How to think about guaranteed income even if you are not concerned about running out of money.
Saving for Retirement – and Then Some
We spend a lot of time talking about (and to) retirees who are worried about running out of money in retirement, but that is not always the primary concern. In this post I will consider an “over-funded” retiree or investor.
Technically, there is no formal definition of “over-funded”, but in general it refers to someone who realistically does not have to worry about running out of money during retirement. This is usually due to an extremely large portfolio and net worth, but is also a question of personality and habits. This retiree should, in theory, be able to live comfortably in retirement without worrying about money or their withdrawal rate, barring any once-in-a-lifetime, life-changing event (for example, a sustained market drop beyond what we have seen throughout history coupled with continued excessively-high spending). Something extreme might risk this retirees net worth, but it is very unlikely.
The specific amount needed to reach over-funding can differ from one person to another. For one retiree who is committed to living a modest lifestyle in retirement with no debt, a few million dollars may be enough to consider them over-funded. For another retiree who wants to live a much more lavish lifestyle, it will likely require much more to consider them over-funded. Therefore to consider someone over-funded you really have to take their personal goals into consideration with their net worth.
Retirees with no guaranteed income (e.g. annuities, insurance) and no income floor (e.g. healthy pension, fixed index annuities) will generally fall into two camps. The first is the retiree with enough money and confidence in the future that they are comfortable taking on risk and keeping everything in investments. This type of retiree generally will not change their lifestyle or large purchases even during large market downturns. The second type of retiree is one that might be nervous about market fluctuations and might second guess a large expenditure when it comes time to withdraw from the portfolio.
Risk Capacity vs. Risk Tolerance
Even with similar levels of funding and spending levels (risk capacity), the two camps or retirees have differing risk tolerance. Risk capacity asks whether or not you can afford to take on a certain amount of risk – this is a mostly quantitative question, it can be calculated. In other words, the more investments you have and the more diversified your net worth is, the higher your risk capacity should be. Conversely, if you have limited retirement investments and income sources, you do not have the financial means to take on too much risk when it comes to investing or spending.
Risk tolerance asks whether or not you feel comfortable taking on that amount of risk – this is a qualitative question, it is up to the individual. So we may have two clients who technically should have high risk capacity, but they differ in their risk tolerance, their willingness to take on risk.
It is important to mention that these factors are not static throughout your lifetime as an investor. When a person is young, that is usually when they have the most human capital expected throughout their lifetime, and thus risk capacity is fairly high. Since the time of retirement and relying on withdrawals rather than earnings is far away when you are young and first begin your career, usually these investors have high risk tolerance and invest mainly in equities, which are more volatile than other options.
Risk capacity tends to affect risk tolerance, but it does not control it. As you get older and closer to retirement your human capital tends to wane, but your net worth may have grown substantially. Over-funding retirement years keeps your risk capacity high. However, knowing retirement is so close you might now feel differently about your risk tolerance. At this older age you might become more nervous when you see your portfolio balance fall, knowing there is less time for it to rebound. This is your risk tolerance changing as you age.
Taking Risk Tolerance into Account
If you are a retiree who is over-funded and noticing your risk tolerance is becoming lower, you might benefit from investing in insurance products or building an income floor to guarantee a certain amount of income regardless of market conditions. Guaranteeing a good bit of income can also allow you as a retiree to actually take on more investment risk inside your portfolio if you so choose. There are a number of ways to do this, such as annuities, other insurance products, or bonds, depending on your personal goals and comfort level.
Even if you have a high risk tolerance and are over-funded there are still reasons you might want to consider insurance products or some type of income floor. Here are three scenarios to consider, among many others:
- Use it to secure a legacy for your heirs while enjoying guilt-free spending during the course of your retirement.
- Increase your withdrawal rate to spend on things that felt out of reach.
- If there is an age difference between you and your spouse, help guarantee a lifestyle for your spouse after you pass.
The bottom line is that you should consider insurance products or building some type of income floor, and not just once! We know risk tolerance changes as the average investor ages, usually decreasing substantially during retirement. If you had no interest in an income floor at 55, you might at 65 or even at 70. Check in with yourself and your advisor if your priorities have changed.
Anessa Custovic, PhD
