Why Risk Tolerance Questionnaires Don’t Work for Determining Retirement Strategies

Can’t get there from here.

Using a risk tolerance questionnaire (RTQ) to establish a retirement income strategy is akin to your doctor checking your pulse to measure your cholesterol. There is nothing wrong with checking your pulse, but it is an inappropriate test for the situation. We propose an alternative test – the RISA – to select the best deaccumulation approach.

During your accumulation years, you work and use the proceeds to fund essential living needs, emergencies, financial milestones, and hopefully save and invest a portion for retirement. Through it all, your human capital is how you pay the bills and “invest for the long term.” These savings enjoy a long-term horizon meant to cover retirement. Though there will be expenses that will need to be funded, thinking in terms of the assets-only wealth accumulation process offered by modern portfolio theory (MPT) is a reasonable approximation.

Investors are generally told 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 stomaching short-term market fluctuations that will hopefully balance out into a greater growth rate over time. RTQs have emerged as a tool to help advisors identify the amount of volatility their clients can stomach with their investment portfolios.

During accumulation, RTQs can serve as a helpful tool for advisors. They fit well with an assets under management (AUM) revenue model that offers a set of model portfolios designed with different risk levels. An RTQ also provides documentation for compliance about why a particular portfolio recommendation has been made.

While we applaud the many new developments that incorporate risk tolerance, capacity, and composure into RTQs, it is unclear how well they measure risk tolerance, how stable risk tolerance is during different market environments, and so forth. This article is not about these issues. Rather, we identify a significant shortcoming with RTQs, as well as a solution, when it comes to the question of retirement.