In retirement, there are at least nine risks that households will face.
Those include systematic risks: including political (public policy and inflation) and business (market, issuer, income) and unsystematic risks: including behavioral (spending) and chance (household shocks, heath care and longevity).
Other organizations, such as the Society of Actuaries, put the number of retirement risks a household will face at 15: longevity, inflation, interest rates, stock market, business continuity, employment, public policy, unexpected health care needs and costs, lack of available facilities or caregivers, loss of ability to live independently, change in housing needs, death of a spouse, other change in marital status, unforeseen needs of family members, and bad advice, fraud or theft.
Regardless of the exact number of risks a household will face in retirement, it’s important to identify, how a relevant a risk is. In their book, Risk: A Practical Guide for Deciding What's Really Safe and What's Really Dangerous in the World Around You, David Ropeik and George Gray write that “risk is the probability that exposure to a hazard will lead to a negative consequence.”
And according to the Retirement Management Advisor® (RMA®) curriculum, which draws from Ropiek and Gray’s book, a risk is relevant if the risk involves and identifiable hazard; if the investor has exposure to the hazard; if the consequences are too severe for the investor to ignore; and if the probability of negative consequences is high enough to make the combination relevant.
Francois Gadenne, the executive director of CTRI, explains it this way: “It is a chain of questions that must be walked-through, one step at a time in order to get an answer about the relevance of a risk. A risk becomes relevant when all four questions have affirmative material answers. One negative immaterial answer breaks the chain, and makes the risk non-relevant.”
So, for instance:
- If a hazard cannot be identified, the risk is not a relevant risk that one can manage, hedge, pool, or avoid. Thus, it is not a relevant risk for the investor.
- If the investor has no exposure to an identified hazard, the investor has no skin in the game for that hazard. Thus, this is not a relevant risk for the investor.
- One may have exposure(s) to a serious hazard but suffer no material consequences from it. Thus, is not a relevant risk for the investor.
- One may have exposure(s) to a serious hazard with potential material consequences, but the probability of negative outcomes is lower than the population average. Thus, it may not be a relevant risk for the investor.
So, what are the risks that advisors who hold the RMA certification discuss most with their clients and what steps do they take to manage and mitigate those risks?
Also of note is the manner in which retirements risks are managed. According to the principles of risk management, avoidance is the tool used for high severity, high frequency risks; insurance or pooling is used for high severity, low frequency risks; retention/reduction is used for low severity, high frequency risks; and retention is used for low severity, low frequency risks.
In the RMA curriculum, the tools presented are similar, but the terminology is different:
- Diversification (risk retention) for low severity, low frequency risks
- Hedging (risk management) for low severity, high frequency risks
- Risk pooling (insurance) for low frequency, high severity risks
- Reserves (risk avoidance) for high frequency, high severity risks
So how do advisors incorporate the lessons from RMA curriculum about risk and risk management into their practice with their clients?
In his practice, Roger Whitney, CFP®, CIMA®, CPWA®, RMA®, AIF®, a senior financial adviser with Agile Retirement Management, discusses sequence of return risk in early retirement with his clients, as they transition from an accumulation portfolio to a retirement portfolio. “Individuals have invested for accumulation for decades,” he said. “Near retirement it's crucial that they convert to a retirement focused portfolio to fund their lifestyle.”
Within five years of retirement, Whitney creates a five-year cash flow estimate for retirement and identifies how much money they will need from their financial capital each year. And he divides the client household’s financial assets into (as outlined in the RMA curriculum) four different layers: contingency or reserves, income floor, upside, and longevity.
“Our goal is to have them into retirement having a clear understanding of how the first five years of retirement cash flow will be funded,” Whitney said. “Not only does this mitigate sequence of return risk but also gives them a strong behavioral foundation to invest successfully.”
For his part, Bill Harris, CFP®, RMA®, the co-founder of WH Cornerstone Investments, said clients worry about major concerns such as the market’s performance and protecting against long term care costs. But, he said, his firm also takes a slightly atypical approach to identifying and managing the retirement risks their clients face. “We white board a client’s life and strategize with the client on what curve balls can come their way,” he said. “Simple questions, like ‘What are you worried about?’ can reveal risks we may have overlooked. Ultimately, our job is to work with the client to help them minimize their concerns/worries.”