Retirement Investment Planning May Be Changing for Many Wealthy Childless Households
Unlike wealthy households with children, childless households often don’t prioritize making bequests to individuals as part of their financial and estate plans. In fact, ensuring a financially stable and fulfilling retirement is often the sole primary planning goal. And because of the outstanding market performance of the last 15 years, many pre-retiree and early retiree childless households are strongly positioned for a successful retirement. In today’s high-yielding money market environment, it’s a legitimate question to ask whether these households should have a majority of their assets in stocks, even if they have high risk tolerance.
I work with a lot of LGBTQ households as part of my practice. Consequently, as one might imagine, I work with a lot of childless households as part of my practice.
And especially recently, I have noticed that the investment planning discussions with clients who have no descendants have a very different flavor than those who have children.
This is a prototypical pre-retirement client childless couple that I work with:
Married couple, both aged 60
Both spouses are still working and earning $275,000 as a household
Both spouses are each saving $20,000 per year to their retirement accounts
Combined they have $1.3 million of investments in retirement accounts, and $200,000 in taxable brokerage account
Each member of the couple will start receiving about about $3,000 per month in Social Security at Full Retirement Age (age 67)
They’re planning to work another 2-4 years
Mortgage has been paid off or is close to being paid off
Household living expenses of $110,000 per year (excluding taxes)
They have moderately high risk tolerance and have been comfortable investing a good portion of their retirement assets in the stock market.
A household in this situation is almost invariably in very good shape to retire in 2-4 years. They can live off distributions from their retirement accounts for a few years, and then they can enroll in Social Security and will have a healthy mix of guaranteed Social Security income and relatively low withdrawal rates from their retirement accounts. And a big reason why they’re now in a good position to retire is because they have greater than average risk tolerance and have been consistently investing in the stock market.
Now here’s the question: how much risk should this couple take in their investment accounts right now in April of 2024?
The Two Basic Client Risk Profile Metrics
Before we address that question, let’s talk about household risk measurement: typically, when we financial planners work with clients, we seek to understand a client’s risk profile, and there are two traditional risk measures that financial planners try to gauge:
Risk tolerance: In an investment planning context, risk tolerance is generally thought of as a measure of the client’s ability to stomach severe reductions in their investment portfolio. A slightly different definition is the willingness to take on risk to achieve additional investment gains even if that magnifies potential investment losses. Importantly, risk tolerance assessments are supposed to be “valid” and “reliable.” A “valid” assessment means that it should not be affected by a client’s current financial situation but rather is a measure of an underlying, more permanent mentality. And a “reliable” assessment should provide consistent results between administrations of the assessment. Importantly, we don’t want to have an assessment that tells us that a person has a high risk tolerance, but when the market crashes, the client starts panicking. That would make such an assessment invalid (and worthless). (Note: this is a brief summary of the concept of risk tolerance and of risk tolerance assessments…tomes of research have been created on designing and administering risk tolerance assessments, which I won’t get into here.)
Risk capacity: Risk capacity is a qualitative measure of how much risk one can take given their current financial and life circumstances. For instance, a young single person with a steady, high-paying job, no children and $200,000 of savings would generally have high capacity for risk. The same would be true for a retired couple that lives modestly and has $5,000,000 of savings. On the other hand, a young couple with $300,000 and three young children has at best moderate amounts of risk capacity, especially because if one of the parents lost their job, they would likely need to use that savings immediately to support the household. They couldn’t necessarily afford to lose 30-50% of that savings in a sharp market downturn.
Notably, risk tolerance and risk capacity are supposed to be independent measures. And in fact I have a few multi-million dollar household clients where the investor has a lot of risk capacity, but they really do not have a lot of risk tolerance. Consequently, their portfolios tend to be more conservatively invested than most clients, even though they have lots of money. I should note that in practice, when conservative investors get wealthy, they do become somewhat more open to taking risks with their portfolio (but not as much as you might think). In that respect, I find that almost all risk tolerance assessments are neither completely valid nor completely reliable when there are huge changes in household wealth, but the better assessments in the risk tolerance field are fairly reliable and consistent in the context of a bear market in the stock market.
When investment advisors make a recommendation on an investment portfolio, we take into account both risk tolerance and risk capacity. I personally start with risk tolerance as the most important measure for determining a recommended portfolio, but very often I adjust the riskiness and potential returns of a portfolio depending on the risk capacity of the household.
The Missing Third Piece of the Risk Profile: “Risk Personal Value”
For the last few months, I have had a bit of unease that the two above measures, risk tolerance and risk capacity, weren’t fully capturing the risk profile of client. And that unease was especially true for childless couples similar to the household profile described at the beginning of this article.
