Call it the “risk paradox.” You know when to play safe—you don’t invest money you’ll need soon in the stock market. So why doesn’t your 401(k) plan see it the same way? Most plan participants intuitively grasp the concept of risk capacity. They know when they need to take a risk and when to stick to something safe. Your retirement plan doesn’t seem to accommodate this nuance.
Why?
Those crafting plan investment menus certainly try to incorporate risk in their options. Indeed, often the tools offered by retirement plan service providers rely on risk assessments, commonly known as risk tolerance questionnaires.
You’ve probably taken one. They feel personal, don’t they? Your immediate reaction is, “Yep, that’s me!” Upon reflection, however, the results feel generic at best and misleading in the worst case. They’re more like gossip columns—enticing but ultimately hollow.
They do, however, get you to talk about something important: how much you fear falling markets. Understanding risk tolerance helps you confront financial fears. That’s good. It’s just not good enough.
What it can’t do is help you achieve your financial goals. This requires stern adherence to mathematical reality—a firm definition of how much you can afford to lose or how much you must gain. Welcome to the realm of risk capacity. This is where the rubber meets the road.
Risk capacity measures what it takes to get you where you want to be. Risk tolerance tells you whether you want an aisle or a window seat.
So, again, why can’t 401(k) plans take this all into account? Unfortunately, there are legal and practical restrictions. These encourage companies offering retirement plans to stick to narrow definitions. A basic tolerance quiz falls within those lines. Comprehensive non-plan-related personal data veers far past those lines.
That’s the bad news. The good news is you have all the personal data at your fingertips. And you are free to use it in any manner you see fit.
To understand why you can take different actions than your plan sponsor, you must understand the difference between how much risk you can handle and how much risk you’re willing to take.
“An assessment of risk capacity is more of an objective assessment regarding how much risk a person can take based on their financial situation, considering such things as their income and expenses, assets and liabilities, time horizon, goals, and other obligations,” says Michelle Capezza, Of Counsel at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. in New York City. “An assessment of risk tolerance is more of a subjective gauge regarding an individual’s willingness to take on risk, and how much risk they would be comfortable taking on.”
This clash between cold, hard facts and fuzzy feelings presents an obstacle to plan sponsors. What you need and what plan sponsors want might be two entirely different things.
Why your 401(k) defaults to risk tolerance instead of risk capacity
Face it, plan sponsors feel much safer with the concept of risk tolerance compared to risk capacity. A simple universal questionnaire represents a low-liability method for obtaining “personal” information. These questionnaires also benefit from having broad industry approval.
Sure, it’s personal, but is it relevant?
It doesn’t matter. Because it’s standardized, easy to administer, and generally accepted within the financial community, the risk tolerance questionnaire satisfies the minimum regulatory requirements for investor education. Many sponsors view completed risk questionnaires as compliance shields.
“Behavioral scientists like Meir Statman say they have perfected risk tolerance questionnaires,” says Ron Surz, president of Target Date Solutions in Sacramento, California. “I trust Meir. Completed questionnaires are proof documents.”
For plan sponsors and their service providers, it’s a low-cost way to do the least they can to stay within government guidelines. Remember, as retirement plans become increasingly personalized, plan sponsors assume greater fiduciary liability. That’s why plan education tends to be generalized rather than individually tailored.
Furthermore, retirement plans are not legally obligated to incorporate personal financial data beyond what applies to the plan itself. Not only is there no legal obligation, but the plan also has no legal access to your external personal information—the very thing required to accurately determine your risk capacity.
The risk capacity information barrier
Consider the key components necessary to calculate your risk capacity, and you’ll immediately understand why plan sponsors might be reluctant to pry into your personal life. For example:
- If you’re married, you’ll need to consider your spouse’s assets and income.
- In addition, you have to include all your financial accounts and any potential inherited wealth.
- Don’t forget your outside income streams. After all, while you might have no problem listing an old pension or annuities, do you really feel comfortable disclosing to your current employer that you’re moonlighting with a side gig?
- Finally, to complete your personal balance sheet, you’d need to report your liabilities, including debt and projected healthcare costs.
The plan sponsor is your employer, not your financial advisor. Embracing your financial needs and acting upon those is your responsibility, not your company’s. Your company, in offering a retirement plan, takes on only a small piece of your money management puzzle. You can’t make decisions with this incomplete set of data. Do your own homework to calculate your personal risk capacity.
“Risk capacity is about one’s financial ability to bear risk,” says Cheryl L. Evans, Director, Financial Security Program, Center for Financial Markets at Milken Institute in Washington, D.C. “It relates to your concrete financial circumstances, such as the amount saved, debt, and stage in life. It is tied to how much risk you can take on without putting your financial stability or life goals in jeopardy.”
Risk capacity is the thread that ties your entire financial plan together. Unlike emphasizing feelings with risk tolerance, risk capacity relies on objective measures that allow you to align all your goals, including the ability to retire in comfort.
Bridging the risk capacity gap
You have the power. You possess all the tools. No one else has the ability to collect all the vital pieces of your financial jigsaw puzzle. You don’t have to assemble those pieces necessarily—many hire financial professionals for that purpose. But even if you bring on an expert, it’s still up to you to take an inventory of your situation.
Think of this as if you’re running a business. The two most important financial reports any business produces are the balance sheet and income statement. The balance sheet lists all assets and liabilities. This reveals your net worth. The income statement charts income and expenses. It allows you to determine your cash flow needs. It’s best to split expenses into two categories: Non-Discretionary (essential spending you cannot cut); and Discretionary (expenses you can cut should you need to).
You can identify one aspect of your risk capacity by calculating how many years your assets (from your balance sheet) will last based on your spending (from your income statement). You see that, while a part of this calculation, your 401(k) alone cannot provide this type of analysis. Yet, incorporating risk capacity into your savings, spending, and investment decisions can help you achieve your financial and retirement dreams.
“When advisors rely only on how someone ‘feels’ about risk, it can lead to allocations that don’t fit their real financial circumstances — a red flag under ERISA,” says Terry Morgan, President at OK401k in Oklahoma City. “Risk capacity, grounded in data and time horizon, creates a defensible, prudent process. That framework helps fiduciaries show measurable diligence in a personalized report.”
Yes, theoretically, plan sponsors can add this personalized approach to their list of employee benefits. But the liability risk for them is too high. On the other hand, the liability risk for you is too high not to take advantage of combining the mathematical reality of risk capacity with the emotion alerts derived from risk tolerance.
Taking ownership of true risk capacity
If your 401(k) contains tools that encourage you to reveal your tolerance of risk, don’t shun them. Use them, but understand their limitations. They’re great at uncovering your feelings, or maybe even taking a deeper investigation into them. Just don’t make any life-altering decisions based on those feelings.
Instead, ask yourself the tougher question: “What do my facts tell me I can do or should avoid doing?” It may involve a little math, but don’t worry, risk capacity is something you can count on.
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