Retirement Talk Podcast Episode

64. Understanding Risk Capacity and Risk Tolerance in Retirement Planning

August 6, 2021
Understanding Risk Capacity and Risk Tolerance in Retirement Planning

Are you aware of the risk that comes with your retirement investments? If so, have you considered reframing the way you think about risk tolerance? 

In this episode, Laura discusses Kitces article on risk tolerance in Think Advisor and why it’s important to understand the benefits of the risks you’re taking. Listen in as she highlights the difference between risk tolerance and risk capacity, along with highlighting the 5 essential pillars in the Redefining Wealth Process for planning for retirement.

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Show Notes

Intro (:06)

Today’s Article from the Weekend Read (1:43)

Reframe the Way You Think About Risk Tolerance in Retirement (2:35)

Disconnect in Retirement Risk Tolerance (4:05)

  1. Clients don’t have a real clear understanding about the process
  2. Their advisor they may be working with has not addressed this in the same way you’re discussing

What is the amount of risk a retiree client needs to be subject to? (5:30)

Focus on Consistent Returns (7:32)

Risk Capacity vs Risk Tolerance (10:32)

Conservative Retirement Client Cases Mentioned in the Article (12:00)

Current Market and Ongoing Cycles for Retirees (16:53)

Retirees Need to Defend Against Huge Market Downturns (18:45)

Regression Analysis Software (20:00)

Stress Test (20:23)

Five Essential Pillars in the Redefining Wealth Process (24:14)

  1. Income
  2. Tax
  3. Coordinating Income Sources
  4. Healthcare
  5. Investment & Estate Management 

Links:

redefiningwealth.info

lswealthmanagement.com

Listen & Subscribe

JAG:

Welcome to Retirement Talk, the Redefining Wealth Show, specifically for pre-retirees and retirees to help you better understand and navigate and educate during these financial times. We’re here to discuss thoughts and ideas with some of today’s foremost experts in the field of finance and retirement, as well as discuss trending topics that could impact your bottom line. These discussions can help you make better financial decisions and be informed so you can live the lifestyle you imagine and make better financial choices. Laura Stover is a registered financial consultant and CEO of LS Wealth Management, as well as founder and owner of LS Tax, a consulting firm. She’s been featured in Forbes, CNBC, and the Wall Street Journal. I’m John JAG Gay, here’s your host for Retirement Talk, Redefining Wealth, Laura Stover. Welcome into the show.

Laura:

Hello. Hello. Hello. Hello. You are here because you want to learn how to retire and how to retire right. I’m joined today by my good friend JAG for these Friday additions, and this is our opportunity to highlight one of the four articles that we sent out this past Friday, and we send them every single Friday to our subscribers for our ever so popular weekend reading email series.

JAG:

If you want more info on that, you can sign up for free, just go over to redefiningwealth.info to subscribe, fantastic content. Lot of work that Laura puts into these every single week. She hand selects each article that she feels you need to stay in the know about and provides a breakdown on each one. These are four articles on trending topics in the retirement planning space, all designed to help you make better financial decisions to and through retirement. Again, subscribe for free by going over to redefiningwealth.info for the weekend read.

Laura:

Well, you have to have the framework in place, you must have the key financial pillars addressed, no matter what amount of wealth you have amassed. In the article we’re featuring this week, and that I’m highlighting today, it’s part of those four articles from the weekend read. It comes to us from Think Advisor. It was titled Kitces: This is the Big Problem with Risk Tolerance. And this is a fabulous topic. Mike Kitces is a revered financial planner. He’s a thought leader in our industry. He mentors advisors, and I’ve had the privilege and experience to work with him, be part of his newsletters and in many speaking engagements, I’ve heard him. And the big focus here is to reframe the way that we think about the topic of risk tolerance, that whole paradigm. And I believe it’s a great article because you know after doing this, as long as I have, I realize that words like risk tolerance or capacity for risk or aggressive, moderate, conservative, these all may very, very different things to different people.

Laura:

And what I believe he is hitting on, something that is very much changing within the financial industry and the way that financial planning used to be done with a paper questionnaire for the most part, sit down, fill this questionnaire out. You really become a number and you’re either conservative, moderate, moderate growth, moderate aggressive, aggressive, and you end up with what we refer to as a standard portfolio based exclusively on that risk score and they call that financial planning. And this is really a cookie cutter approach. Risk tolerance varies dependent on an abundance of factors. Two people in fact could have the exact same risk tolerance, the exact same amount of investible assets, but different income need, and that alone makes a very large difference. So it’s very important, it’s imperative as far as the concept to wrap our understanding of the different dimensions around the topic of risk.

