BNY Mellon Investment Management head of retirement Richard Parkin explains why it is important to recognise that retirement clients might have limited resilience when creating an investment strategy.
Nobody wants to see the value of their retirement savings fall, no matter where they are in their investment journey. But the impact of losses for someone in retirement can be more acute than for someone still working.
Those still working and earning money have more opportunities to address a drop in their portfolio – including saving more or working longer. But if a retired investor’s portfolio heads south, there are fewer levers to pull. Put simply, a person’s financial resilience reduces when they retire.
Financial capital v human capital
Consider the difference between an individual’s ‘financial capital’ and their ‘human capital’. Financial capital refers to monetary and physical assets like savings, pensions, property, and investments. Human capital can be thought of as a stream of future income to be realised over time. It is built up through the acquisition of skills and abilities, which add to productivity, and pay off later in life. Combining these two metrics gives an individual’s overall wealth.
A young person is more likely to have low financial capital, but high human capital. This is because they have many years still to gain skills and experience, and to work, earn money and ultimately build savings – including their pension pot.
An older individual, on the other hand, is likely to have high financial capital but less human capital – they are no longer earning an income and have more obligations to meet that deplete their savings.
Source: BNY Mellon Investment Management. For illustrative purposes only.
Assessing risk
It is important to consider this when assessing the appropriate level of investment risk to take in retirement. Individuals undertaking risk assessment have three factors to consider:
- Risk tolerance – How comfortable is the investor with risk (and the potential impact on returns) in the long term?
- Knowledge and experience – How informed is the investor to make decisions that include risk?
- Risk capacity – Considering cashflows, financial circumstances, goals/objectives, and time horizons, how resilient is the investor to risk?
Generally, risk tolerance stays stable for most of an individual’s life. However, if for example, an individual switches jobs, gets a raise, or inherits money or assets – their financial circumstances change. This can alter an individual’s risk capacity.
As such, basing the level of investment risk purely on someone’s risk tolerance may not be the right answer.
A 20-year-old who is inherently risk averse has a low risk tolerance but the value of their human capital gives them a high risk capacity. They may prefer a cautious portfolio but with many years to accumulate wealth and overcome any setbacks, they can afford to take more risk. Conversely, someone in retirement may still be willing to take some risk but if they have limited assets relative to their income needs, they have a low risk capacity. The consequence of this is that they are less able to deal with losses and need to invest accordingly.
Another way of saying this is that generally younger investors should be more focused on making gains than avoiding losses whereas those in retirement may need to concentrate more on avoiding losses rather than making significant gains.