By most measures, the wealthy childless couple described at the beginning of this article has fairly high risk capacity. Would this household be materially harmed if their portfolio went down by 30% at some point in the next twelve months? Absolutely. But would the household face actual financial distress if their portfolio went down by 30%? Not really. They earn plenty of income, and in most cases, the retirement planning solution to a significant market decline would be for both of them to work a year or two longer, reducing the time that they wouldn’t be earning income from either their jobs or Social Security.
And let’s say that this household has average to higher-than-average risk tolerance. In other words, they are comfortable with taking risks in their portfolio and are unconcerned by significant short-term declines in their portfolio.
So if we have a household that has high risk capacity and higher-than-average risk tolerance, the usual advice would be to recommend a moderately aggressive portfolio consisting of 60-70% stocks.
But the question is for this particular childless couple is: what value does earning more wealth actually provide?
And the answer is: there really isn’t any, especially if the couple is going to continue to live relatively modestly and does not in fact have aspirations to go on fancy vacations, or buy expensive cars with extra wealth.
In other words, even though this household has capacity and willingness to take risk, they really don’t get any personal value in terms of better life outcomes from taking this risk. So why take it?
“Risk Personal Value” Is Especially Relevant Today…
There are two main reasons why this concept of “risk personal value” is an increasingly important investment planning consideration in today’s financial environment:
Recent market returns have been very strong. As discussed in a previous blog post, a lot of pre-retirees and recent retirees have benefited enormously from the market returns over the past 15 years. This has led to a situation where many households who have been consistent savers over the last couple decades have ended up far wealthier than they ever imagined.
Low risk investments are offering attractive yields. It is very easy for investors these days to earn around a 5% annualized yield just from simply investing in very low-risk money market funds. With inflation currently around 3%, that means that investors could be earning around at least 1.75% yield in real inflation-adjusted terms. Real, inflation-adjusted yields have not been this attractive since before the 2008 Financial Crisis.
Many childless households have benefited tremendously from recent strong market returns. Unlike families with children were having to pay the costs of raising their offspring, childless couples with similar incomes have had much more capacity to save money in their retirement funds. As long as a substantial portion of their retirement funds had been invested in the stock market, these households have almost undoubtedly generated strong returns in their retirement funds. And this had led many of these high-income households to be in great shape to retire in their mid-to-late 50s.
Now factor in the current interest rate environment: this is the first time in 15 years that one get a meaningful low-risk yet attractive yield in money market accounts. This isn’t like the interest market environment from 2020-21, where you would be lucky if you were earning anything in a money market fund. Now money market funds are offering good yield.
Disclosure: Money market funds have some risk. But money market funds certainly entail much lower risks than stocks or bonds. In particular, wealthy pre-retirement households taking meaningful stock market risk could upend life plans to retire at a certain age or to enjoy life and spend heavily in their early retirement. Would this be ruinous? No, because they probably have enough money anyway. But taking significant market risk could be disruptive.
Now if these pre-retirement or early-retirement households had children, maybe they could justify continuing to take meaningful risk in the portfolio. In fact, many of my wealthy clients who have children understand that they do in fact have a long-term investing horizon, because they are investing a lot of their money not for themselves, but for their children. And in those circumstances, it can make sense to stay invested in the stock market, because wealth transfer is a high-priority goal and they have multi-decade timelines for this wealth transfer.
But for those wealthy pre-retirement households who don’t have heirs, even those who have high tolerance, it’s fair to ask if they should be taking meaningful risk, since they may not have a need more returns, even if they have the risk tolerance and risk capacity to chase those returns.
“Reduced Risk” Doesn’t Mean “No Risk”
To be clear, I would not be a fan of most wealthy households investing 0% of their money in the stock market, even those who have lower-than-average risk tolerance. Stocks have good “overall portfolio value” as a part of a diversified portfolio, especially because they are a decent long-term (but not short-term) hedge against inflation. And adding international and emerging stocks also provide good diversification value.
In addition, having some portion of a taxable account portfolio in stocks would often make sense simply from a tax planning standpoint so that some of the investment returns could be taxed at capital gains / Net Investment Income (“NIIT”) tax rates. This consideration is particularly valid for taxpayers in the highest income tax bracket.
Moreover, while money market funds are a relatively attractive fixed-income investment right now, I think a separate allocation to high quality, short-duration bonds such as US Treasuries and / or I-Bonds can make sense as part of households’ portfolio in today’s market environment.
Finally, it is unclear how long this era of attractive money market rates will last. In fact, one of the biggest questions in the investment management world is where the “natural interest rate” will settle in the post-COVID economy. Will we go back to sub-2% treasury bill rates, or is 5% interest rates the new normal? The reality is that it may take a recession to find out the answer to this question.
But in the meantime, I’m ok recommending a higher-than-average allocation to relatively low-risk investments for childless households that are in a strong position to retire soon. As always, the particulars of the client situation matter, but when you’re already in a great position to retire and don’t have any heirs to bequest your money to, it can be wise to take some chips off the table, and that is especially true in an investing environment where you can get an attractive yield in a low-risk investment vehicle.