From the March 2008 issue of Research Magazine • Subscribe!

March 1, 2008

New and Improved Risk Profiling

By now we should all know, given the press coverage on the issue, that the first of our 76 million baby boomer generation turned 60 two years ago on January 1, 2006. Turning 60 is an important milestone in our lives as we start to look ever more closely at the reality of our retirement. o What resources do we have that will generate income during retirement? o How can we turn these resources into income? o Is there a gap between our expectations and the actual amount of income our resources should be able to generate?

This demographic maturation and its matching questions are among the key drivers of the shift from the investment accumulation mindset to the retirement income mindset.

The importance, the impact and the urgency of this shift in mindset on the financial services industry have been a matter of debate over the last few years. Some argue that investment management is and will always be as it is today, and that the shift from accumulation to income generation will not significantly change the industry. Others believe that the shift is real and will not be addressed successfully with business-as-usual attitudes and solutions.

Today, the importance of this shift seems well accepted as the industry consensus. However, degrees of perception about the extent of the impact and its urgency vary from company to company. This may be related to the differing nature, maturity and segmentation of their respective investor clients.

The Traditional Investor Life-PlansChart 1, from RIIA's 2006 White Paper, illustrates a traditional and linear view of the investor's life-plan (investment accumulation followed by investment "decumulation" to provide retirement income) over a range of accumulation and retirement life-cycle steps shown on the x-axis. This behavior is further mapped against two broad categories of offerings provided by the financial industry on the y-axis (best effort products providing hopeful accumulation solutions and guaranteed products providing reliable income solutions).

This is a conventional way of looking at the life-plan of investors, a well-defined period of work followed by a well-defined period of retirement. This is also the most commonly used context, explicitly or implicitly, to answer retirement questions about resources, income and expectations.

The Boomer Investor's Blended Life-PlansHowever, research provided by Merrill Lynch suggests that recent observed investor behaviors seem to follow a different map (see Chart 2). This map suggests that the shift into retirement will happen more gradually, go back and forth between accumulation and decumulation and happen over a longer period of time than the traditional model.

This more complex investor behavior makes it harder to discern relevant and actionable changes for the advice-giving industry. Answering questions about retirement resources, income and expectations becomes more difficult and requires more frequent iterations. Consequently and in contrast to the traditional life-plans, investors with blended life-plans require more accurate measurement and tracking of their attitude towards risk. Such risk attitudes are likely to change over time and this will impact the perceived value of financial services over the lifecycle of the investor. In particular, boomers with blended life-plans are able to create more options for themselves than retirement investors with traditional life-plans. Traditional answers, such as annuities, become part of a broader tapestry of choices.

Steve Mitchell from Merrill Lynch points out that for a significant majority of boomers, work in retirement is likely to be the primary vehicle for hedging and postponing the assumption of risk. To the extent that boomers who are healthy and have marketable skills have the flexibility of working, they will likely rely on their human capital rather than buy insurance to mitigate many of the retirement risks outlined in last month's article. Work is effectively used as a form of retirement hedge, but it is not the only retirement hedge available to boomers with blended life-plans. Professor Meir Statman points out that such retirement-minded investors also have houses, inter-generational families and greater than expected flexibility in downshifting. Given that insurance is one of the retirement options available to investors, what forms of insurance will become popular (and for what types of risks)? To explore these questions further, we will extend last month's mapping of risk factors with a discussion of investors' risk attitudes.

Rational Attitudes Towards RiskLast year's series by Professor Moshe Milevsky demonstrated that traditional risk attitudes may not be sufficient when facing the risk of running out of money in retirement. Harry Markowitz' 1952 paper in the Journal of Finance formalized the analytical framework for traditional risk attitudes by showing that investors found utility in both low risk (defined as the variance of returns) and high returns (the expected returns); a risk-averse investor would prefer greater returns for a given level of risk as well as less risk for a given level of return.

Since it is unusual to find both low risk and high returns in the real world, investors are usually faced with a trade-off decision between risk and return.

The interesting question then becomes: How much return is an investor willing to trade off for a given unit of risk reduction? The answer depends on the investor's degree of risk aversion. Risk-tolerant investors will trade off very little return for a given unit of risk reduction. Risk-averse investors will trade off a lot of return for a given unit of risk reduction. A key aspect of the traditional value that financial advisors bring to their clients is helping them choose the prudent and suitable risk-aversion-matched mix of risk-free and risky assets.

Clearly, financial advisors need to be able to measure an investor's willingness to expose themselves to the hazards, consequences and probabilities of a risky investment. This is traditionally measured with a variety of risk-profiling processes including questionnaires. Working with traditional risk-profiling questionnaires reveal two important questions: Should a risk profile be limited to market risk or should it include the other risks we identified last month? Do repeated risk-profile measurements vary around a stable central tendency or do they vary widely with circumstances?

A Retirement Income-Focused Risk Profiling QuestionIn a paper published on his website (, William J. Bernstein suggests that a risk-tolerant investor focuses on the investment's mean expected returns more so than the variance. Such an investor's primary question may be: Can I buy on the dips? In contrast, a risk-averse investor focuses on the investment variance more so than the returns. Such an investor's primary concern may be: Can I survive the dips?

This observation suggests that we may want to add retirement income-minded questions to our investor risk-profiling processes. Such questions will help us discern more accurately if and when our investors have an investment accumulation mindset or a retirement income mindset?

How can you tell, using market-risk-focused questionnaires, if an investor is fixating on the expected returns rather than on the variance of returns? Investors with a high score to the question "What is your tolerance to the variance of returns?" are probably focusing on the expected returns rather than the variance of returns. They may be looking eagerly at their desired level of expected returns rather than looking warily at the variance-induced consequences that they may not survive. Investors with a low score to the variance question are probably looking warily at the consequences rather than the expected returns.

To improve our individual investor risk profiling as the market moves from an accumulation mindset to a retirement income mindset, we may want to add a question such as: "How much of your income do you want guaranteed?" This question, or similar questions focused on retirement income, will help you elicit additional and relevant emotions related to the consequences of shortfall.

Such questions can and should be asked early and continuously during an investor's accumulation career. The closer to retirement, the more difficult it will be for the investor to remain rational and objective about the question.


Francois Gadenne is president of Retirement Engineering Inc., a Boston-based R&D company that designs insurance and investment products for retirement-income needs (; he is a co-founder of the Retirement Income Industry Association.

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