The Process of Risk Management
As we mentioned in the prerequisite Thrive Retirement Specialists Insight entitled, "Evaluating the Big Five Retirement RisksTM Every Retiree Face," the very act of retiring subjects a retiree to five unique risks: 1). spending risk, 2). sequence-of-returns risk, 3). purchase power risk, 4). longevity risk, and 5). investment risk. You took the time to understand each risk better and have contemplated your level of willingness and ability to accept each, but now what? Is there anything you can do to change your risk exposure profile?
Fortunately, the answer is yes. Through a combination of certain tools, tactics, and further tradeoff considerations, there are ways you can change your risk exposure profile. This is the process known as risk management. A proper retirement plan will seek to manage the risks to which you feel averse to a level you find palatable so that you can feel at ease, thereby increasing the probability of staying on course with the plan. Risk management is an integral part of the retirement planning process that is too often given too little time and thought.
Big Five Retirement RisksTM
Let's take a closer look at each of the Big Five Retirement RisksTM and the tools, tactics, and tradeoff decisions that can be considered as you work to find your optimal risk exposure profile.
1). Spending Risk Management
Again, the odds of precisely forecasting your income needs for a long-term retirement are slim. A successful retirement plan should build in some flexibility. How much flexibility needs to be built in is contingent upon how well this risk is managed through the following techniques:
- Build a Realistic Budget and Projection – Building a budget based on and checked against current spending and desired lifestyle decisions is a good start. Included in that budget should be an accurate projection of tax and health care expenses. Possible contingent expenses should be explored as well to get an idea of potential size, scope, and timing. Lastly, spending flexibility should also be built in to account for the fact the projection will likely be wrong to some extent and to acknowledge the potential for spending shocks.
- Know Your Authentic Goals – Your authentic goals are much deeper than your stated goals of earning $X amount of dollars per year. Your authentic goals are aligned with the values that truly drive you. You will be less likely to stray off course if your plan expenses and assumptions are consistent with your authentic goals.
- Maintain a Buffer – A buffer is nothing more than an asset reserve. Certain retirement assets will be used to fund certain retirement plan expenses. Having a buffer, or asset reserve, set aside to fund contingent expenses will allow you not to take from assets dedicated to funding other retirement expenses. Having other assets outside the portfolio that you can draw on will help keep other areas of your plan on track by not reducing assets funding those other goals.
- Frequent Plan Update and Review – Because there are so many changing variables and assumptions that feed into a retirement plan, updating and reviewing your plan on a regular interval is key to keeping you on track. Updates allow you to incorporate recent history and tweak variables and assumptions as needed to see if any action needs to be taken before you end up too far off course, requiring some drastic action or lifestyle change to get back on course. In this case, comparing actual spending to budgeted spending would be in order.
2). Sequence-of-Returns Risk Management
Sequence-of-returns risk cannot be eliminated, but it can be reduced and managed through some combination of the following techniques:
- Maintain a buffer – Having other assets outside the portfolio that you can draw on during a financial market downturn helps to avoid/minimize selling from the investment portfolio at a loss.
- Employ a dynamic withdrawal strategy – Maintaining flexibility in the amount of one's spending allows one to take less income from the investment portfolio during a financial market downturn.
- Reduce portfolio return volatility – Investment portfolio return volatility can be reduced through proper portfolio construction and the asset allocation decision. A properly constructed portfolio of low-cost broadly diversified index funds combined with the overall level of stock and bond exposure can be used to control the range of possible return outcomes. Investment philosophy, asset allocation, portfolio construction, and portfolio management all matter a great deal.
- Reduce reliance on investment portfolio – The more your fixed expenses can be funded by fixed sources of income, the better. The primary source of fixed income for most retirees will be Social Security, which is why having a proper claiming strategy in place is so important. Other fixed sources of income could include payments from a defined benefit pension plan or an annuity that is owned or can be purchased.
- Control the controllable – Returns can vary due to reasons outside your control, such as poor economic conditions, but they can also vary due to factors within your control. Unfortunately, many retirees hurt themselves unintentionally through actions of their own that lead to below-market returns. These actions include paying too much for advice/investment management, poor investment selection or timing, poor portfolio construction, and failing to recognize behavioral pitfalls.
- Frequent Plan Update and Review – A retirement plan that relies on an investment portfolio for a significant portion of income can be sensitive to market returns. As a result, regular updates that incorporate recent performance allow you to stay on top of potential sequence-of-returns risk so you can act right away and make small changes along the way. Those changes could be positive (the ability to take more) or negative (the need to take less or go to a buffer reserve, etc.).
3). Purchasing Power Risk Management
While there is nothing that can be done directly to affect the inflation rate, there are some ways to reduce the unknown it casts over a retirement plan and to help mitigate its effect. Following are the primary purchasing power risk management techniques:
- Proper Investment Portfolio Construction – There are certain asset classes that can be included in your investment portfolio that can reduce your purchasing power risk by directly hedging against inflation or increasing in value as a result of inflation, thereby offsetting its negative effect.
- Asset Allocation Decision -- The proportion of the investment portfolio allocated to riskier but higher-return potential assets like stocks versus less risky but lower-return potential bonds can play an important role by helping the overall return of the investment portfolio stay above the rate of inflation.
