Risk Management and Your Retirement Savings Plan
By Laurie Haelen
By investing through your employer-sponsored retirement plan while you are working, you are helping to manage a critically important financial risk: the chance that you will outlive your money.
But choosing to participate is just one step in your financial risk management strategy — you also need to manage risk within your accounts to help them stay on track.
All investments, even the most conservative, come with different types of risk. Understanding the various risks can help you make educated choices in your retirement savings plan mix.
• Market risk: The risk that your investment could lose value due to falling prices caused by outside forces, such as economic factors or political and national events (e.g., elections or natural disasters). Stocks are typically most susceptible to market risk, although bonds and other investments can be affected as well.
• Interest rate risk: The risk that an investment’s value will fall due to rising interest rates. This type of risk is most associated with bonds, as bond prices typically fall when interest rates rise and vice versa. But often stocks also react to changing interest rates.
• Inflation risk: The chance that your investments will not keep pace with inflation or the rising cost of living. Investing too conservatively may put your investment dollars at risk of losing their purchasing power.
• Liquidity risk: This is the risk of not being able to quickly sell or cash-in your investment if you need access to the money.
• Risks associated with international investing: Currency fluctuations, political upheavals, unstable economies, additional taxes — these are just some of the special risks associated with investing outside
the United States.
How much risk?
How much risk are you willing to take to pursue your savings goal? Gauging your personal risk tolerance — or your ability to endure losses in your account due to swings in the market — is an important step in your risk management strategy.
Because all investments involve some level of risk, it’s important to be aware of how much volatility you can comfortably withstand before you select investments.
Your plan’s educational materials may offer worksheets and other tools to help you gauge your own risk tolerance. Such materials typically ask a series of questions and then generate a score based on your answers that may help guide you toward a mix of investments that may be appropriate for your situation.
Once you understand your risk tolerance, the next step is to develop an asset allocation mix that is suitable for your investment goal while taking your risk tolerance into consideration.
Asset allocation is the process of dividing your investment dollars among the various asset categories offered in your plan, typically stocks, bonds and cash/stable value investments.
Generally, the more tolerant you are of investment risk, the more you may be able to invest in stocks. On the other hand, if you are more risk- averse, you may want to invest a larger portion of your portfolio in conservative investments, such as high-grade bonds or cash.
Your time horizon will also help you determine your risk tolerance and asset allocation. If you’re a young investor with a hardy tolerance for risk, you might choose an allocation with a high concentration of stocks because you may be able to ride out short-term swings in the value of your portfolio in pursuit of your long-term goals.
On the other hand, if retirement is less than 10 years away and you can’t afford to risk losing money, your allocation might lean more toward bonds and cash investments.
(However, consider that within the bond asset class, there are many different varieties to choose from that are suitable for different risk profiles.)
All investors — whether aggressive, conservative or somewhere in the middle — can potentially benefit from diversification, which means not putting all your eggs in one basket. Holding a mix of different investments may help your portfolio balance out gains and losses. The principle is that when one investment loses value, another may be holding steady or gaining (although there are no guarantees).
What about more conservative investors, such as those nearing or in retirement? Even for these individuals it is generally advisable to include at least some stock investments in their portfolios to help assets keep pace with the rising cost of living. When a portfolio is invested too conservatively, inflation can slowly erode its purchasing power.
Your employer-sponsored plan also helps you manage risk automatically through a process called dollar cost averaging (DCA). When you contribute to your plan, chances are you contribute an equal dollar amount each pay period and that money is then used to purchase shares of the investments you have selected. This process, investing a fixed dollar amount at regular intervals, is DCA. As the prices of the investments you purchase rise and fall over time, you take advantage of the swings by buying fewer shares when prices are high and more shares when prices are low, in essence following the old investing adage to “buy low.” After a period, the average cost you pay for the shares you accumulate may be lower than if you had purchased all the shares in one lump sum.
DCA involves continuous investments in securities regardless of fluctuating prices. You should consider your financial ability to continue making purchases during periods of low and high price levels.
Although it’s generally not necessary to review your retirement portfolio too frequently (e.g., every day or even every week), it is advisable to monitor it at least once per year and as major events occur in your life.
During these reviews, you’ll want to determine if your risk tolerance has changed and check your asset allocation to determine whether it’s still on track. You may want to rebalance or shift some money from one type of investment to another to bring your allocation back in line with your original target, presuming it still suits your situation. Such regular maintenance is critical to help manage risk in your portfolio.
When developing a plan to manage risk, it may also help to seek the guidance of a financial professional. An experienced professional can help take emotion out of the equation so that you may make clear, rational decisions.
Taking the initiative to manage the risk in your retirement plan is a critical step to a successful and fulfilling retirement.
Laurie Haelen, AIF (accredited investment fiduciary), is senior vice president, manager of investment and financial planning solutions, CNB Wealth Management, Canandaigua National Bank & Trust Company. She can be reached at 585-419-0670, ext. 41970 or by email at lhaelen@cnbank.com.