Changing the Definition of Risk in Retirement Planning

For retirement savers, risk is about more than seeing your investments fall short of a benchmark. Risk manifests differently at various stages in the investment process: Volatility becomes risk when it drives self-defeating behaviors. Drawdown becomes risk when it occurs at a stage in life when recovery is difficult or impossible. Longevity becomes risk when it’s ignored in the planning and portfolio construction process.

This is a fundamentally different way of thinking about risk. In 1991, the Nobel Prize-winning economist and father of Modern Portfolio Theory, Harry Markowitz wrote in Financial Services Review that “some economic theories find it convenient to assume that the individual is immortal, or that death is a Poisson process independent of the age of the individuals. For actual financial planning, however, aging and mortality are salient facts that must be included in the model.” (See also: Strategies for Clients in a Rising Rate Environment)

This is an important distinction. In building financial models, analysts can assume that plan sponsors and institutions live forever. The same cannot be said for individuals. Institutions have an essentially infinite time line and the opportunity to spread risk over a large population. An individual has only one working life and one opportunity to save and invest for retirement. The law of large numbers won’t come to his or her rescue if a mistake is made in the planning process. In recognizing this risk, one is forced to reconsider what constitutes risk for an individual saving for or entering into retirement. 

Early in the accumulation or savings stage, an individual most closely resembles an institution. With 40-50 years of assumed working life ahead, he or she can take greater risks and ride out the market’s inevitable downturns. The primary challenge here is volatility. Volatility here acts as a proxy for behavioral risk through mechanisms like trying to time the market. When the market falls, investors respond by going to cash and miss all or part of the next up cycle, eroding long-term returns. 

As an individual ages, the nature of risk shifts to what could be thought of as absolute loss. The individual’s time horizon to accumulate wealth shortens and traditional measurements of performance like annualized standard deviation become less important. An individual approaching her last decade of work may not really care if she outperforms the market on a relative basis (i.e. the S&P 500 is down 30%, but her portfolio is only down 15%). Instead, she now only has a finite time to recover her losses. Entering into this particular period, a portfolio needs to be reconstituted to reflect this reality.

Finally, there is the “spend” stage where the portfolio is called on to provide income and financial support during retirement. Studies show that running out of money during this period is many people’s single biggest fear. This risk may be defined simply as “longevity.”

Historically, the amount of time that an individual spent in retirement was brief. Partly as a result, many of the tools built around retirement planning are predicated on the need to minimize risk and maximize income. This leads to portfolios that are bond-heavy and that seek to minimize volatility. 

In today’s world, an individual may spend as many as 20 to 30 years in retirement, fully a third of his or her life. But a lot can change over the 30 years many people may expect to spend in retirement. Markets cycle up and down. Inflation erodes returns. Yet, through it all, the need for growth never disappears entirely. 

The portfolio construction process needs to recognize this new reality, which suggests the need for a more substantial equity weighting than has been the case in the past. But as equity weightings increase, volatility is likely to rise as well. That can be addressed by adopting a two-track approach – a portion of portfolio assets committed to generating income and a separate bucket invested for growth. How these allocations are proportioned could be determined by a number of factors, including age at retirement, spending needs and risk tolerance. Under this scenario, the income portion is spent down, but is replaced over time from the increased value of the growth pool which should help extend the longevity of spending in retirement, according to research conducted by Horizon.

The reality is that retirement has changed, but many of the assumptions that underlie the retirement saving process have not. As Markowitz notes, institutions may be immortal as a practical matter, but individuals have to plan for an unknowable, but finite, lifespan. Redefining risk across the stages of accumulation, protection, and spending phases is a good place to start. (Continue reading: Why Clients Fire Financial Advisors)

Scott Ladner is Head of Investments at Horizon Investments, a leading provider of modern goals-based investment management.