Traditionally, financial companies and financial advisors have asked the following question of investors: "What is your tolerance to the variance of returns of risky assets?" This question was particularly appropriate during the investment accumulation phase and the matching diversification-based investing approaches.
Recent product enhancements, such as principal protection, payout and other features, have made a positive initial foray into the emerging decumulation phase. But do they address all of the investors' risks that we should care about as we continue to work our way from the investment accumulation mindset and towards the retirement income mindset?
Identifying Risks for Retirement IncomeLet's run a thought experiment: You are responsible for the retirement income strategy of your business or practice. You are eager to remove the impressions of distrust and complexity that you believe hinder market acceptance and revenue growth. You are also averse to the idea that the there may be a fundamental shift in investor expectations from diversification-focused asset accumulation towards retirement income-focused asset "decumulation". You believe that an incremental solution to this shift is possible.
How would you go about approaching the situation? In particular, what specific problem or problems are you trying to solve for the investors? We should probably start by making a list of the risks that concern your clients, such as:Market Risk: The investor's portfolio experiences larger and/or longer than expected downside fluctuations in market prices and in asset values.Issuer Risk: The investor's portfolio is negatively affected by unexpected changes initiated by or impacting the issuers of the assets, including changes in terms, unexpected downgrades in credit rating, or business failure.Inflation Risk: The purchasing power of the investors' assets is negatively impacted over time. Household Shock Risk: The investor experiences unfortunate events (e.g., death of a spouse, divorce, unemployment) with the potential to require unexpected and forced changes in earlier and hard-to-reverse decisions related to portfolio composition.Spending Risk: The investor spends more than the planned income and may have to invade capital.Income Risk: The investor's investments experience unexpected or un-manageable reductions in income generation either because of changes in the interest-rate environment or because of lower than expected performance of portfolio choices.Health Care Costs Risk: The investor experiences unexpected and expensive changes in the cost of maintaining his health, requiring spending above budget and the need to dip into capital.Longevity Risk: The investor lives longer than planned or expected, increasing the likelihood of not maintaining the desired standard of living.Public Policy Risk: Government legislative and regulatory changes affecting retirement and income planning lead to earlier-than-expected portfolio depletion or the invalidation of previously sound recommendations.
By rearranging these risks into generic types and putting them in a table format, we can see the beginning of a risk matrix with nine risks arrayed across three categories of risk. [See Table 1.]
The Retirement Income Risk Framework"Probabilities" are but one dimension of risk and often do not represent the most relevant dimension from a client's perspective. This is because, in most cases, consequences trump the odds. For instance, how would you think about probabilities if the matching consequences included losing your life?
From our investor's point of view, a risk is relevant if there is an identifiable hazard; the investor has exposure to the hazard; the consequences are greater than what the investor is prepared to ignore; and, the probability of such negative consequences is high enough to make the combination relevant.
Adding these dimensions to our previous list of risks produces the risk matrix seen in Table 2.
Looking at our initial question "What is your tolerance to the variance of returns of risky assets?" in the context of this table, we can see that the risks relevant to the investor with a retirement income mindset may be more numerous than those for the investor with an investment accumulation mindset. This is not the case because these risks are new (hazard) or because their probabilities were not contemplated before. Rather, it's because the investor is now meaningfully exposed to these risks (exposure) and realizes that the negative outcomes (consequences) can no longer be ignored.
Thinking about retirement income planning can bring about a dislocation of expectations. The investor may have to contemplate that remaining life-cycle consumption must be decreased to a painful level upon discovery that savings are or will be inadequate to allow retirement at the desired age and at the desired standard of living.
At this point, experienced financial advisors have been heard to say: "Investors have retired before. Financial advisors have provided retirement income services before. What's new? What's changed?"
What's changed is the quantitative impact driven by the demographics of the baby boomers. This growing, quantitative change is reaching a point where it also creates qualitative changes, including:o The portion of the financial advisor's practice focused on high-net-worth clients (vs. merely affluent clients)o The portion of the financial advisor's services dedicated to retirement income planning (vs. traditional investment management)
If you combine this annual increase in the raw numbers of incoming retirees with the matching qualitative impacts on served markets and practice mix, you should start to see the need for new, retirement income focused, scale-driven products, processes and advice-focused business models.
To further refine our understanding of such changes, it may be helpful to review last year's lessons, taught by Professor Moshe Milevsky, in the context of the retirement income risk framework. First let's summarize the lessons:o Lesson 1, The Trigonometry of Retirement Income: The sequence of returns implies that with respect to market risk, advice needs to be iterative and flexible given the probabilities involved and the impact of the consequences.o Lesson 2, The Uncertainty of Death and Taxes: The hazard arising from public policy risk, in particular changes in the marginal tax rate, implies that our decisions must provide tax-outcome diversification as well as asset-class diversification. o Lesson 3, Sustainability and Ruin: A probability of sustainability, or ruin, can be computed by combining inflation, longevity and market risks.o Lesson 4, Inflation Rates and Retirement: Investment returns must cover inflation as well as taxes. There are many inflation indexes. Which index is most relevant given a client's specific exposure to inflation risk?o Lesson 5, Spending Buckets and Financial Placebos: Can your cash-flow generation strategies create unexpected market risk exposure?o Lesson 6, Longevity Risk: There are many longevity risk tables. Which table is most relevant to the exposure faced by a specific investor?o Lesson 7, Annuitization: This lesson summarizes the pros and cons of annuities for investors and advisors who need to hedge exposure to income risk.o Lesson 8, Defined Benefit Pensions: Winners and Losers: What are the potential and observed market risk consequences that risk-capping may have on the company stock?o Lesson 9, Moral Hazard: This lesson explains the issuer-risk hazard created by the investors' asset allocation behavior for the insurance companies that provide equity put options in their variable annuity contracts.o Lesson 10, Questions to Ask Annuity Wholesalers: What are the organizational and strategic exposures that income riders create for issuers and what questions should advisors ask wholesalers?
If we organize these lessons in table form, we can begin to see patterns that would otherwise be easy to miss. [See Table 3.]
One way or the other, we can see that qualitative changes from the accumulation mindset become more visible as shown by Milevsky's lessons that address key retirement income focused topics. We can also see blanks that suggest that there may be other topics that we would want to read about in future articles.
In our next article, we will look at ways of improving individual investor risk profiling to help us deal with and manage the changes in the investor's mindset from investment accumulation to income distribution.
Francois Gadenne is president of Retirement Engineering Inc., a Boston-based R&D company that designs insurance and investment products for retirement-income needs (www.IncomeAtRisk.com); he is a co-founder of the Retirement Income Industry Association.