Retirement Risk Tolerance
Risk is involved in everything we do. It doesn’t matter what stage of life you’re in, risk management is always a critical component of personal financial planning.
Avoiding risk altogether may mean hiding in our homes or hermetically sealing ourselves in a bubble. Neither are appealing options. So, we’re left to cope with risk in other ways.
The three other main ways to deal with risk is by:
- Assumption, or
Due to the decline of pension plans, individuals, for the most part, are on the hook for their own retirement costs. This means that employees now have to worry about low interest rates, outliving their money and wild swings in the stock market. It was much easier when employees simply had a pension check deposited into their account every month.
What happened is that companies have transferred the risks of retirement to their employees.
Of course, we can transfer some risks like outliving our money to an insurance company, but that’s a topic for another day.
Since we have to assume the risks of our own retirements, we need to focus on the risks we’ll face and how to reduce them. The remainder of this piece will consider how to reduce risks with your retirement investment portfolio.
Retirement planning starts in earnest about five to ten years before the day we choose to leave the workforce. We have to know what resources we have and how to manage the risks of converting our assets into a home-grown pension plan. Part of that planning means reconfiguring our investment and retirement portfolios.
Our ability to assume risk drops the closer we get to retirement. That’s because our time horizon is shrinking and our incomes turn off. When retired we’re on a fixed income. We need to make sure our money lasts for the next 10, 15, 20 or more years!
Entering retirement is a high-risk high stakes decision that we need to get right. Our risk tolerance has changed and so should our portfolios. We should all only retire once. Now is not to take risks we cannot afford.
Part of what we want, then, is preservation of capital. We want our money to be there when we need it. We assume the risk of our own retirement but that doesn’t mean we have nothing to do. By focusing on preservation of capital, we can reduce the risk of wild market swings by owning a less volatile portfolio. This tends to mean more bonds.
Having a big chunk of bonds in your portfolio is the equivalent of driving cautiously while wearing a seatbelt. We’re still at risk when we drive, but being smart about it means we are more likely to survive if something goes wrong.
While we don’t know the future, we can use history to give us an idea of the possible range of returns. The range is dependent on how our money is invested and our mix of stocks and bonds.
As the graphic shows, the more bonds in a portfolio, the smaller the return but also the smaller the downside.
Retiree’s living on a fixed income face massive assumed risk with bonds today: starting yields are at all-time lows. Since bond returns are highly sensitive to starting yield, we can expect anemic income for the foreseeable future.
A bond works like this: you lend a company or government money for a contractual stream of income over the life of that loan. For instance, if you lend (aka buy a bond) $100,000 for $2,000 of interest per year for five years, then at the end of five years you’ll receive your $100,000 back and you will have collected $10,000 in interest along the way. Your expected yield is 2% per year. As long as the company or government doesn’t go bankrupt, you’ll make an expected 2% a year.
In the chart above, the average starting yield for a 10-year US Treasury bond since 1965 has been 6.06% which is remarkably close to its average annual return of 6.76%.
Today the starting yield is 0.69% on the 10-Year Treasury and 1.58% on a composite of all US government bonds.
Therefore, if we reconfigure the chart above to not reflect history, but expected future rates of return over the next 20-years, the chart looks like this:
In the future, with low interest rates, expected returns are low, yet the risk is the same. A quick comparison shows if we need a 5.0% return to meet our goals, we need to assume the risk of a portfolio that contains 60% to 70% stocks (see second graph). This is versus the good-old-days, where a portfolio of 100% US Treasury Bonds delivered 5.4% a year with almost no risk (see first graph).
When planning for retirement or for those in retirement, how do we reduce the risk of low bond returns and stock market risk? The primary options are to assume more stock risk to help boost expected returns, work longer if able, or reduce lifestyle expectations by cutting expenses. These are all tough trade-offs to make and must be weighed individually based on your goals, objectives and risk tolerances.
With pensions eliminated for most, we have to manage our own retirement risks and it is no easy task. Fortunately, the ways to deal with the risks of low interest rates are well within our control.
As wealth managers, we help clients balance risk and reward every day. Weighing trade-offs and deciding on the risks that are worth assuming, reducing and transferring are key components to personal financial planning and being a risk manager.
Here’s to risk management,
Adam K. Wright, CFA, CFP®
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