JAG:

Laura, I know you and Michael have discussed this important topic previously. There’s a disconnect, right? Many people from the clients you’ve helped across the country. They number one, don’t have a real clear understanding about the process. And number two, the advisor they may be working with has not addressed this in the same way you’re discussing or in a way that Kitces’ is discussing in this article. In many cases, people fall into that hamster wheel scenario, the score dictates the portfolio allocation, to your point. However, it really is falling short of the client’s goals, or most importantly, they’re assuming, and taking away more risks than they have to, or even realize they’re subject to many times. That’s the big one and the most common piece of this, right?

Laura:

Yes, and more risk does not, I repeated it does not equal more return. It’s about risk management. Compound percentage returns on dollars, in order to compound, you have to have capital. You have to manage volatility during the downward trend. So think of it this way, it’s a balanced philosophy. I believe it’s very critical to defend against the devastating impact large draw downs can have on the longterm growth of an investment portfolio. We’re talking about pre-retirement and retirees. If you are younger, yes, we have a dollar cost averaging, we have a much longer timeframe, but we have to, for the pre-retirement age client for the retiree, we must develop an implement investment strategy, specifically geared to the client’s unique investment goal and their risk tolerance. But it’s imperative to understand what is the amount of risk the client needs to be subject to for the return that they need to be successful. Period. It stops and starts there.

Laura:

You take the least amount of risk possible, that’s what the most fluent and successful investor is the Buffets, the Ray Dalio’s, the Dave Swanson’s, Yale endowments. These places have figured this out. The average consumer, the average investor has not. So we really take a couple of hours sometimes in our conversations, maybe we’re criticized for talking too much, but it’s imperative that we don’t have a cookie cutter approach. And this actually goes to that level of fiduciary base planning. We do not want to be in a position where a hundred percent of how well the market does is really going to dictate and determine how well your portfolio or your livelihood is going to be in retirement.

JAG:

So that means you have to get to know the client’s situation and dive deeper. I mean, I would want that if I have a pain in my neck, I’m going to seek out medical advice.

Laura:

Are you a pain in the neck?

JAG:

We’ve been working together a while, Laura, I’ll leave that question rhetorical. So I actually did have an issue with the neck from some car accidents, and I went to see a specialist. I want to get an MRI. I want to know my situation, many analogies here, like all these types of specialists at different things, why would you not especially do this with your retirement nest egg? If someone leads product first, that is a red flag, turn right around and find that door. We don’t want to assume more risk because this is the generalist approach, the buy and hold approach, conservatives or fixed income took a hit first quarter because of interest rates. You can still lose with conservative. So really narrowing down the amount each individual needs to be successful is really a different concept for many. So the process is discover, get to know the client, the topic of risk then gets developed on a much deeper level.

Laura:

With a focus on consistent returns. So our clients understand that successful investing occurs through avoiding big market losses. The math wins each time. Most firms, 99% send out that questionnaire that you fill out, come in, we’re going to have your plan ready. You open the account and that’s pretty much it. This article really illustrates why we need to make this shift, why we need to play it differently and take a more integrated approach when it comes to financial planning.

JAG:

Yeah, absolutely, and I’ve seen those questionnaires you’re referring to. They’d often deal with time horizon, short-term, long-term strategies, if you need income, the availability of other assets. A real written plan is really crossed over and expanding the client’s overall knowledge about investments, I know you spend a lot of time in that evaluation doing just that, Laura, and it’s not that we don’t still need those things, but you need to take them apart, go under the hood a little bit, find the right time horizon, need for income, the availability of other assets, your knowledge level about investments, you should have a deeper understanding of expectations.

Laura:

And if we develop that and educate clients on that topic, we kind of refer to it as the CAN approach, risks capacity, attitude, need, what is your capacity for risk? Unlike tolerance, it is the amount of risk that the investor must take in order to reach their financial goal. What is the rate of return necessary to reach that goal? And you know, that can be estimated by examining timeframes and the income requirements and the rate of return, that information can be used to help the investor decide as far as what types of investments to engage in and the level of risk to take on. But the A stands for attitude. What’s your attitude about risk? And N in the CAN approaches the need. Do you really need to take this much risk for what you need to be successful?

JAG:

I love a good acronym loved that CAN approach. The big difference is when you approach that way. So this is really redefining the purpose when you do it this way, the income. Income targets must first be calculated in order to decide the amount of risks that may be required instead of doing it the other way around.

