Rethinking Risk Tolerance for Retiring Clients

The traditional approach to evaluating the risk tolerance of retiring clients has some problems, according to Michael E. Kitces, director of research at Pinnacle Advisory Group.

He notes that most advisers probably use questionnaires with 15 or so questions to evaluate a client’s risk tolerance. The questionnaires ask about such things as when the client needs to withdraw assets; what other assets the client has; the client’s knowledge level about investments; and what the client would do if markets declined. The client gets a total risk score based on his or her responses.

Kitces told attendees of the National Tax-deferred Savings Association’s (NTSA) 2014 403(b) Summit that advisers are really asking questions about three different things through these questionnaires. First is risk capacity, or the capacity to take risk based on the ability of the investor to absorb losses without getting wiped out. Next is risk perceptions, or what does the client actually define as risky investment behavior. Last is risk attitude or tolerance, based on considerations around how the client feels about risk/return tradeoffs, whereby taking risk means there could be a bad outcome or there could be great gains.

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Kitces said there needs to be some way to account for the difference between risk capacity and attitude, separating time horizon and income needs from people’s willingness to trade off. “For example, we tell young folks, ‘You’re young, you should take more risk,’ but we don’t even ask if that’s going to make them nervous.”

For retiring clients, Kitces posed two scenarios. One retiring client doesn’t need much money, and doesn’t need it for many years because he has a large portfolio, and another client needs lots of money immediately and has less in his portfolio. Both are conservative investors. The first one’s questionnaire scores will average out to indicate he should invest in a moderate portfolio, Kitces explains, but because of his low risk tolerance, it’s just a matter of time before he has losses that are personally devastating to him. In addition, just because the client has the capacity doesn’t mean he should take the risk. The second client’s questionnaire scores will indicate he should invest in the most conservative portfolio, but this portfolio will fail to meet his need to accumulate lots of money.

“These are some of the core, essential problems with traditional risk evaluation,” Kitces said, noting that there is no easy solution for the second person in his example. “If he has a low risk tolerance, he cannot get high income, so he needs a different goal.”

A high risk capacity allows for any risk attitude, but a low risk capacity requires a high tolerance, he added. Risk attitude defines the upper limit of risk to take.

Risk perception presents another problem. Kitces said it seems clients have high risk tolerance in good markets and low tolerance in bad markets. But the problem is not that their tolerance changes, he warns. The problem arises when clients start thinking a short-term market trend is indicative of long-term results. This could lead them to misjudge risk and make bad decisions. Clients tend to remember most clearly what has happened most recently.

“This is where education and financial literacy matters,” Kitces said. “Advisers must do constant educating so client perception is realistic. Perception is something we can actually help clients with.”

However, advisers need to start separating risk capacity from risk tolerance, according to Kitces. “Just because someone may have a large portfolio or a long time horizon, we shouldn’t violate their risk tolerance and give them an overly risky portfolio,” he concluded.

Banks Ask to Continue as Pension Asset Managers

BNP Paribas and Credit Suisse, which have each pled guilty to U.S. criminal charges, are asking to be able to keep managing U.S. pension plan assets.

The banks have applied for an exemption that would enable them to keep their status as qualified professional asset managers (QPAMs). The QPAM Exemption allows the manager to engage in transactions with parties in interest with respect to the plan without running afoul of the prohibited transaction restrictions of the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code. It contains an anti-criminal rule that requires that neither the QPAM nor any of its affiliates have been convicted of a variety of crimes within 10 years immediately prior to the transaction. Ambiguities arise particularly when there are investigations of foreign affiliates in foreign jurisdictions, because foreign laws may not be enforced in the same way they are enforced under U.S. laws, and certain acts that may be “criminal” or “felonies” in this country may not be treated similarly in other jurisdictions.

According to news reports, BNP pleaded guilty in June to processing nearly $9 billion in transactions from 2004 to 2012 that violated U.S. sanctions against Sudan, Iran and Cuba, and it agreed to pay a $8.97 billion penalty. On May 19, 2014, Credit Suisse pleaded guilty to criminal charges that it facilitated tax evasion by helping U.S. clients avoid paying taxes to the IRS. The $2.6 billion fine imposed is the largest ever monetary penalty in a criminal tax case.

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Failing to qualify as a QPAM has a number of significant legal consequences both for the asset manager and for a pension plan that has assets under the QPAM’s management. The QPAM could potentially be liable for a breach of its contracts with Employee Retirement Income Security Act (ERISA) clients to the extent that it made a representation that it qualifies as a QPAM. The plan’s fiduciary could potentially have its own liability in connection with the manager’s transactions under ERISA’s co-fiduciary liability rules. The Department of Labor (DOL) recently issued a helpful advisory opinion that makes clear that the sole judicial action that triggers a violation of the QPAM exemption’s anti-criminal rule is a criminal conviction.

BNP and Credit Suisse are big players in the swaps market. A swap, a tool often used by a pension plan to manage financial risk, is a contract between the retirement plan and another party, usually a swap dealer. When transacting a swap in its most basic form, the plan and the dealer agree to exchange certain cash flows or other rights to which each party is entitled before they enter into the swap. For example, the plan may own bonds that periodically pay cash based on a fixed rate of interest while the dealer owns bonds that periodically pay cash based on a floating rate of interest. Through the swap contract, the parties “swap” those payment streams without having to buy the underlying bonds.

According to Bloomberg, the Labor Department must rule in favor of extending a bank’s QPAM status before sentencing, or it is automatically revoked. Credit Suisse’s sentencing is scheduled for August 12, and BNP Paribas does not yet have a sentencing date.

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