MMM Newsletter and Website Header 10.2.15

By Rob Williams, Charles Schwab & Company


Key points


  • When planning for your retirement income, you need to figure out how much risk you can afford to take in your retirement portfolio.


  • Investors are taught to think of risk as “risk tolerance,” or their comfort level when taking on investment risk. But we think it’s more important to know your risk capacity, or how much risk can you afford.


  • Once you figure out your risk capacity, you’ll be better able to allocate your investments to meet your needs over time.

When you’re planning for your retirement income, you need to know more than just when you’d like to retire and how much money you’d like to have. You also need to factor in investment risk.

Typically, investors are taught to think of risk as “risk tolerance” or their level of comfort with investment risk. That is, can you emotionally stomach the ups and downs of your investment portfolio? But there’s another way to think about risk.

What is risk capacity?

Risk capacity is how much risk you can afford. Will you still be able to meet your investment objectives if your investment portfolio falls in the short-term? In other words, how much can you afford to lose, and how long can you afford to wait for your investments to recover?

Over time, investments in stocks and other higher-risk instruments typically generate higher returns than lower-risk instruments, such as cash and bonds. Over short time horizons, however, they can be quite volatile. If you have a long time horizon, and can weather ups and downs without selling out of the markets, time generally works to your advantage.

The shorter your time horizon, the more important it becomes to consider your risk capacity. If you need money soon, your capacity to take risk for a portion of your portfolio is—and should be—lower than if you don’t. This is one of those critical concepts in investing.

How does risk capacity apply to your portfolio?

An often-used rule of thumb on what percentage of your investable assets to invest in a combination of riskier, growth-oriented assets (such as stocks) and more predictable, less growth-oriented assets (such as cash and high-quality bonds) is to take 100 minus your age and invest that number in stocks. Then, invest the rest in cash or bonds. But we believe that approach is too simple.

Instead, consider your needs over a short time horizon. If you’re nearing retirement, think about how much money you need in the next two to four years. Invest that conservatively. Then invest the rest based on your longer-term time horizon and risk tolerance. In other words, work backwards to build your allocation.

Here’s an example

Fred and Nancy, ages 65 and 63 are preparing for retirement. For simplicity, let’s assume that Fred and Nancy have $1,000,000 in investments for retirement. These investments are held in a combination of a brokerage account and a traditional IRA account.

Fred and Nancy would like to spend $50,000 per year from their investments. They expect to get $25,000 per year from Social Security and other income sources. That gives them a total desired “paycheck” of $75,000 annually in the first few years of retirement.

We suggest a roughly two-to-four year foundation of more stable investments—short-term bonds and cash investments—before taking more investment risk. For Fred and Nancy, a three-year projection of this need is $50,000 times three years, or $150,000 in cash investments and short-term bonds, using either a short-term bond fund or high-quality bonds or CDs with maturities from two to four years. That leaves $850,000 for other investments.

This portfolio contains roughly 60% in higher-risk investments—including a small allocation to high-yield bonds—and 40% in cash and short- and intermediate-term bonds. This is a sound place to start with their portfolio, built on Fred and Nancy’s short-term needs but also based on their long-term objectives to grow their portfolio to fund the later years of their retirement.

Although we use mutual funds in this example, you could easily use a portfolio of CDs or short-term bonds with maturities between two and four years to cover your short-term allocation. Some investors may also want to cover their cash-flow needs for four years and beyond using a portfolio of bonds with longer maturities.

As retirement progresses, Fred and Nancy may find their needs increase, and if they plan to spend what they saved, their time horizon shortens. When that starts to happen, it generally makes sense to decrease the allocation to stocks and increase it to cash investments and bonds. This allocation also happens to be about what we would suggest for the average investor at or near retirement.

Why should investors approaching retirement add a two – to four-year investment cushion?

We think having a financial cushion designed to last up to four years makes sense for most investors getting close to or living in retirement. Over the past 50 years, the average bear market for U.S. stocks lasted a little more than one year, and the time it took the S&P 500® Index to recover to prior highs was about three-and-a-half years.

Note that we are using the S&P 500 index. We would not recommend a portfolio based exclusively on this index. The time to recovery for assets held in a diversified portfolio would likely have been shorter—not considering withdrawals, if any, from the portfolio.

What to do now

If you want a more personalized approach to asset allocation, consider what you will need soon and your capacity. How much risk can you afford to take over two to four years—about the time to weather a bear market? Invest the rest based on other factors—such as your risk tolerance, need for cash flow from your portfolio after four years, and other objectives.

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About LRPC’s Monday Morning Minute

Lawton Retirement Plan Consultants, LLC (LRPC’s) Monday Morning Minute is crafted to provide decision-maker’s with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to retirement plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.

Additional Important Disclosures

Examples provided are for illustrative purposes only and do not constitute a recommendation by Schwab or a solicitation of an offer to buy or sell any securities. The information here is for general informational purposes only and should not be considered personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Investing involves risk, including loss of principal. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications, and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. The S&P 500 Index is an index of widely traded stocks. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.