In this video Matt Stevenson provides a nuanced approach to retirement planning, emphasizing the importance of understanding both ‘risk tolerance’ and ‘risk capacity.’ While risk tolerance is a subjective measure based on individual comfort levels with market volatility, risk capacity is a more mathematical evaluation of how much risk one can afford to take without compromising their future lifestyle.
Through a detailed example of a fictional couple, the host illustrates how even those who seem well-prepared for retirement can risk falling short of their income goals if they don’t carefully consider the potential impact of market downturns. Stevenson suggests that calculating one’s risk capacity, instead of solely focusing on risk tolerance, is crucial for financial stability in retirement.
How Much Risk can You Afford to Take with Your Retirement Plan
Understanding the Difference Between Risk Tolerance and Risk Capacity
Retirement planning can be a complex and daunting task, and one of the critical questions that often arises is, “How much risk can I actually afford to take with my retirement plan while maintaining my desired lifestyle for the years to come?” To answer this question effectively, it’s essential to differentiate between two key concepts: risk tolerance and risk capacity.
Risk Tolerance: The Subjective Comfort Zone
Risk tolerance refers to your comfort level with investing. It’s a subjective measure that depends on your individual preferences, attitudes, and emotions towards financial risk. Some individuals are naturally inclined to take more risks in their investment choices, while others prefer a conservative approach. This aspect of risk is fluid and can change over time, influenced by market conditions and personal circumstances.
Over the last few years, we’ve witnessed significant market fluctuations, from robust bull markets to periods of market volatility. These fluctuations have often led to rapid shifts in investors’ psychological mindsets. When emotions drive investment decisions in retirement, there’s a risk of derailing carefully crafted retirement plans and potentially compromising your future lifestyle.
Risk Capacity: A Mathematical Approach to Risk Assessment
To make informed decisions about your retirement plan, you should also consider risk capacity, a more mathematical approach to understanding the level of risk you can afford to take. Risk capacity is determined by assessing your financial assets and evaluating how much risk you can endure without jeopardizing your lifestyle over the next few decades. Let’s explore this concept through an example.
Bob and Nancy: A Retirement Planning Scenario
Imagine Bob and Nancy, both aged 63, with retirement on the horizon at age 65. They are fortunate enough to have a combined Social Security benefit of approximately $80,000 annually, serving as a solid foundation for their retirement income. Their diligent savings habits have accumulated around $3 million in various retirement assets, including 401(k) plans, IRAs, and after-tax savings in a brokerage account.
Bob and Nancy decide to withdraw 5% of their retirement savings annually, which amounts to $150,000 per year. When added to their Social Security benefits, they achieve a pre-tax income of $230,000. To account for taxes, let’s assume an effective tax rate of 25%, resulting in an after-tax income of $172,500. This income surpasses their initial goal of $150,000 per year, indicating that they are on track for a comfortable retirement.
The Hidden Risk: Market Volatility
While Bob and Nancy may seem to have a solid retirement plan, there’s an underlying risk factor they need to address – market volatility. Their investment portfolio, which has historically experienced 40% declines on several occasions over the past few decades, poses a potential threat.
In a hypothetical scenario where their $3 million portfolio experiences a 40% drawdown, they would be left with $1.8 million. This represents a substantial loss of $1.2 million during a market downturn. Such a significant decrease in their nest egg could have severe repercussions for their retirement lifestyle.
With a 5% withdrawal rate on their reduced savings of $1.8 million, Bob and Nancy would have an annual income of only $90,000. When combined with their $80,000 in Social Security benefits, this results in a pre-tax income of $170,000. After taxes, they would have approximately $127,500 to spend each year, falling short of their income goal by over $20,000.
Determining Your Risk Capacity
To mitigate the risk of a shortfall in retirement, it’s essential to assess your risk capacity accurately. Bob and Nancy’s scenario highlights the significance of this assessment. By adjusting their risk capacity equation, they can make strategic decisions to safeguard their retirement lifestyle.
In this example, a 20% drawdown instead of the previous 40% significantly improves their situation. With $2.4 million remaining, a 5% withdrawal rate yields $120,000 annually. Together with their $80,000 in Social Security benefits, they achieve a pre-tax income of $200,000. After accounting for taxes, they have approximately $150,000 in annual spending capacity, aligning with their retirement income goal.
Key Takeaways
- When planning for retirement, it’s crucial to understand the distinction between risk tolerance and risk capacity.
- Risk tolerance is subjective and influenced by emotions and market conditions.
- Risk capacity is a mathematical assessment of how much risk you can afford based on your financial assets.
- Market volatility can significantly impact your retirement plan and necessitates careful risk assessment.
- Evaluating your risk capacity helps you make informed adjustments to maintain your desired lifestyle in retirement.
In conclusion, building a robust retirement plan involves more than just accumulating savings. It requires a deep understanding of your risk capacity and how market volatility can affect your financial future. By taking a proactive approach to assess and manage risk, you can work toward securing the retirement you’ve envisioned. Remember, retirement is about income, not just a sum of money saved, and careful planning is the key to ensuring a comfortable and financially secure retirement.
Also read: How To Manage Your 401k
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