Your risk tolerance will help to you maximize and protect your retirement savings when you make sound choices. As you save and near retirement, your risk tolerance should change, adapting to your financial and income needs. In order to manage your retirement planning effectively, you need to understand your risk tolerance, grasp your financial needs in retirement, and make effective decisions about your savings and asset allocation.
Overall, you should be ready for a “smooth” financial transition into retirement – when you stop earning a full-time salary or business income, and start drawing on the savings you accumulated over many years. Let’s go into more detail about risk tolerance and why it’s so important.
What is Risk Tolerance?
By definition, risk tolerance is the degree of volatility in financial returns that you are willing to endure. It is typically broken down into three distinct levels:
Aggressive
Moderate
Conservative
None of these levels is any better or worse than the others. Aggressive-minded retirement investors, or those with a high risk tolerance, are more willing to put money at risk in exchange for potentially more growth. Conservative-minded retirement savers, or those with a low risk tolerance, prefer options which will keep their principal, or initial retirement savings, intact. It’s not uncommon for someone’s risk tolerance to evolve as someone ages.
For example, younger savers may structure their retirement money with a more aggressive risk tolerance because they have more time to ride out the peaks and troughs of the market. In contrast, those who are nearing retirement age may move their assets to more conservative position. Their goal would be to protect the wealth they have built up over the years.
That being said, these are fairly broad stroke generalizations about saving for retirement. It’s important to note that many people prefer a more conservative approach to retirement planning overall. But everyone is different, so people need personal guidance when tending to their own retirement matters.
Why is Risk Tolerance Important in Retirement Planning?
Your risk tolerance helps to guide the decisions you and your financial professional make to manage your retirement money. Before you put money into an investment, or even an insurance vehicle like an annuity, you should work through a risk tolerance questionnaire.
This metric, along with others such as your goals, objectives, liquidity needs, time horizon, and overall financial picture, are what help financial professionals create personal recommendations for you as an investor.
As you decide on strategies for your retirement future, here are some important points to keep in mind.
First, no matter what your circumstance, you will want to maximize your savings, and your decisions should factor in this ultimate end-goal. Your choices should reflect what you are comfortable with, but also incorporate the broader picture. The best decisions should be based on the potential gains versus the potential risks, using math, statistics, and logic instead of emotions to guide your decision-making process.
This is important because retirement is lasting longer due to longer life expectancies. A generation ago, when a person retired at the age of 65, he or she would need to plan for a 10-15-year retirement. Today, it’s entirely possible that you might live into your 90s, which means that you need to prepare for a 30-40-year retirement span.
This post on planning for longevity in retirement will help to show how you can prepare for the long term.
Beyond Risk Tolerance: Other Important Factors
Inflation is another factor to consider when retirement planning. While the average rate of inflation is 3% annually over 25 years, this adds up considerably and actually doubles the cost of living over this time span.
Part of the risk of the longer lifespans that we are experiencing is the need for long-term medical care and increased medical and health costs overall. Living in a nursing home can cost as much as $80,000 per year, which can absorb a significant chunk of your retirement savings. Many families rely on Medicaid to help cover these costs for their aging family members. Contrary to popular belief, Medicaid supports more that low-income Americans.
In fact, Medicaid is an important part of financial planning for older Americans from other income brackets, especially middle-class individuals. There are proposals to reduce the funding for Medicaid (as well as Medicare and Social Security) that will have a significant effect on the retired population. As a result, it’s important to ensure that you will have sufficient money to cover these likely-to-be-costly medical and personal care expenses.
So, How to Determine Your Risk Appetite and Plan Accordingly for Retirement?
When you work with your financial professional you will answer questions from time to time that will help to identify your appetite for risk. As mentioned earlier, this is usually in the form a questionnaire. While these questionnaires aren’t foolproof, the results can guide further conversations and decisions on strategies to manage your retirement savings.
You will want to consider maximizing gains as well as protecting yourself against losses. One of the downsides of many risk tolerance questionnaires is that they often focus heavily on losses – they may lead to overtly conservative choices, as a result.
We support conservative retirement saving and income strategies but also advocate for ensuring you have sufficient money – or more than sufficient! – for your entire retirement.
Final Thoughts about Risk Tolerance
Whatever your risk tolerance, you should be prepared to have frank conversations with your spouse and financial planner.
Your discussions should cover what your expectations for retirement include, how much money you need to save to enjoy the life you want, and how to best save for retirement in a manner with which you are confident and comfortable.