Getting Risk Right

May 3, 2010 • Page 3 of 3

While it is likely that some purist mathematicians will find fault with the Money Tree model, it would seem that in this case, the ends justify the means. If you believe, as many do, that the bell-shaped curve accurately represents most market activity, and that the standard method's main shortcoming is that it underestimates the severity of the outliers, the Money Tree fat tail method elegantly balances the need for those severe outliers with the need for a methodology that advisors can understand and explain to their clients.

I doubt that this method is the final word in improving our retirement risk modeling, but it appears to be a step in the right direction.

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3 Comments

Comments

13 years ago

Additional Aspects of "Getting Risk Right"

Two very important risks that must be taken into account for a retired single person or couple are the costs of long-term care and the costs of prescription drugs. Long-term care costs can vary from zero to over a million dollars over the lifetimes of a married couple. The best the current software that's out there in the marketplace can do is model deterministic types of events (such as, say, a person will enter a nursing home for two years starting at age 80). That type of calculation ignores the great variability in these costs. There is less attention currently paid to deal with future prescription drug costs.The way to communicate the magnitude of these risks is with probability distributions of these costs. These probability distributions are calculated using a version of Monte Carlo testing. These probability distributions depend on the mortality and morbidity profiles of the client(s), as well as (for prescription drugs) their current prescription drug use, as well as the underlying conditions that cause the need for the current drugs to be taken. Long-term care insurance and prescription drug plans can be incorporated into the probability distributions, in order to give accurate advice to clients about how to manage these risks. When this information is provided to clients, the client(s) obtain a much more comprehensive understanding of their true risks. They can incorporate this information to help develop optimum spending and investment strategies.An actuary who specializes in financial planning can best provide this information.Jack [email protected]
[email protected] 13 years ago

Risk and Life Planning

I agree with the premise that risk, as it relates to retirement planning, or in this case life planning , is not purely mathematical. Clearly, there are behavioral and emotional components to clients' attitudes regarding risk. I do not believe, however, that the concepts discussed in the article and life planning are mutually exclusive. Whatever one's goals, and whether or not one believes in the teachings of the Kinder Institute, at the end of the day, we still need to make some estimates as to whether or not a client has the financial means to fund their goals. The author is a great believer in behavioral finance, and he is well aware of the role emotions play in financial decisions. At the same time, he believes that mathematical models are necessary to help clients determine whether or not their spending habits are sustainable.
13 years ago

Exec Director, Kinder Institute of Life Planning

I can see how a "fat tail" option would help with sensitivity analysis of retirement returns, but my problem is with the whole definition of "Risk". I think the industry confuses market risk (i.e. variance from expected returns) with the entirely different human experience of risk which is by its nature emotional, not mathematical. I've seen clients change their entire stance toward risk in a single meeting because they discovered a life goal they were super passionate about--something so meaningful to them that they would risk everything. It seems to me that the biggest risk to any client is that they end up sleepwalking through a life they hate. How do we know how much risk a client is willing to take if we (and they) don't know the stakes? I guess what I'm saying is that this entire discussion of risk modeling rests on a massive and unspoken assumption: that clients want the life they have. Our work at the Kinder Institute shows that this is simply untrue. Almost every client we work with discovers that they have exciting, meaningful, and fulfilling aspirations that they didn't know they had "permission" to pursue until a thoughtful financial advisor took the time to do more thorough goal-setting work with them. The ultimate goal shouldn't be a "safe" retirement, but a fulfilling life.

Getting Risk Right

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