What’s Your Risk Capacity: Why It Matters

Last week we discussed the value of having a guaranteed retirement income source. Annuities offer some strong advantages with their contractual guarantees. But they are only one part of the financial picture.

Overall, a portfolio could have many holdings: stocks, bonds, mutual funds, annuities, CDs, or even other financial instruments.

This brings up the question of portfolio allocation. Is there a paradigm which you should follow?

Ultimately, we would say it varies among individuals. Your portfolio strategy should be a good fit for your current situation, needs, goals, risk tolerance, and risk capacity.

Of course there are some well-known general rules of thumb for starting discussion, like the Rule of 100 for portfolio diversification. 

As you get closer to the life stage of distribution — or where you are living off your retirement savings — risk tolerance and risk capacity become even more important. But just what are these risk-related metrics?

What Is Risk Tolerance?

“Risk tolerance” is one of those terms which people hear often in financial circles.

It refers to someone’s ability to psychologically cope with periodic declines in the value of their investments. In other words, your risk tolerance is your appetite for market risk – or the pressure point at which portfolio losses become psychologically unbearable.

What About Risk Capacity?

Risk tolerance is quite different from your risk capacity. Risk capacity refers to when portfolio losses are so steep you need to change your plan. It’s a point at which you have to readjust course.

It’s not unusual for people, even when retired, to have high risk tolerances. In the last few decades, they’ve gone through two major bear markets and their portfolios have largely, if not entirely recovered from the losses.

However, while risk tolerances may be high for people aged 50 and up, their risk capacities have fallen. This has strong implications for the future.

Why Does This Matter?

When you reach retirement, life evolves. Your financial strategy shifts from preservation – when you’re saving up money and “preserving” it for retirement – to distribution – when you’re living off the savings you’ve put aside.

From an income planning standpoint, the time before you retire is a critical juncture. Let’s put this in the perspective of a declining risk capacity:

• As you get closer to retirement, your time horizon for preparation shortens
• Too large of a position in equities can leave a portfolio more exposed to future bear markets
• Your portfolio is likely to be a major source of income streams for your retirement
• A bear market may take years to recover from, which can be a timespan people don’t have in retirement
• From there, portfolio losses could prompt larger, premature withdrawals – which has strong tax implications

The takeaway? When too much of your portfolio might carry more risk than is appropriate for your risk capacity, it could have adverse effects on your long-term financial well-being.

As financial markets go through swings at different points, you can benefit from having some measure of financial certainty. That is why it may be practicalto have “safe money” vehicles such as annuities as part of your portfolio.

Why Should You Consider Annuities?

The right annuity will offer protection from market risk as well as guaranteed lifetime income, protection against inflation, and tax-deferred money growth potential.

It’s a vehicle which lets you preserve retirement assets while having growth opportunities. Just like with anything, however, annuities aren’t for everyone. Nor are all annuities equal in the value they deliver.

Strategizing for a Financially Confident Retirement

An annuity should provide a clear solution for existing problems in your financial plan. Not sure how to find the right one — or determine if one is right for you?

No sweat, a financial professional from SafeMoney.com can help you.They are also available to assist you with answering personal retirement questions and finding solutions to reach your lifelong-held goals.

Use our “Find a Financial Professional” section to connect directly with someone. You can request a personal strategy session to discuss your needs and goals. Should you have any questions or need a personal referral, call us at 877.476.9723.