When considering retirement investing, many people have dealt with a 401(k) counselor at work. Or they have done business with the average financial salesperson (read: broker, “financial advisor” or such). And they often complete “risk profile questionnaire” at the request of said advisor. The risk profile questionnaire (RPQ) typically asks questions including:
- How many years out you will need the money/retire
- your feelings about risk
- your thoughts on investing in stocks vs CD’s
- If you’d need to draw income from the account
These questions are all fine and dandy. However in respect to someone who is planning to USE their retirement funds to secure their retirement, the typical risk profile questionnaire (RPQ) misses the mark tremendously. Let’s approach the bullet points above individually. And then discuss what I would recommend to someone approaching their retirement years.
Retirement Investing Time Horizon
First, even though the RPQ asks about time horizon, it does not address a fundamental financial occurrence. The risk to your retirement objectives GROWS as your account grows. Why? If someone age 25, has $5,000 in their IRA, and they suffer a 30% market correction – i.e. $1,500 – it is likely they could rebuild the IRA with CONTRIBUTIONS. Even they make a median salary.
Someone age 62, with a $450,000 401(k), who takes a 30% haircut – $135,000 loss – likely can not replenish their funds with cash flow from work. That is, if they earn a median income. A hit this big could also push the desired retirement/financial independence date back a few years. Not an attractive option! Therefore, a retirement investor/saver needs to focus differently on the level of risk over time to their portfolio.
Advisors typically ask RPQ questions like this: if you lost 10,20 or 30% of your account value, would you sell stocks and move to something more conservative? Basically, the person asking the question wants to know at what point you will grow nervous and cash out. Is it at a 10% loss? A 20% loss? 30%? As you can see, this whole idea of an investors idea about risk is based on only one measure of risk – volatility. That is, how much the account will “bounce around.”
And as we covered above, we need to approach that risk appropriately for retirement investing. However, the investor faces many other risks. Risks include:
- changes to the tax code
- the chance that social security privileges might be changed
- the chance that a major health catastrophe will hit
- and many other risk including market volatility.
The solution – ask real risk questions so that the investor is clear what might come and how to deal with it.
Stocks vs CDs?
Interestingly, most people filling out RPQ’s are not extremely knowledgeable about investing. Ssome are, but the majority aren’t. And chances are, if they are filling out an RPQ with a 401(k) counselor or advisor, they at least assume they know less about investing than the counselor!
Therefore, when questions are posed about the attractiveness of stocks, vs bonds, vs CD’s, the investor often gives a very uninformed answer. The investor is then brought to emotional answers. Such as, “oh my husband hated stocks when he was alive, he lived through lean times after losing a lot of money in stocks so he never invested again and neither will I.” This would be an example of an emotional answer.
We Need Details!
However, what needs to happen is that retirement investing requires a much more detailed financial profile and analysis. In other words, a one pager won’t cut it here. An entire universe of financial vehicles needs to be accessed to find the proper savings vehicle/investment for the particular case of each investor. For example, someone with 3 million dollars might be fine with all of their money in stocks – a 30% correction though large, would not put this person in the poor house.
However, someone retiring with $250,000, with a family history of living long lives, may need to provide income. But also add protection for living too long and preventing the exhaustion of funds! This person may be better suited to some guaranteed income products on the market today that last a lifetime.
Each person is unique and the RPQ doesn’t, can’t get to the root of this, the questions needs to be much more complex.
Will You Withdraw Income?
The example I just made flows into the last bullet point – the need for income. Those who don’t need to touch their retirement savings because they have pensions and a solid social security check can, if they choose, approach their assets – 401k, IRA, 2nd home, stock etc, differently from the person with no pension who will need their assets to provide an income stream of some amount.
And since there is no large entity guaranteeing this income (as the state of MA for example guarantees state employee pensions with tax revenue), it is paramount that we put a plan in place that uses those assets most wisely, preparing for as many of the diverse risks mentioned above as possible, and providing income supplementation that does not make the investor lose sleep.
Typical Is not Good for Retirement Investing – We Need Atypical Analysis Here
The typical approach in the financial industry is the ‘drawdown method.” This is a simple method meaning, if we assume (key word) that your assets grow until age 65 at X%, then assume (there it is again – that pesky word) that you will earn Y% in retirement, your money will last Z years. The problem with this again is, if the market crashes, it will change the time table tremendously.
And there are numerous examples that show that the timing of your retirement can have an enormous effect on how much income you can take from a drawdown portfolio. If you were beginning your withdrawals from a drawdown account in 2008, it is likely you’d have had to completely rearrange your plans because your withdrawals were based on assumed average returns, which is a lousy way to plan for the risk of a major market correction – taking money out of your account for income at a market bottom only exacerbates the problem.
An alternative to the drawdown method for retirement investing is to consider separating your planning to an income side of your portfolio and a future growth side with the income side allocated to savings vehicles that hedge or eliminate some of the risks faced by a retirement investor – for example, living too long, volatile market returns, inflation, etc.
All in all, if you have often felt more confused after filling out a risk profile questionnaire, or you had a suspicion that your entire portfolio could not be driven by such a simple set of questions, you are not alone.
Often the RPQ is a ‘compliance’ tool to help an advisor say they did the proper due diligence on a client before making portfolio recommendations. However, it does not even begin to scratch the surface of the questions that need to be asked.
When it comes to planning your retirement investing security, make sure the person you’re working with asks the right questions, because you don’t have many chances to do this right – time is ticking!
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