Friday, Nov. 6
Posted 2 p.m. EST
Risk is one of those things that most people would like to strangle and throw into the river.
In Bankrate's most recent poll, nearly four out of 10 retirees worry about the risk that they'll outlive their money. Among those who are still working, 40 percent expect to delay their retirement due to the financial crisis, an event that forced Americans to look risk squarely in its beady little eyes.
Think your financial planner can help you manage risk? Maybe, but a new study points out that advisers don't have all the tools they need to accurately assess it. In other words, they aren't taking all of the dimensions of risk into account.
Two dimensions
In "Mismeasurement of Risk in Financial Planning," Richard K. Fullmer, senior portfolio strategist at Russell Investments, enumerates the two dimensions of risk.First, there's the risk of a probability of an event. Monte Carlo simulation is used by advisers to address probabilities of market ups and downs and other variables like inflation. Advisers use this tool to help their clients gauge the potential success or failure of their retirement plans.
Second, there's the risk of the magnitude of an event: Think really steep market decline. This is the element of risk that's missing from planners' toolboxes.
Total risk is the product of probability and magnitude. Most planners rely strictly on probability risk. The tool they should use is: Shortfall risk = probability of shortfall x magnitude of shortfall.
In Fullmer's words, "The probability side of risk is the likelihood that an event happens. The severity side of risk is -- if that event happens, how much pain is there to me? So what is the actual risk of the event happening?"
What this means to you
When Fullmer applies these facets of risk to 30-year portfolios with lower withdrawal rates such as 4.5 percent or less, it turns out that a conservative portfolio may have the highest probability of success as well as the lowest magnitude of failure. (Failure is defined as the amount of planned spending that cannot take place because the portfolio went broke.) That would be a portfolio with 20 percent in stocks and 80 percent in bonds. As the withdrawal rate increases to higher levels, however, conservative portfolios cannot be expected to earn a high enough return. The result is that at higher withdrawal rates, the probability of success will be better under portfolios that have larger equity allocations.But an interesting thing happens. Although the probability of success may improve as investment risk is added to the portfolio, this improvement comes at a cost: If markets are unfavorable, you could potentially go broke sooner than if you had used a more conservative portfolio.
If you want a carefree retirement, one that enables you to suffocate risk once and for all, you're going to have to save a bundle so that you can invest conservatively and spend conservatively, with a paltry withdrawal rate of 4 percent or less initially, adjusted annually for inflation.
It's never too early to start figuring out your retirement needs. Check out Bankrate's Retirement Income Planning series.