When it comes to risk planning in investments, especially in retirement, take care not to go about it the wrong way. Don't make the mistake of establishing unrealistic return goals and forcing yourself into an asset allocation and risk profile that is inappropriate for your situation. Your assets are finite and can only provide a certain amount of money on a sustainable basis. Reaching too far for return in retirement can be a cataclysmic experience if you get your timing wrong and are unprepared for the financial consequences. As such, your risk profile is of the foremost consideration in your retirement planning. Because no advice is appropriate for all investors, this process requires both objective and subjective analysis of your own situation. We'll show you how to you determine how much risk your retirement portfolio can tolerate. (For background reading, see Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)

Take a Look at Expenses
The first step in this process is to determine your spending rate on an annual basis. The calculation is a simple division of your annual spending needs into your total portfolio value. For example, if you have a $1 million portfolio and plan on spending $50,000 per year, you have a 5% rate of spending ($50,000/$1 million). So what does your spending rate tell you?

One way to view your spending rate is as a gauge for the lifespan of your portfolio. More specifically, the higher the spending rate is, the shorter the lifespan of your assets, and vice versa. Assuming proper portfolio diversification, a 4-5% spending rate is generally considered sustainable over the long term while still protecting, if not enhancing, your real spending power. To illustrate, consider the fact that the average college/university endowment has a 4.6% spending rate (according to the 2006 National Association of College and University Business Officers survey) and keep in mind that endowments are operated to be infinite pools of money. So, if you can live on a 4-5% spending rate, then you're in pretty good shape and can sustain a moderate to high risk tolerance in your portfolio.

The problem is that most people probably haven't saved enough money to live on a 4-5% rate of spending by retirement. Still, this knowledge is a very valuable general rule in your investment planning because it allows you to use your spending rate as an easily understood guidepost for risk tolerance. For example, if you have a spending rate of 10%, you know for sure that your portfolio's lifespan could be relatively short if you hit a protracted bear market. Therefore, you would need to invest in a very conservative manner to minimize fluctuations in portfolio volatility, lest your spending rate force you to sell large positions in a down market. Conversely, if you only have a 1% spending rate, your risk tolerance would be virtually limitless, as would your potential for portfolio growth.

As such, the key point here is to understand the potential effects of normal spending on your risk tolerance, which carries over into asset allocation and diversification considerations. The best way to illustrate this concept is by looking at the performance of a portfolio invested entirely in the S&P 500, with and without spending. Figure 1, below, illustrates the cumulative market value of a $1 million investment in the S&P 500 during the period of March 2000 and May 2007, with and without a $50,000 (or 5%) rate of spending.

Figure 1
Source: Hammond Associates

As you can see in Figure 1, a spending rate of $50,000 per year during a bear market would create an unrecoverable loss in real spending power. Although this is an extreme example, it illustrates the need for diversification for a retiree, who will almost certainly be pulling from a portfolio on a regular basis. Again, the higher your spending rate, the more exposed you are to fluctuations in market value and the lower your risk tolerance, which is why diversification is so important in your retirement planning. (For more insight, see Managing Income During Retirement.)

So, once you've determined your spending rate, sit down with your financial advisor and begin the process of sorting out the risk of various asset allocations while taking into consideration your spending needs. Any reputable financial services firm will have asset allocation, risk management and financial planning software that can assist you in this process. Nonetheless, there are a few key points you want to keep in mind during these sorts of discussions.

Metrics to Think About:

  • What is the expected annual standard deviation of monthly returns?
    Standard deviation is probably the most important statistic because it will tell you the likely fluctuations in your portfolio's market value from year to year. For example, if you have an asset allocation that will fluctuate plus/minus 15% every year and you have a 10% spending rate, then you're taking on too much risk. (For more on this topic, check out Understanding Volatility Measurements.)
  • What is the probability of taking a large loss in a given year, say 10%, 15% or more?
    This is another very important statistic and essentially represents your total dollars at risk to achieve a given rate of return. For example, if your portfolio is expected to make 10% over the long term, but is placing 25% of your assets at risk in a given year, and you have a 10% spending rate, then you're probably taking more risk than you can tolerate.

  • What is the expected rate of return for a given asset allocation?

    This is important to know because your asset allocation should produce a rate of return that will pay for your spending needs, protect against inflation and maybe even grow your portfolio. However, as mentioned before, don't let your return goal back you into an inappropriate risk profile. Start by discussing your spending needs and associated risk tolerance, and then try to eek out the best asset allocation given those constraints. (To learn more, read Asset Allocation Strategies and Achieving Optimal Asset Allocation.)

    It is an unfortunate reality that most people don't save enough to cover their retirement needs on an indefinite basis. Furthermore, this leads a lot of people to reach for return to make up that difference, implicitly ignoring their risk profile, which is primarily driven by spending needs.

Keep in mind that in retirement, your risk tolerance is driven primarily by spending needs as opposed to your psychological tolerance for fluctuations in market value. Trading only according to your psychological tolerance for risk is a luxury of being young. The fact of the matter is that unless you are in a position to live on a 4-5% spending rate in retirement, your portfolio will have a finite lifespan and accepting that reality is key to your financial planning. Just remember, high spending rates mean low levels of risk tolerance and low spending rates means high levels of risk tolerance.

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