- Make Changes to Spending – A retiree could decide to spend less as they get into the later years of retirement by spending less on discretionary items like travel and leisure. This, of course, presumes the discretionary spending savings do not need to be reallocated to other expenditures that can increase as one ages, such as health care. Another way to reduce spending is to reduce the proportion of expenses that are more sensitive to inflation. For instance, one could trade in a larger home for a smaller one to reduce the monthly expense for property taxes, utilities, homeowner's insurance, and maintenance.
- Increase Sources of Inflation-Adjusted Income -- Social Security has an annual cost-of-living adjustment based on the Consumer Price Index (CPI). Delaying social security as long as possible is also a way to protect against inflation risk. As benefits increase to age 70, a larger percentage of the individual's retirement income plan will be inflation-protected. Annuities often offer the ability to purchase either a set annual inflation increase in benefits or allow inflation protection based on an index, like the CPI. Long-term care insurance also offers inflation protection to ensure the benefits do not lose their purchasing power over a long retirement. When looking at insurance products like annuities and long-term care insurance, it is important to note that purchasing too much inflation protection can create an added cost that acts as a drag on total return.
- Frequent Plan Update and Review – The inflation assumption is a key assumption made in a retirement plan. Regularly reviewing the retirement plan and updating the inflation assumption as needed will serve to identify any potential issues so you can make corrections before they become an issue.
4). Longevity Risk Management
Of all the risks, longevity risk is probably the most puzzling. How is a retiree supposed to maximize their spending during their retirement years but not run out of money if they do not know how long their retirement will last? Fortunately, there is a mix of tools, tactics, and tradeoffs that can be used to manage this risk to the extent a retiree feels necessary. Following are some of those techniques:
- Increase Sources of Guaranteed Income -- Social Security will likely be your primary source of guaranteed income. You will continue to receive social security payments as long as you live. You may also have the benefit of a defined benefit pension plan that pays guaranteed income until you pass. Insurance annuity products can be purchased in some proportion and can pay either an immediate stream of income or steam of income at some future date. Insurance companies can pool longevity risk over many individuals, giving them the ability to project more accurate and consistent mortality results. This allows insurance companies to insure against longevity risk at a cheaper rate than an individual who chooses to self-insure.
- Increase your Planning Horizon Assumption – Increasing the mortality assumption will reduce your sustainable withdrawal rate but will allow your retirement assets to fund your retirement over a more extended period with less risk.
- Flexibility on Discretionary Spending – The ability to lessen discretionary spending later in life if needed can help to extend your retirement assets' ability to fund your fixed living expenses.
- Frequent Plan Update and Review -- The planning horizon assumption is another key assumption made in a retirement plan. Regularly reviewing the retirement plan and updating the planning horizon assumption as needed will serve to identify any potential issues and make corrections before they become an issue. Additionally, stress testing the plan by changing this assumption up and down can be a healthy exercise.
5). Investment Risk Management
Of all the risks, investment risk is the best understood because it's typically the only risk considered by most financial advisers and individuals. The following investment risk management techniques are also more widely known and utilized:
- Asset Allocation Decision -- The primary determinant of investment risk exposure is the asset allocation decision. Stocks have a higher potential for return but also higher variability in the path of return. In contrast, bonds have lower return potential but also less variability in the path of return. The greater the allocation to stock in the investment portfolio, the greater the expected return and the higher the investment risk you are taking.
- Proper Investment Portfolio Construction – Having a maximally diversified portfolio at any given asset allocation level will make it less likely to experience the volatility that a portfolio with investment concentrations is likely to have.
- Frequent Plan Update and Review -- Regularly reviewing the asset allocation decision to ensure the level of investment risk being taken is still necessary to support the retirement plan and within willingness and ability to do so is prudent.
Risk Management is an Ongoing Process
The tools and tactics an individual will use and the tradeoffs they will be willing to make will be unique to each individual given their risk exposure profile, attitudes toward the various risks, and available resources. As time passes, part of what was once forecasted becomes actual. Assumptions can change and become more refined. People's lifestyles, spending patterns, and health can change. So too can their risk exposure profile and willingness and ability to accept the various Big Five Retirement RisksTM. Just like in a proper retirement planning process, (see Thrive Retirement Specialist's Insight entitled "Steps That Should Occur in a Proper Retirement Planning Process") you should continue to monitor and formally revisit your risk exposure profile and reassess your willingness and ability to take the various risks you will be subjected to in retirement.
The more risk you want to remove and manage, the more tradeoffs you must make in benefits elsewhere. Managing risk can be expensive. But you must be honest with yourself. If you are not, you can face two potential consequences. The first is to live in fear or to become regretful. Second, is you run the risk of veering from your plan at some point and jeopardizing the sustainability of the plan. Neither of these situations is ideal and can both be avoided through proper risk management planning.
Risk management is an ongoing process and we're here to help. If you have any questions, please feel free to reach out.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing eight-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank where he advised high- and ultra-high net worth individuals on all matters of wealth including investments, portfolio construction, portfolio management and retirement planning.
Tony lives in Dearborn, Michigan with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)