CPD: A new approach to assessing risks in retirement

How to understand alternative ways to assess client risk tolerance in retirement.

In our last article, we examined the common risks that can impact retirement. The financial risks we’re all acutely aware of: longevity risk, inflation risk, market risk and sequencing risk. Any and each of these risks can exacerbate other risks and derail retirement. There are of course the behavioural risks that can intersect with financial risks and often lead to poor decision making.

The objectives and strategies applicable to the accumulation phase of retirement savings are different to those applicable to the drawdown – or decumulation – phase. Similarly, the risks faced during decumulation are significantly different, and simply applying a more conservative investment approach is likely to lead to sub-optimal outcomes for the individual

Decumulation is not accumulation in reverse

While the miracle of compounding is arguably the main driver of retirement savings outcomes over a client’s working life, decumulation brings forward several forces that can significantly interrupt this compounding. These forces are significant risks to be managed, and include:

• Dollar-cost averaging is no longer an opportunity, it’s a threat
  Regularly selling assets to deliver consistent income flows will mean some assets will be sold when the market is down, leaving the investor to either sell more assets, or have a lower income to live on.
• Liquidity considerations are elevated
  A portfolio designed to deliver a sustained income over decades will likely need to balance the higher earnings potential of more illiquid assets with the liquidity required for planned and unplanned drawdowns.
• The stakes are higher
  This is particularly pertinent in the early stages of decumulation, when the savings pool is at its peak.
• Fewer opportunities for recovery
  This is especially pertinent for those who retired several years ago, and for whom returning to the workforce is more difficult.
• Behavioural risks intersect with market risks
  Volatile markets can increase the chance of an individual crystallising losses during market dips.

Other ways to consider risk in retirement

To the extent that decumulation brings forth a unique set of risks not relevant to accumulators, the assessment of these risks requires a different approach. There are several reasons why the techniques used to assess risk for clients in the accumulation phase are inappropriate for decumulation scenarios:

1. They often concentrate more on attitude to risk more than the capacity to tolerate risk.
2. Many questions don’t make sense in a decumulation scenario; they are typically focused on reaction to portfolio losses rather than the changes in the size and stability of income flows.
3. Risk profiling in the accumulation phase helps to decide how aggressively a client can be invested in equities. It does not help to differentiate between appropriate strategies and products for retirement.
4. Investors in the accumulation phase generally pay less regular attention to their portfolio, a separation between an investor and their portfolio that no longer exists in decumulation. Those investments are now being scrutinised and accessed more regularly; therefore behavioural risks are therefore higher.
5. Risk assessments often take place infrequently, meaning they don’t reflect the dynamic nature of risk and the changing attitudes (and needs) of your clients in different stages of retirement.

Risk tolerance v risk capacity

In most instances, risk capacity – the financial ability to absorb losses – is the chief determinant of the suitable level of risk for an investor to take. However, the experience around the world – likely to be replicated in Australia – is that many risk assessment processes conflate risk tolerance (the psychological attitude to risk) with risk capacity, despite the fact they should be assessed separately.

In the UK for example, a recent study by the financial regulator (FCA) found only 30 percent of advice firms were using separate processes for assessing the two^[1].

Further problems can occur with risk capacity assessments that are subjective guesses, or which focus on pots of money – each with their own arbitrary goal – and fail to reflect how an investor’s goals interact with each other over time.

Poor – or absent – risk capacity assessments can lead to an investment approach that is either too aggressive, increasing the risk of knee jerk investor behaviour, or too conservative, threatening the sustainability of income flows.

Inappropriate questions

Accumulation strategies are generally singular in their focus: to maximise the total investment returns achieved to grow each client’s retirement portfolio as much as possible.

Investors are generally advised to invest as aggressively as possible to earn the greatest risk premium from the stock market over the long-term, subject to their comfort with short-term market fluctuations. With the passage of time, market volatility will often balance out into a greater growth rate over time.

Traditional risk tolerance questionnaires have therefore been designed to help advisers identify the amount of volatility their clients can stomach within their investment portfolios – which is likely to be quite different to their attitude to income stability or certainty in retirement.

Whereas for accumulators, questions about whether risk is something to be feared, or an opportunity for upside, are likely to be relevant. For decumulators, questions designed to measure sensitivity to loss will make far more sense.

The same FCA study referred to previously found that 77 percent of advisory firms in the United Kingdom used the exact same process and questions for assessing the risk attitudes of both accumulators and decumulators.

