A new white paper from investment management firm GMO, “Investing for Retirement: The Defined Contribution Challenge,” argues the ongoing trend of employers moving away from defined benefit (DB) pension plans in favor of defined contribution (DC) arrangements has left American workers far less secure in their retirement income prospects. The paper contends retirement investors must come to a new understanding of investment risk and the importance of asset allocation to ensure better outcomes—one that is less concerned with risk-adjusted returns and more closely reflects the importance of avoiding catastrophic portfolio losses near or during retirement.

Paper authors Ben Inker and Martin Tarlie suggest the most common method for building multi-asset portfolios both inside and outside retirement planning context—Modern Portfolio Theory—is overly preoccupied with the concept of maximizing return for a given level of risk. The main problem, the team writes, is that Modern Portfolio Theory asks the wrong question for retirees: given a level of risk, i.e., return volatility, which is the portfolio that maximizes the expected return?

This is the wrong question because it focuses on returns, not wealth, Inker and Tarlie argue. Returns, after all, are only the means to an end, the end being the wealth that is to be consumed throughout retirement. Not only is it the wrong question, but it presupposes the investor has a good reason for choosing a particular level of return volatility. So two investors faced with similar circumstances in terms of current wealth, future income and future consumption needs may have very different portfolios simply because their attitude toward return volatility differs.

A better approach is to focus on what really matters (i.e., wealth), the team argues. An investor saving for retirement has fairly well-defined needs, both in terms of how much wealth he needs to accumulate and his pattern of consumption in retirement. An investor’s portfolio should be driven primarily by his needs and circumstances, the argument goes. It should not be a function of his personality or his attitude towards risk, especially considering the general lack of confidence U.S. workers demonstrate on financial education and wellness.

So the more appropriate question for retirement plan participants, Inker and Tarlie suggest, is how do I achieve the portfolio that minimizes the expected shortfall of wealth relative to what’s needed? All other things being equal, a person who is more risk averse should save more or consume less, the pair explains, but this is not what is suggested by the traditional approach to retirement portfolio-building, which puts more risk-averse individual in a less volatile portfolio without making any compensating savings or consumption adjustments. The team argues this can actually increase the wealth risk to an individual in that he is less likely to achieve his wealth needs.

Another virtue of optimizing retirement portfolios based on minimizing the potential for an end-stage wealth shortfall, the pair writes, is that it is a highly customizable approach that can more easily address the question of how to invest for a more risk-averse person who expresses his increased risk aversion through, for example, a higher savings rate. This flexibility is a consequence of asking the right question, Inker and Tarlie say.

A full copy of the report, which includes more technical arguments and exhibits on the tenets of Modern Portfolio Theory and how it stacks up to a more wealth-focused approach, can be accessed at www.gmo.com/America/.