Laura:

Yes. And the risk capacity is a concept that really needs to be understood clearly before making any type of investment decision and together, then the two can help to determine the amount of risk that should be taken in a portfolio of investments.

JAG:

So by two, you mean risk tolerance and risk capacity.

Laura:

Yes. And that determination is combined with a target rate of return. How much money you want your investment to earn help construct an investment plan or asset allocation by knowing the answer to that. The risk capacity, the risk tolerance, it sounds similar, but they’re not the same thing. Risk tolerance is the personal risk tolerance, the amount of risk an investor’s comfortable taking, or the degree of uncertainty than an investor is able to handle. Remember when you invest, there’s never a guarantee if you’re in the market, so risk tolerance often varies with age, income, financial goals, and it can be determined by many methods, including questionnaires to reveal the level at which an investor can invest, but still able to sleep at night. And then the discussion of the capacity of risk, it comes down to if something bad happens, would you still be able to reach your goals? Would your goals be at risk? And we have to have the knowledge about investments that’s going to be related to what is known in our industry is risk perception. How do you perceive that risk? And then what is your willingness to take the risk and that in turn, how does that relate to your risk attitude? How do you feel about risk and what is your need? How much risk do you really need?

JAG:

Yeah, you’ve got the three separate kind of structures here when we start to look at this, and it’s really important to understand to start with that first one, risk capacity, and they’re not all equal. You might have the capacity, you might have the need, but that doesn’t mean you have the attitude. You have the attitude, but you don’t have the capacity. You don’t have the need, we need to make sure we weight all of these things appropriately for the individual. And one of the things that really attracted me to this particular article, Laura, were a couple of scenarios that were outlined. He outlines two different client cases, two different individuals that are both conservative, right? They both have a conservative attitude. They both have a conservative risk attitude or approach taking risks of their investments. And so our listeners understand the importance of this, I got a guy here that is in need of income in 15 years. He has an income goal of just $15,000 a year.

Laura:

Right. So that’s something that we see rarely, quite often, we’re going to see someone that maybe doesn’t need any income, but this man probably has a good social security benefit, maybe a good pension benefit, maybe he doesn’t spend a whole lot. He has a $1.5 million portfolio. He only needs 15,000 a year. So he could probably spend that money and he’ll be fine.

JAG:

Now, the woman, in this case, on the other hand, she needs an income of $65,000 a year, starting next year, from a million dollars. So she has a million dollar portfolio, she wants to kick out 65,000 a year, starting immediately. And here’s the thing, I mean, if something bad happens, Mary we’ll call her, she’s doomed. She’s in trouble.

JAG:

Now, John, on the other hand, he be fine if something bad happens in the market he’ll be okay. He has time to recover, doesn’t need that much income. In both of these cases, this has to do with risk capacity. Would you be okay or not in a worst case scenario, right? Risk capacity on John, he’s got a lot of risk capacity, he doesn’t need much income. But Mary needs a lot of income, but they both consider themselves conservative, right? So they’re not really open to taking a lot of risk. They just don’t like to lose money, as the article says, even go so far to say, you may think that this is a little on you, who would say something like this, but if this happens right John warned that he would sue any advisor who lost this money.

Laura:

Well what happens to John’s portfolio? There’s a good chance he ends up with a moderate growth allocation because a lot of those questionnaires that we go back to, how old are you? When do you need the money? How long do you need it for? In this case he needs it for 15 years. How much do you have in terms of all of the metrics there with a lineup to say, he’ll probably be tipped more moderate, he’s not really needing that large of a withdrawal out of his portfolio. But it doesn’t talk about the need. So this is where there’s a disconnect many, many times. This guy’s got a ton of capacity, as far as his risk score, he’s probably a 50, 60 on a scale of zero to 100 in terms of equity to fixed income. And he’d end up with a more moderate portfolio.

Laura:

But technically if he and Mary, let’s assume they have the same size portfolio, they are the same risk profile, conservative, but when one needs 65,000 and the other only needs 15, she is going to be much more dependent up on the outcome and the growth of the portfolio than he is. She can’t afford to lose as much when you’re taking 65,000 versus 15,000. He’s not as dependent on the income from the portfolio. So this is where we have to be careful because in most cases, a brokerage firm would probably overly weight her in laddered bonds. Now what happened at the beginning of 2021, we saw fixed income really take a hit because of interest rates. So with the broker, you may be put in too many bonds to technically fit her allocation with the insurance salesman, they’re going to pitch annuities. So it’s all about balance. It’s all about the definition of the capacity, the need and the attitudes.

