In our just-released Q3 Financial Professional Outlook
survey, we discuss how advisors are generating retirement income
for clients in or near retirement
. Today’s post will cover how advisors allocate assets and the concept of risk capacity versus risk tolerance.
When asked how they approach asset allocation for clients near or in retirement, 38% of advisors said they allocate assets based on a risk profile questionnaire
. Risk profile questionnaires can be useful tools, but they are best at evaluating an investor’s self-reported risk tolerance during their accumulation years – how much portfolio volatility they believe they can handle. They help prevent the dangerous habit of jumping into and out of the market at the wrong times. A few round trips like this can cripple an investor’s long-term results.
One way to represent risk capacity is to calculate an investor’s “funded ratio
.” The funded ratio
is an institutional concept that has plenty of relevance for retail investors. In its simplest form, the funded ratio is assets divided by liabilities.
Funded Ratio = Assets ÷ Liabilities
In slightly more complex terms, the liabilities are the actuarial net present value of a retiree’s future spending goals
. We calculate it using best practices of actuarial math
rather than the more typical rules of thumb used to answer retirement-oriented questions like the 4% Rule or scratching the surface of the problem with questions like “What’s your number?” How you calculate that number makes all the difference.
In essence, the funded ratio is a yardstick that measures the feasibility of an investor’s spending plan based on his or her assets. It also allows the advisor to monitor and adapt a portfolio’s allocation through time
The bottom line
The funded ratio bases the asset allocation on risk capacity rather than the risk tolerance, as defined by a questionnaire. This helps you to focus on meeting your clients’ needs for sustainable withdrawals, predictability, and the flexibility to respond to changing circumstances.