Measuring Retirement Capacity for Loss
There are two reasons why you should limit the amount of investment risk you might take:
-You might not be able to stomach losses of more than a certain amount (your risk tolerance).
-You might be unable to afford to accept the losses which could occur if you take too much risk (your risk capacity).
We often refer to your risk tolerance as your risk personality – it’s a psychological and, mostly, inherent personality trait. It doesn’t change much in the short term, but, like your personality, it can change over the years. I’ve talked about risk personality in previous blog posts.
Risk capacity is factual – it refers to the amount of money you can afford to lose. It follows that if you can’t afford to lose a certain amount of money, you should reduce the amount of risk you are taking.
Risk capacity is pretty easy to measure before you stop work – if you need to have some money to pay off your mortgage, it follows that you can’t afford to have less money than you need to pay off the balance when it is due.
If you work out that you need £500,000 in your pension to be able to retire at 65, then you can’t afford to have less than £500,000 in your pension at 65; so if you have £550,000 in the run-up to age 65, you have the capacity to lose 9% of your pot before your plan to retire at 65 is ruined – so don’t take the sort of risks with your retirement savings that could result in your losing more than that.
So, risk capacity is simple to work out…before you retire.
Once you’ve retired, as usual, it all gets a bit more complicated.
Put simply, it doesn’t matter if the value of your retirement portfolio goes down – as long as it can still give you the money you need to spend every year. That makes it pretty hard to determine your capacity for loss.
We need to remember that there are two types of expenditure in retirement:
-Essential expenditure. Things you have to pay every year, like your council tax, electricity bill, TV licence. Try telling the local authority that you can’t pay your council tax bill this year because your portfolio has gone down by more than you expected – I don’t think that you’ll get much sympathy!
-Discretionary expenditure. Things like holidays, gifts to children etc. While it might be disappointing to cut back on discretionary spending, the consequences wouldn’t be disastrous.
Now, one man’s essential expenditure may be another’s discretionary expenditure.
For some people, private medical insurance is a necessity; for others, it’s a luxury. Ask a teenager and a pensioner whether a landline is a necessity, and you might get two very different answers!
But let’s not dwell on that.
Your capacity for loss for the part of your retirement portfolio which pays for essential items is lower than it is for the part which pays for discretionary items.
Readers of this blog will know that we use a software system, called the Timeline, to allow us to work out the likelihood that your retirement portfolio will succeed in providing you with the money you need to spend in retirement.
It’s logical that the expected success rate for the money which pays for your essential expenditure should be pretty high – as close to 100% as it can be.
The expected success rate for your discretionary expenditure can be lower – it’s up to you to decide how much you would mind having one less holiday a year if the markets aren’t playing nicely.
So, the first step to working out your capacity for loss in retirement is to divide your retirement spending between essential and discretionary items.
You could then take that one step further and divide your retirement savings into two portfolios – one to pay for essential elements and one to pay for discretionary items.
The portfolio for the necessary items should have a very high probability of success (as your capacity for loss is low), and the portfolio for discretionary items can have a lower likelihood of success (as your capacity for loss is higher).
You can afford to take more risk with the portfolio for discretionary items, and, hopefully, that will result in higher returns.
Now, some people might like the simplicity of having two retirement portfolios. However, others might prefer to have a notional portfolio split – whatever approach you choose; you still need to know how much you need to provide for your essential expenditure safely.
It’s pretty tricky to work out what your capacity for loss is for retirement income.
If you aren’t analysing your spending carefully and using a sophisticated piece of software, like the Timeline, then, frankly, you’re guessing.
And if you’re guessing, you could quickly be taking too much risk. And if you’re taking too much risk, you might just end up having that conversation with the council about how you can’t pay your tax this year as the stock market fell in value last year!
Planning your spending in retirement is all about making an Informed Choice.