Deciding how much investment risk you should take in retirement
In this post, I am going to look at how you should, ideally, decide on how much investment risk you can take for retirement income.
Let’s get things straight first – it’s not possible to avoid risk in retirement.
Some people imagine that, if they put all their retirement savings into a deposit account, they won’t be taking any risk. That’s just not right.
They’ll still be taking the risk that the spending power of their money will reduce, that the tax on the interest might rise, and that the bank might fail.
Investing in this way might reduce some of the risks you have to take, but it doesn’t remove them altogether.
And, of course, there’s usually a cost to avoiding risk; you just need to compare the returns in 2019 from shares to the interest paid by deposit accounts to understand the potential costs of risk aversion.
Your Retirement Risk Profile should take account of the following elements:
-Your Risk Personality.
-Your Expected Level of Interest and Involvement in your portfolio.
-Your Capacity to Accept Losses.
In this post, I’ll be looking at your risk personality. I’ll examine interest levels and capacity for loss in future posts.
You need to understand how you might feel when things go wrong from an investment perspective; this is a personality trait and is best understood by using psychometric types of questions.
Your experience, both financial and non-financial, will also help identify your risk personality.
It is essential to consider your risk personality in isolation from your capacity to absorb losses. The latter is factual, and its purpose is, where necessary, to limit the amount of risk you might instinctively take as a result of your personality.
To determine your risk personality, you must understand what your reaction might be to future events.
There is a trade-off between higher expected returns and the amount of risk in your portfolio. How will you feel if your retirement portfolio falls in value and then takes some time to recover?
In an ideal world, you will take as much risk as you can stomach, to benefit from the highest potential returns.
But it’s essential to work out how risk might affect you personally, and how you might feel about it, as everyone will need to withdraw different amounts from their retirement savings every year.
Imagine two brothers, Bob and Jack, who retire on the same day.
Both of them have retired with portfolios of £500,000. Bob needs to withdraw £25,000 per year, to top up his guaranteed pensions and cover his annual expenditure, while Jack needs just £10,000.
They both put all of their money into a UK share index-tracking fund.
In its first year, UK shares lose 40% of their value, and they don’t start to recover for another three years.
By the end of year 3, Bob is left with £225,000 of his £500,000 (and he needs his portfolio to grow each year by 11% per year to avoid further losses).
Jack, on the other hand, still has £270,000, and if his portfolio grows by more than 4% per year, it will start to go up in value again.
We’ll know what Bob and Jack’s risk personalities are by what they do next – if they sell their portfolios and move into cash, then there was probably a mismatch between their risk personalities and the risks they have taken.
Before they invested, Bob and Jack should, of course, have analysed their risk personalities, thinking about how they might feel about this type of fall in value – this sort of drop is almost inevitable at some point in a 30-year retirement if you put all your money into UK shares.
It’s better to work out your risk personality before you invest, rather than finding out what your personality is after the crash!
As you can see, the consequences of this type of fall are different in retirement than they are when you are saving up (when you hope that shares will recover, as they usually do).
Bob and Jack are like most people – they didn’t inherit their £500,000 or win it on the lottery or Premium Bonds. They saved it over their working lives, through pension and ISA contributions.
So they have had the experience of the good and bad of investing – they would have had some money invested when the dot.com bubble burst in 2000, and they experienced the banking crisis of 2007/08.
They have also enjoyed the last ten years of consistently good returns from stock markets.
Their experience will help them to understand what their gut reaction is when asset prices fall. Still, it’s important to remember that they may react differently in retirement when they might feel less able to simply wait until values recover, or decide to work longer if they don’t.
Some less apparent financial experience might also help them to determine their feelings about risk:
-they are likely to have taken out a mortgage during their working lives – did they opt for the certainty of a fixed rate or did they take their chances with a variable rate?
-when considering jobs, did they opt for a lower salary with a secure employer, the variability of self-employment or something in between (e.g. a job with a combination of salary and commission)?
A combination of your gut reaction to risk and your experience will help you to determine how much risk you will be able to stomach.
Your financial planner should be able to carry out a formal assessment of your risk personality and then link this to an ideal portfolio to match your risk personality.
The planner will then be able to demonstrate how that might affect your portfolio over the longer term, taking account of the withdrawals you can expect to make.
If you feel that you are taking too much risk for your personality (or returns aren’t high enough), you can then amend the portfolio until you arrive at a combination of risk and return with which you are comfortable.
But you shouldn’t stop there – once you have worked out what your risk personality is, you then need to calculate your capacity for loss. We’ll look at that next week.