JAG:

I mean, it’s a big fail if you just try to categorize people by these questionnaires. I think both of these scenarios are what’s missing during the planning process. If you’re just relying on those pieces of paper.

Laura:

It’s determining what the need is, and Kitces says that the fundamental problem for Mary is that her risk attitude and her capacity are misaligned. She needs a different goal and the advisor needs to reset that goal.

JAG:

We hope you’re enjoying Retirement Talk, the Redefining Wealth Show. If you’d like to learn more about our featured article for today, subscribe to the weekend read. Sign up for free, just go to redefiningwealth.info and click subscribe. The LS team wants you to make the best decisions for your financial future. Learn more about today’s topic in tax changes, text tax guide to 474747. Once again, text tax guide to 474747. Position your portfolio for managing volatility better, understand where you are with your risk tolerance, schedule a 15 minute strategy session, go to redefiningwealth.info and click schedule. Now back to Retirement Talk with your host, Laura Stover.

Laura:

You know, we could go a lot of directions here, but I think it’s very meaningful as far as the conversation, because right now the market’s been on a tremendous run. However, we saw just a little bit of volatility a few weeks ago. I saw headlines and right away everyone wondered if we were going into a correction. A 2% movement feels like a crash these days because the market has been on fire. It was a small little pullback, but that illustrates to somebody if you see that, and you look at your statement and say, “Oh, it’s down this month.” Maybe you lost a few dollars, and if you’re filling a pull or a push in that direction, that means your risk tolerance could be misaligned. And if we go back to Mary, who we were talking about before the break, she’s not going to fell right in that type of a scenario.

Laura:

If we go into a bad market downturn, which at some point we know that’s likely to happen again. Well she’s in a conservative allocation, so she’s not going to fill in the long-term because, if she runs out of money, that’s really what the problem is. You have to balance the amount of expectations that the person has. I mean, this is one of the reasons, JAG, why we segment out, we never want to risk the income that a client will need. In this case, she needed a significant amount, more income than what John needed, even though they were the same risk profile, we have to plan for her income. The income should not be risked. But then the monies that she doesn’t need access to today, but three years, five years, 10 years down the road, that’s the proper way to segment out the investments, but also go a step further where there’s some processes and maybe algorithms over those portfolios so that when the market does have a significant pullback, that she’s not losing too much.

Laura:

It is critical to defend against huge market downturns. Retirees can not lose their entire nest egg, like in ’08, we heard all of the stories in ’08. We look back at 2011, that was a very volatile year. 2015 was very flat. All of these market cycles are going to continue to happen. So if we are structured right from the get go, we plan for the income. And then we segment the portfolio and we have some tactical management with some algorithms and overlays. This is a proper balance so that the retiree is making the return that they need to be successful over the long run.

JAG:

This is something that you and Michael have talked about in previous episodes, Laura, and that is a regression analysis. Something that you do to help people get this right. You want to stress test your plans, determine how do you see required rate of return. That’s we’re looking for, that required rate of return, and that’s one direction that we’re going to stress test the plan. We’re going to say, okay, what’s the minimum rate of return that we need to be successful, you can really show clients how to manage volatility and avoid those devastating draw downs in retirement, like you were mentioning a moment ago.

Laura:

Well, you’ll be surprised. A lot of times people do not need to take as much risk as they think. And many times when we analyze their portfolio that they are taking way more risk than what they realize. So the regression analysis, it’s a Nobel prize software, and this is very telling, this as part of our evaluation meeting where we actually do a stress test. After ’08, many banks had to do what was called a stress test to make sure that those types of things wouldn’t happen again. We saw a lot of banks go under in ’08 and with the whole real estate and the loans and the credit default swaps. We stress test portfolios. We look at five or six things as far as market corrections data. It’s a regression analysis of market conditions. And we’re going to look at that beta, what is the measurement of risk within your portfolio? And so often clients are taking way more risk than they realize, and it’s not necessarily equaling more return. We want to look at the rate of return. Does the client need to earn at a minimum and in a downmarket, where will they be? We want to make sure that they have portfolios built to last a lifetime.

JAG:

Absolutely. And I think it’s such a helpful exercise to understand that need to understand the required rate of return.

Laura:

And that stress test, many financial planners are using a tool, it is a Nobel prize winning research, determining that risk attitude and the score separately from capacity. We do not want to group all these things together. Risk perception shifts, and it has to be managed constantly. How you feel today, you may change your mind over time and you still need to look what’s that required rate of return that you’re going to need to have to be successful. We could go into a couple of bad years in the market. People’s perceptions going to change. When the market’s up, we’re all in euphoria, right? We all want to buy more. When the market goes down than the attitude changes, we want to be safer. So these balances and these baseline portfolios, it’s very important to have these discussions and manage expectations, and pull everything together with an integrated approach and have the planner be able to an optimally address. The client’s over our risk profile.