Risk profiling doesn’t help to determine strategy

Traditional risk profiling outputs are designed to help advisers match the allocation between growth and defensive assets to a client’s individual risk tolerance. And, notwithstanding the growth of alternative investments, growth assets are largely seen to be direct equities, or equity-based products such as managed funds, exchange traded funds or separately managed accounts.

The sequence is usually to (1) determine the appropriate asset allocation and (2) decide on the right products to meet the client’s objectives.

For those clients in decumulation mode however, there are so many different product solutions – catering for different client needs for flexibility and certainty – that the sequence needs to be reversed. The choice of strategy – which should include the use of different types of annuities and new innovative income stream products – should be made before any asset allocation decisions.

A suitable risk profiling approach in decumulation should therefore help shed light on the appropriate strategy and product selection.

Lack of separation understates behavioural risks

Accumulators are generally making long-term investment decisions about assets they don’t intend to access for some time. As such, there is a degree of psychological separation from these funds that likely manifests as a higher risk tolerance. This is especially true of superannuation funds, which are inaccessible until age 60, and therefore for many investors don’t feel ‘real’.

In decumulation however, individuals become more engaged with their savings. They need to access them and make decisions about their savings on a far more frequent basis. Increased loss aversion is natural for retirees, but often one’s true attitude to losses isn’t known until a loss is experienced.

Risk profiling processes geared around accumulation may therefore underestimate an individual’s true aversion to loss. In turn, this can lead to increased risk of value destructive behaviour.

Risk is dynamic, not ‘set and forget’

Attitudes to, and capacity for, risk is dynamic. Attitudes and capacity typically evolve over time in response to changes in a client’s circumstances and goals. Changes in income, employment status, health, relationships and living arrangements can all impact a person’s capacity and willingness to take on investment risk.

Any reliance on an initial risk profiling process to remain accurate throughout a client’s life is, therefore, highly misplaced.

A best practice approach to measuring attitude to risk in decumulation

There is much scope for an improved approach to retirement income strategies in Australia (a fact called out by ASIC and APRA in their 2022 Retirement Income Covenant Review). A valuable starting point is to look to the experiences of other similar developed markets, namely the United Kingdom and United States.

Gauging the need for certainty

Internationally recognised US retirement planning academic Professor Wade Pfau is one of many experts who believe a new approach is needed to:

1. Assess retiree attitudes to risk
2. Develop retirement income strategies aligned to those risks

His latest work in this area is the Retirement Income Styles Awareness (RISA) Profile^[2]. The RISA profiling tool was developed after years of research by Pfau and colleagues, which identified retiree attitudes towards funding essential living expenses as one of the key determinants of their retirement income ‘style’.

The tool maps retirees along two dimensions:

1. Safety first versus probability
2. Optionality versus commitment

A client who nominates safety first retirement income sources will typically look to incorporate defensive and protected capital solutions to better secure their retirement savings. The income provided by these sources is less exposed to market swings or comes with some degree of capital protection. Although no strategy is entirely safe, a focus on defensive and capital protected strategies implies a relative degree of safety compared to the less certain market outcomes of probability-based income sources. A safety-first approach will generally forgo any upside potential of probability-based income sources for the relative assuredness of a contractual guarantee.

Where a client indicates a preference for a probability income style, it specifies a willingness to gravitate toward retirement income sources dependent on the potential for market growth to provide an ongoing retirement income stream. These include traditional diversified investment portfolios and other growth assets. They are predicated on the idea that while market growth is not guaranteed, markets have grown over time and the probabilities for cumulative growth tend to rise as the time horizon increases. While market returns are not guaranteed, some retirees are comfortable taking the probability bet.

Optionality reflects a client’s preference for keeping their options open and remaining flexible so they can respond to changes in the economic landscape or their personal circumstances. This preference aligns with retirement income solutions that are easily adjusted and do not have predetermined holding periods.

On the other hand, commitment reflects a preference for committing to one solution. In this scenario, your client would not feel the need to keep their options open. Instead, they are willing to select a particular retirement income solution to meet their needs. Clients who prefer commitment often get satisfaction from advance planning.

Mapping individuals along these dimensions allows them to be aligned with one of four retirement income strategies.

Questions to determine retirement income ‘styles’

The first question aims to gauge a client’s views on how they expect to fund their retirement income.

An example of a question to assess this dimension is:

Which of these two statements most closely reflects your views on retirement income planning?

“I see my investment portfolio as funding the majority of my retirement expenses.”

or

“I see my essential retirement expenses funded, to the extent possible, from protected income sources, with the rest of my expenses funded by my investment portfolio.”

A second question then seeks to gauge a client’s preference for a flexible approach, versus the certainty that comes from committing to a particular strategy throughout retirement.

