The Education of an RMA Michael Lonier, RMA FINDING THE RISK CAPACITY BEYOND RISK TOLERANCE

Transcription

1 The Education of an RMA Michael Lonier, RMA FINDING THE RISK CAPACITY BEYOND RISK TOLERANCE

2 RMA Students Come to Class Grounded in Risk Tolerance Coming into the class, most students use risk tolerance questionnaires (RTQs) to understand their clients preferences and to build portfolio allocations Their compliance dept. usually requires it as part of their suitability workflow The advisors also note that the RTQ results give them useful input about their clients intent and approach to investing

3 RTQs Are Part of Long Accepted Practice, Reinforced by Compliance Students do not easily or quickly move away from this default Even to the end of the course, risk tolerance is often conflated with risk capacity in student discussions Risk tolerance appears to have high credibility with advisors as a yardstick for asset allocation and understanding client attitudes about risk

4 Four Methods for Generating Retirement Income From Savings 1. Total Return Systematic Withdrawal Based on risk tolerance (RTQs), time horizon, or both 2. Income Investing Live off income from interest and dividends 3. Guaranteed Lifetime Income Simple immediate and deferred income annuities 4. Asset/Liability Matching A structured portfolio to cover Floor and invest Upside based on the Household Balance Sheet View

5 Incoming RMA Students Typically Use Total Return SWPs and/or Lifetime Income Total return portfolios are relatively easy to deploy and manage across large teams of advisors Annuity use depends on whether the advisor or someone in the firm is licensed as an insurance producer Income investing is more common with DIY investors Less so with professionals not part of MPT though advisors will add dividend stocks or funds to portfolios Asset/Liability matching is more uncommon Planning and administration is more complex than Total Return

6 1. Total Return Allocations Based on Risk Tolerance Risk Tolerance results from RTQs are used to set the portfolio allocation Not mathematical or scientific based on emotions, feelings about risk, subject to current influences, headlines The relationship between a risk tolerance rating and a stock allocation is arbitrary Wealthfront.com is a robo-advisor that uses MPT, the efficient frontier, and an RTQ to set a client s portfolio allocation

7 1. Total Return Risk Tolerance and Risk Aversion Not the same thing can be as difficult for students as the difference between risk tolerance and risk capacity In economics, risk aversion is the degree of preference for a lower certain return vs. a higher uncertain return Characterized as constant or decreasing/increasing absolute or relative risk aversion RTQs attempt to boil down the complexities of risk aversion into a simple formula for portfolio allocation Ignores the value of understanding the client s risk aversion tendency which can shape their spending (utility) curve in retirement

8 1. Total Return Allocations Based on Time Horizon Higher allocation to risk (stocks) for longer time horizons More time to recover from a loss, though a large loss could occur at any time on the horizon Glide paths mitigate risk of loss as the horizon nears One-size TDFs and age-in-bonds formulas do not fit all! A long retirement horizon does not fit this approach 30 year accumulation period is different than 30 year retirement income period, in which large losses may impair income Betterment.com is a robo that uses a time horizon and goalsbased planning (buckets) to set the asset allocation

9 2. Income Investing Allocations Based on Cash Flow from Interest and Dividends Spend the interest and dividends paid by the portfolio each year, leaving principal untouched Appeals to naïve investors Really just a sub-optimal version of systematic withdrawal from a total return portfolio exposed to additional specific risk Allocation usually driven by amount of income required May fully allocate portfolio to income payers to reach income goal value stocks, REITs, MLPs, preferreds, junk bonds High allocation to risky income payers means higher risk of loss during downturns when dividends are cut, without Floor or Reserves to pick up the pieces

10 3. Guaranteed Lifetime Income Allocations Those with disciplined lifetime income approaches target the floor of fixed/essential expenses for annuitization The balance is generally invested in a total return portfolio for discretionary expenses using systematic withdrawal May be coupled with life insurance for additional survivor protection Generally based on annual income/expense cash flow, not on balance sheet liability matching

11 4. Asset/Liability Matching Allocation Based on Household Balance Sheet Risk Capacity Floor allocation = PV of liabilities PV of (SC + HC + PV other income) Upside allocation = FC (Floor + Longevity + Reserves) Upside is the risk capacity discovered on the balance sheet The Retirement Policy Allocation is based on the math found on the client s household balance sheet Not on fickle risk tolerance, arbitrary allocation formulas linked to RTQs, or one-size fits all time horizons glide paths Glide Path based on funded-ness, not time horizon

12 The Key Lesson of the RMA Course The household balance sheet provides the basis for a complete, structured portfolio that manages retirement risk using the four major risk management methods Four distinct sub-portfolios: 1. Upside portfolio to retain market risk while diversifying away business risk 2. Floor portfolio to hedge credit risk with risk-free and insured assets 3. Longevity portfolio to pool longevity risk with longevity insurance using DIAs/QLACs 4. Reserves portfolio to avoid market risk with a cash cushion

13 One Last Idea Students Learn to Overcome Risk capacity is not the amount of risk the client needs to take to reach their goals The Floor covers the amount the client needs from savings to pay for their lifestyle, or at minimum, their fixed expenses Risk capacity is the cushion on their balance sheet beyond the Floor, Longevity, and Reserves allocations that can be exposed to market risk for long-term growth without jeopardizing lifestyle Supports discretionary spending and legacy goals Risk capacity = Upside With an RPS, the client does not take risks the client manages risks

14 Imagine If Your Doctor Used a RTQ-like Tool to Setup Your Treatment Plan You d answer this and maybe 10 or 12 similar questions: 1. When it comes to my health, I would describe myself as someone who is both knowledgeable about proper diets and eats well at every meal. a) I strongly disagree b) I disagree c) I somewhat agree d) I agree e) I strongly agree

15 Yes, A Medical History is Part of Any Doctor s Workup But by itself, it s not enough, it s an incomplete diagnosis You wouldn t settle for a treatment plan based on such incomplete information Why would anyone settle for such an incomplete plan for the disposition of his or her life s savings?

16 The RMA s Path from Risk Tolerance to Risk Capacity Runs from client funded-ness through the household balance sheet to the Retirement Policy Statement During the course the RMA student is asked to revise his understanding of risk tolerance and to begin using the balance sheet and risk capacity to allocate risk in the retirement plan This should lead to a fuller understanding of the client s risk exposures and a more complete plan in which the client s best interests are foremost

17 An Possible Exercise to Gauge Progress in the RMA Course At the beginning of the course, each RMA student would take a typical RTQ, like the Vanguard or BlackRock form And submit the asset allocation they think they should follow based on the quiz and their supporting logic At the end of the course, the students would be asked to revisit their initial allocation and the supporting logic How might their allocation and supporting logic change? What might the student learn from the exercise?

18 Michael Lonier, RMA The Retirement Preserve at Lonier Financial Advisory LLC Osprey, FL