What’s Your Risk Capacity: Why It Matters

Whats 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’re only one part of the financial picture. Overall, a portfolio could have many assets: 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 should be allocated to reflect your current situation, your needs, your goals, your risk tolerance, and your risk capacity. Of course there are some well-known general guidelines, like the Rule of 100 and portfolio diversification.

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

What’s 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 pre-retirees or retirees to have high risk tolerances. In the past two 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 many equity allocations (for example, a big stake in the stock market) can leave a portfolio more exposed to future bear markets
• For investors without income sources like pensions, financial portfolios are likely to be a primary vehicle for spending needs
• A bear market may take years to recover from, which can be a timespan people don’t have in retirement
• If you’re relying upon your portfolio for spending, portfolio losses could prompt larger, premature withdrawals – which has strong tax implications
• In time, it can lead to your portfolio being depleted prematurely, or force you to reduce your spending levels, which impacts retirement lifestyle

The takeaway is when too much of your portfolio is allocated into equities like stocks, it could have adverse effects on your retirement financial life.

As the financial markets go through extreme swings, you need some measure of financial certainty. That’s why it may be practical and prudent to have “safe money” vehicles such as annuities as part of your portfolio.

Why 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. Like any financial product, however, annuities aren’t for everyone. Nor are all annuities equal in the value they deliver.

If you're ready to see if an annuity makes sense for your portfolio and retirement lifestyle goals, can help you. Use our Find a Licensed Advisor section to connect directly with an independent financial professional, and to request a personal strategy session to discuss your needs and goals. And should you have any questions or concerns, call 877.476.9723.

Author: Super User

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