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Written By: Steven Gordon

Most, if not all, people want a high return on their investments. The question is, “How much risk should they take? How much risk are they willing to take?” A good starting place to determine the appropriate amount of risk for your portfolio is to examine your level of risk aversion with a risk tolerance survey and to know your financial goals.

 

The two major risks that investors face are 1) a decline in their portfolio value; and 2) not achieving their financial goals.

 

The first type is called Market risk, caused by movements in the market that adversely affects your portfolio. You can mitigate Market risk by shifting from stocks to bonds. However, the reduction of Market risk may increase the second type of risk called Longevity risk, or the risk that you will outlive your retirement money.

 

Longevity risk is determined by a number of factors (using financial calculators):

1) Value of your current portfolio

2) Planned savings rate

3) Planned retirement age

4) Planned retirement income

5) Composition of portfolio

 

Based on this information, a computer model estimates the future risks and returns on your assets and overall portfolio to show how much money you’ll have at each age.

 

In retirement, people generally switch from asset accumulation to asset withdrawal. Reducing Longevity risk often means a reallocation of assets to compensate for future withdrawals, estimating emergency money, and predicting asset growth.

 

To calculate the amount of retirement income needed, estimate your living expenses in retirement. Then determine how much pre-tax income is required to pay for those expenses. Once you have your pre-tax income figured out, estimate the amount of emergency money you’ll need. The recommended sum is one enough to cover your cost of living for six months.

 

The next step is to look at asset growth, which is important for protection against inflation and withdrawals. For example, after twenty years with an annual 3% inflation, you will need $72,250 to purchase the same amount of goods for $40,000 today. If your assets grow slower than the rate of inflation, then your portfolio life will be shortened or you’ll need to cut back on spending (and decrease your standard of living).

 

Asset growth also protects against the consequences of longer life expectancy. With people’s lifespan rising, so do their risk of outliving their retirement income. A reallocation of their portfolio that takes the above retirement factors into consideration is one way to mitigate the financial risks.

 

Another source of retirement income protection is longevity insurance. You start investing now with an agreement that at certain age later, you receive monthly payouts for the rest of your life. Longevity insurance offers higher returns than most traditional pension plans, as well as inflation protection and death benefits for inheritance options.

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