Laura:

That’s important. If you’re working with a robo-advisor or you’re doing it yourself, you’re probably using these old methods. Now that’s fine. And as I said before, if you’re younger, the vast majority of individuals, if you’re just trying to save and you want growth for some day down the road, when you do retire, you’re probably not going to be as concerned with the market fluctuations or market fluctuations in your 401k if you don’t need that money for a long period of time. Your attitude at that point is just, hey, we need some growth. But over time, as the portfolio grows, you need to integrate things, manage them on an ongoing basis and have some really valuable conversations. It’s not something you just plug into a financial planning software and figure out.

JAG:

You know Laura, it’s funny, you talk about age and being younger. So as I’ve said on the show before, I’m 40. So on paper, I’m young, I’ve got a little bit of ways to go before I retire, but my wife and I were talking about this and some of the stuff I’ve learned just doing the show with you, you and Michael, maybe I don’t want to retire at 65. Maybe I wanted retire at 60 or 55 and then have a longer retirement. So using some of these strategies will maybe help me as I get a little bit closer to retirement. I might be closer to retirement, hopefully I’m closer to retirement at 40 than a lot of people my own age are well.

Laura:

That very well may be true. And I just spoke with a 45 year old who listens to the show. He wants to retire within the next five years. His wife wants to retire within the next year. He’s amassed millions in his retirement account. This is the key folks. We have a process, the redefining wealth process. There’s five essential pillars, no matter where you are in life, if you’re 40, if you’re 45, if you’re 65, if you are 70, these five pillars, income, where’s your income coming from? How’s it going to be taxed? Tax is one of the pillars. Income is a pillar. Coordinating those income sources, health care, paying for healthcare. In addition, Medicare is not a full health care plan. You need a healthcare plan that kind of relates back to that pillar one with the income, managing the investment part, not losing too much of your nest egg, and for some folks, the estate planning component is a necessity in terms of how that’s going to pass if you have the death of a spouse or passing from your estate to your children.

Laura:

Those five key pillars are essential to every single person, and if you’re not working with someone who has a defined process, that’s really where everything starts and stops. Making certain then after that process is established, really breaking down the risk discussion as the article so eloquently points out, having that deeper understanding, why take more risk, it’s all about dollars and we go through the math on this on an ongoing basis, it’s about dollars. If you preserve your capital, when the market goes up with the percentage returns, you have more return. You’ll geometrically compound the portfolio. So this is a very important discussion. Make sure you go over to redefiningwealth.info. Get yourself signed up for the weekend read and learn more about the topic that we’re talking about today.

Laura:

Thank you for tuning in today. I hope you found the information here helpful and insightful. The LS team and I strive to provide you with a variety of different resources to help maximize your financial efficiency. More importantly, we want to help better educate you on topics like what you heard today. That’s why I want to offer you a complimentary review of your entire financial and retirement plan. I’ll meet with you either in person, virtually, or by phone and help you address top financial concerns as well as any leading retirement pitfalls. You might be unaware of. We’ll walk you through our Redefining Wealth framework, begin with your purpose and cover all of the aspects of a well-rounded retirement plan.

Laura:

Go to redefiningwealth.info and schedule a meeting time that’s most convenient for you at no obligation. We’ll provide you with a complimentary financial roadmap. Schedule your free financial review. Now by going to redefiningwealth.info.

JAG:

For more information on today’s show, go to redefiningwealth.info for show notes, you can also subscribe for free to the weekend read, to learn more about today’s episode. When you subscribe, you’ll receive four articles each and every Friday, straight to your inbox. To schedule a complimentary review, go to redefiningwealth.info/review.

JAG:

Redefining wealth is a registered trademark of LS Wealth Management. Investing involves risk, including the potential loss of principal, any references to protection, safety, or lifetime income, generally refer to fixed insurance products, never securities or investments. Insurance guarantees are backed by the financial strength and claims paying abilities of the issuing carrier. This show is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual situation. LS Wealth Management LLC is [inaudible 00:27:58] offer, and no statement made during the show shall constitute tax or legal advice. The firm is not affiliated with or endorsed by the US government or any government agency. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by LS Wealth Management LLC. Investment advisory services offered through optimized advisory services is an SEC registered investment advisor. LS Wealth Management is a separate entity.

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