Some questions bring into sharp focus the difference between investing for accumulation versus investing for retirement income. For example, a key question to consider is:

Should investors with insufficient, potential retirement income from their financial capital expose more of their assets to risky investments?

To explore this question, let’s take a look at the balance sheet of the retail investor.

Investor Balance SheetData from the Federal Reserve Board’s triennial Survey of Consumer Finance (SCF) is designed to measure wealth based on nationwide statistical records. The good news is that this data has been analyzed in depth by Arthur B. Kennickell in a September 2003 paper published by the Federal Reserve Board, titled “A Rolling Tide: Changes in the Distribution of Wealth in the U.S., 1989-2001″. The bad news is that, until a new study is published to update this particular view of the data, we will need to rely on 2001 data for the “amounts and shares of net worth and components distributed by net worth groups.”

To get the most value out of the information, the analysts break the data into percentile classes. For instance, based on the 2001 data, the bottom 50 percent class represents about 53 million American families. The next 40 percent represents about 43 million families. Cumulatively, we have now looked at 90 percent of American families. The next 5 percent represents about 5 million families. The next 4 percent represents about 4 million families. At this point, we have looked at 99 percent of families. Finally, the last 1 percent represents about 1 million families.

Table 1 displays the balance sheet data with these percentile classes as columns.

While this data is old and we eagerly wait for an update, we can clearly see the danger of using a single average across all investor classes.

As shown in the table, the primary asset of the bottom 90 percent of families (as of 2001) is home ownership. This helps put both the importance and the potential target-market for reverse mortgages in perspective. In contrast, the primary asset of the next 9 percent of families is stock ownership and retirement accounts. For the top 1 percent, the primary asset is closely held businesses, following by stock ownership.

This also sheds valuable insights on why some families are so much richer than others. Many families, in each bracket, buy a house; just 10 percent of families grow their stock and retirement account investments to exceed the value of their house and only 1 percent of families grow successful businesses that greatly multiply their net worth. One could say that the key steps to achieving wealth include getting a job, buying houses, opening retirement accounts, investing in financial assets and starting successful businesses.

Turning our attention away from assets and towards liabilities, in Table 2 we can observe that the bottom 50 percent of families have the highest debt burden with a 56 percent debt-to-asset ratio in 2001.

This debt ratio falls rapidly until it almost disappears (2 percent ratio) for the top 1 percent of families. It is relevant to note that this debt data does not include company-level liabilities that arise from ownership of closely held, as well as public, stock businesses. This is a form of indirect leverage for the higher brackets.

Ben Williams, chief technology officer at Retirement Engineering, also notes that the data does not seem normalized or cross-sectioned to account for age. This is important to keep in mind since net worth at retirement matters the most from a retirement income perspective. It is possible that average age increases with wealth brackets. As a result, the debt-to-asset ratio would be expected to decrease as education loans, mortgages and similar forms of debt are paid down.

The resulting net worth data, in Table 3 can now be compared to current family income.

These net-worth figures can also be translated into expected retirement income using, as a first order approximation, a withdrawal rate of 4 percent.

Potential Retirement IncomeThis withdrawal rate provides a rough estimate since the net worth data includes non-financial assets and should be treated with skepticism. However, it is practical to use it since we seek to understand what could be achieved with all available income generation opportunities, including reverse mortgages.

Comparing these results to the 2001 average income of these five percentile classes, Table 4 shows the following results.

These data suggest that all percentile classes would, on average, see a drop in income should they try to live from their assets alone at a withdrawal rate of 4 percent. These replacement ratios are lower than the traditional 70 percent-80 percent used in traditional financial planning.

Now that we see that many, and perhaps most, investors may not have the assets to cover their retirement income expectations and liability, let’s return to our initial question: Should investors with insufficient, potential retirement income from their financial capital expose more of their assets to risky investments?

Embracing Risk ManagementAs Chart 1 summarizes in the form of a personal balance sheet, exposing one’s financial capital to more risk (higher discount rates) does not automatically reduce the discounted value of the liabilities.

Professor Zvi Bodie of Boston University stresses that this issue is important to the retirement investor but that it is seldom understood. (This issue is also the subject of a debate within institutional circles. However, the answer for the institutional side of the business may or may not be the same for the retail side of the business and we only seek to address the questions for the retail investor in this article.)

Looking at this chart, other questions come to mind: Would a retail investor consider it prudent to use the expected rate of return of his or her financial asset allocation to discount the liability? What are the consequences if the return expectations are not met? Who pays for the implied put (making up for the lower asset value in the face of the higher liability) if the return expectations are not met?

These data and these questions add support to findings discussed in previous articles and summarized on Chart 2.

The logic of generating a reliable retirement income stream (in contrast to the logic of total-return maximization) may be moving the financial industry away from a focus on allocating investments among risk assets. Instead, it may be moving the financial industry towards a focus on allocating the investor’s capital among risk management techniques including:o risky investments (traditional and non-traditional assets)o insurance (annuities, health, longevity, etc.)o exposure transformation (hedges, options, derivatives, etc.), and o proper risk-free assets (duration-matched TIPS, etc.)

Think about it: Are you allocating the financial assets of your retirement-focused clients among risky investments or are you diversifying their capital exposure among risk management techniques?

Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see www.riia-usa.org.