Rethinking risk in financial planning

With limiting risk still on the minds of most investors in the aftermath of the financial crisis, financial advisers should make risk management a top priority with clients. But what precisely is meant by “risk” today? For advisers, risk is primarily about market volatility. For individuals, the big risk is failing to reach their overall financial goals, such as a secure retirement. This gap, of course, presents a problem.

The traditional approach to financial planning is to frame a client’s plan around his or her risk tolerance — the amount of investment risk a client is psychologically and emotionally willing to bear.

Most advisers determine risk tolerance by giving clients a questionnaire designed to gauge their appetite for risk. But what if a client’s risk tolerance is greater than his or her financial wherewithal?

Let’s consider a couple that is nearing retirement. The present value of their resources (employment income until retirement, Social Security, investments) roughly equals the present value of their financial obligations (mortgage payments, essential living expenses through their actuarial lifetimes). In short, they are like countless families with very little financial flexibility.

Their goals are fully funded, but they have almost no margin of safety. Even so, they have spent 20 years investing in stocks, and the guidance they give their adviser is permissive of a higher-risk financial profile than their actual circumstances warrant.

What advice should an adviser deliver to this couple?

A conventional message is to stay the course, carry an equity allocation equal to 100 minus your age and bet on the markets. This advice is fundamentally bullish and might work out.

It is also advice within the guidance the client provided. But if the markets disappoint — as they did in 2008 — this couple will likely end up underwater and making painful adjustments later in life.

I would suggest an alternative: an investment plan based on the client’s actual household financial picture, rather than his or her answers to a risk tolerance questionnaire. The objective is to meet this couple’s minimum funding objectives, not outperform the markets, and to smooth out portfolio volatility.

Due to lack of financial flexibility, our couple can’t meet their goals with a large holding in equities. It is too risky and will likely lead to investment losses and a funding shortfall.

A portfolio based on this couple’s risk capacity — their actual financial ability to risk a certain amount of their funds — would invest mostly in fixed-income securities (particularly Treasury inflation-protected securities). A smaller portion would go to equities for limited upside participation.

If this couple ends up accumulating additional savings or lowers their essential costs, the added funds could be invested in equities for more upside potential.

I realize that many advisers will think that meeting these minimum objectives isn’t enough and that the couple should take on significant equity risk in hopes of achieving greater equity returns.

But while some couples might benefit from such a strategy — and equity exposure might provide positive returns — it won’t necessarily deliver positive returns. About 50% of the time, households taking such advice will find themselves in a worse position. 

In other words, when a household has limited financial capacity to bear risk (regardless of its high psychological tolerance for it), the traditional approach of providing advice based on risk tolerance questionnaires potentially leads to incorrect advice. If you can develop a financial plan that will most likely deliver a client’s minimum goals, that plan at the very least should be presented to the client.

The problem with the conventional “stay the course” advice is that it silences the signal of financial stress. Advisers who fail to alert clients to this type of risk are in effect making themselves responsible for the greater level of financial distress that could occur down the road.

Short-term, it may be uncomfortable being a messenger of financial caution, but long-term, the client will thank you.

Andrew Rudd is chairman and chief executive of Advisor Software Inc.

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