significantly affect a retiree’s risk attitude.
Standard Risk Tolerance Profiles for Retirees
While each retiree is different, there are some general profiles of risk tolerance that surface routinely:
- Conservative
- Primary goal: Preservation of capital
- Typical asset allocation: Heavy bond and cash component with minimal equity exposure
- Suitable for: Extremely asset-poor retirees or highly sensitive retirees in the face of market variability
- Primary objective: Balancing growth with income
- Typical asset allocation: Equally weighted in stocks and bonds, often at 50/50
- Suitable for: Retirees who have sufficient assets and can afford a little market volatility
3. Growth-Oriented
- Primary objective: To keep growing assets well into retirement
- Typical asset allocation: Heavy weighting in stocks, perhaps 60-70%
- Suitable for: Retirees with significant assets and a long time horizon who can withstand considerable market swings
4. Income-Focused
- Primary goal: Receive dependable income
- Typical asset mix: portfolio comprised of income stocks, bonds, and other alternative investments that produce income
- Who is it for? Retirees depend largely upon their portfolios for regular income
Matching Investments to Risk Tolerance
Besides determining a retiree’s risk tolerance, his or her investment portfolio must also be adequately matched. Following are some ways to do so:
1. Asset Allocation
This combination of equities, bonds, and other securities represents the retiree’s risk tolerance. The more conservative the portfolios, the higher the allocations to bonds and cash will be, while the aggressive ones will be more weighted to stocks.
2. Diversification
Regardless of the risk tolerance, there should be diversification across asset classes, sectors, and geographical regions that spread the risks.
3. Income-Producing Investments
In this, investment might be concentrated in dividend-paying equities, bonds, REITs, and annuities for retirees focusing on income generation.
4. Bucket Strategy
This is an investment strategy whereby the assets are segregated into diverse time frames on when the money will be needed: short-term, intermediate, and long-term. This will eventually help reduce the risk as the short-term money needs are covered by low-risk investments.
5. Regular Rebalancing
Rebalancing the portfolio periodically adjusts for market conditions and keeps the risk tolerance within a set percentage.
Why One Should Periodically Reassess Risk Tolerance
Risk tolerance is not a constant factor that could be expected to persist throughout an investor’s lifetime. Over time, various changes might alter this attribute of risk tolerance:
- Health status
- Financial situation (e.g., inheritance)
- Life-changing event (e.g., loss of spouse)
- Market conditions
- Retirement goals
To this end, risk tolerance should be reassessed regularly, preferably every year or during significant life changes that may alter the retiree’s income or expense needs and goals.
Pitfalls to Avoid when Assessing Risk Tolerance
As has been observed when assessing the risk tolerance of retirees, avoid the following common pitfalls:
1. Overestimation of One’s Risk Tolerance
Some retirees may overestimate their overall risk tolerance, especially during bull markets. This leads them to take on more risk than they can tolerate when market conditions become unfavorable.
2. Underestimating Longevity Risk
Seduced by the improvement in life expectancy, some retirees might be overly conservative and run out of money in later years.
3. Ignoring Inflation
This may lead to an ultra-conservative approach in which purchasing power is eroded over time if not accounted for.
4. Making Emotional Decisions
Base investment decisions on short-term market movements rather than long-term goals.
5. Misalignment Between Spouses
For married retirees, failure to consider each spouse’s risk tolerance leads to conflict and less-than-optimal investing.
While self-scoring tools are available, there are several reasons why using an advisor will be particularly useful in evaluating and managing risk tolerance, including the following:
- Objectivity: An advisor will likely approach any risk tolerance assessment objectively, uninfluenced by the emotional biases that may color a retiree’s judgment.
- Total Analysis: When considering risk capacity, they can consider all the retiree’s financial circumstances.
- Education: They will be able to help the retiree understand the implications of different levels of risk and alternative investment strategies.
- Ongoing Management: Risk tolerance will be maintained in concert with changing circumstances through periodic consultations with an advisor.
- Behavioral Coaching: An advisor can put market volatility into perspective for clients and help them avoid making emotional decisions.
Conclusion
Risk tolerance forms part of developing a sustainable retirement financial plan. Assessing risk tolerance involves two main parts: understanding the capacity to take risks and the psychological willingness to do so. Given their unique financial situation and limited time horizon, this assessment takes on added importance in retirees.
Considering the retiree’s age, health, level of wealth, sources of income, and personal feelings about risk will provide them with a realistic view of their risk tolerance. This will form the basis for balancing the needs for growth while preserving capital to achieve an investment strategy.
Remember, risk tolerance is not a point-in-time assessment. As life circumstances change and market conditions morph and shift, reassessment and adjustment in strategies would be reasonably necessary. Whether working with a financial advisor or managing investments independently, staying on plan and maintaining an investment approach that keeps the investor within their risk tolerance can mean a much more comfortable and enjoyable retirement.
It is all about balance—a balance that enables retirees to sleep at night, feeling that their financial strategy meets both their needs and comfort level. By taking the time necessary to determine and understand a retiree’s risk tolerance accurately, one positions them for financial success and peace of mind throughout one’s golden years.