An example of a question for this dimension:

How much do you agree with the following statement?

“I prefer more flexible retirement income strategies to accommodate my changing preferences as I age.”

The responses to these and other questions in the RISA profiling tool allows individuals to be mapped to one of four retirement income strategy quadrants. The strategies underpinning these quadrants are similar in nature to those used by Australian advisers, albeit with different labels (figure one). This will be discussed in more detail in a future article.

Other questions to gauge attitudes to income risk

The previously mentioned FCA review of retirement income advice in the UK spurred a flurry of work and commentary around income risk, and its foundational importance in developing retirement income strategies aligned to individual needs and attitudes.

Commentary also focused on the development of questions more suitable for assessing attitudes to income risk, rather than investment risk. Even subtle changes to the questions used in accumulation can make a significant difference.

For example, in accumulation, it may be appropriate to ask a client whether they are willing to take more risk in the hope of higher returns. In decumulation, it might be more relevant for the client to consider whether they value a stable lower income or would rather take more risk in exchange for the potential for higher, but also more variable, perhaps ultimately lower, income.

Similarly, in accumulation, it makes sense to ask whether a client seeks risk as something to be feared, or an opportunity for upside. In decumulation, it is more appropriate to measure sensitivity to loss.

It may also be appropriate to tweak the client fact find used with pre-retirees, or at the very least look at the outcomes through a different lens.

Questions to gauge attitudes to income risk could include:

• What are your daily living expenses?
• Do you have a cash buffer to cover unexpected expenses?
• Do you have dependents that rely on you for money?
• Are your income requirements likely to change in the future?
• Have you considered how you would fund aged care?
• Do you have any large expenses planned?
• Are you expecting to receive an inheritance?

Use of cash flow modelling for risk capacity assessment

In Australia, cash flow modelling is typically thought of as a form of advice – typically used with younger clients – rather a risk modelling tool. But in the UK, cash flow modelling is seen as a primary tool for assessing capacity for risk.

Experts agree a diligent and comprehensive cash flow model is the most accurate way to assess risk capacity, with the ability to model the income effect of different degrees of investment loss central to this calculation.

As part of its thematic review of retirement advice, the Financial Conduct Authority recently published guidance on improving the quality of cash flow modelling for retiree and pre-retiree clients. Areas they highlighted for improvement included verifying the accuracy of client-provided data and using realistic return assumptions^[3].

Another problem identified in the FCA review was the common use of ‘average’ life expectancy (rather than adjusted), and the failure to stress test different outcomes in line with different investment return scenarios.

As the importance of the retirement income sector grows, the use of cash flow modelling for retirees and pre-retirees is likely to become more common.

Retirement throws up many psychological challenges, and unsurprisingly, many advisers working with retirees find their role in providing emotional support and nonfinancial guidance is just as important as the financial advice they give.

The loss of income, social contact, and routine can prove daunting for many, especially those whose retirement was unplanned (perhaps due to redundancy or ill health).

People who have long, successful, enjoyable careers may suddenly find they lack focus, or even purpose, and may have diminished self-worth. Boredom can easily creep in, and mental health can suffer. A perceived loss of financial independence and fear of being a burden on others can also loom large.

Effectively managing financial risks and ensuring a clear understanding of your clients’ risk capacity and desire for both flexibility and certainty are essential components of successful retirement planning. When these factors are well understood by all parties, the likelihood of achieving a comfortable and secure retirement is significantly increased. Prioritising these factors can provide greater peace of mind and financial stability as clients approach their retirement years.

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References:
[1] Assessing customer risk profiles at retirement requires a dedicated tool
[2] Why Risk Tolerance Questionnaires Don’t Work for Determining Retirement Strategies
[3]  Undertaking cashflow modelling to demonstrate suitability of retirement-related advice

This material is issued by Allianz Australia Life Insurance Limited, ABN 27 076 033 782, AFSL 296559 (Allianz Retire+). Allianz Retire+ is a registered business name of Allianz Australia Life Insurance Limited. This information is current as at April 2025 unless otherwise specified and is for general information purposes only. It is not comprehensive or intended to give financial product advice. Any advice provided in this material does not take into account your objectives, financial situation or needs. Before acting on anything contained in this material, you should speak to your financial adviser and consider the appropriateness of the information received, having regard to your objectives, financial situation and needs. No person should rely on the content of this material or act on the basis of anything stated in this material. Allianz Retire+ and its related entities, agents or employees do not accept any liability for any loss arising whether directly or indirectly from any use of this material.