Are You Taking the Right Amount of Risk?
May 12, 2016 | Your Finances
When it comes to your money, do you know how much risk you should be taking? If you’re like most people, the answer lies somewhere between “maybe more” and “maybe less,” with a fair amount of “not sure” in between.
Ask around, and you’re likely to get a number of opinions. But how do you really know if you’re taking the right amount of investment risk to adequately save for goals like retirement? And how do you know if you’re not?
According to Michael Finke, professor and director, Retirement Planning and Living at Texas Tech University, the first step toward understanding is to take a comprehensive view of your finances. “Most people associate risk with just a portion of their portfolio,” he says. “They get tunnel vision when they should be thinking bigger picture.”
A bigger-picture view will take your entire financial plan into account. It also looks beyond day-to-day return chasing to long-term gains driven by your plan as a whole. This means your 401(k), IRAs, pension, annuities, mutual funds, life insurance, real estate, business interests—even things like settlements and inheritances—should all be factored in. When they are, the landscape can look quite different from a risk perspective.
For example, say you’re a 50-year-old with a pension and an IRA. If you concentrate only on the IRA and the market dips, you might be tempted to replace your aggressive stocks with conservative bonds, even though you have a pension that serves as a financial cushion.
According to Finke, this “investment myopia” can lead to lower long-term returns, causing you to fall short of your overall goals. When you look at the big picture, however, the pension becomes more than just a retirement income source. In a sense, it has your IRA’s back so it can pursue the aggressive returns you need to reach your goals.
This isn’t the only scenario in which a comprehensive approach can help you reframe risk. Say you’re 45 and have a family. As part of your financial plan, you’re investing in your 401(k) and have an IRA and some investments. In addition, you have a whole life insurance policy that you took out to protect your family’s finances if something were to happen to you. On the surface, the retirement account and insurance policy may seem unrelated. But when you consider both as parts of an overall financial plan, things change.
Justin Charise, CFP®, Northwestern Mutual wealth management advisor, explains: “Whole life insurance has a cash value that grows tax deferred, is eligible to earn dividends and is guaranteed to never go down. Owning an asset like this may give you some leeway to take on more risk in other parts of your financial plan, like your investments. Because the cash value of your whole life policy can be accessed if you need it, you may feel more comfortable being more aggressive [taking on more risk] with your 401(k), for example.”
When you’re ready to retire, the same whole life policy can continue to reframe risk. “Let’s say you’re retired, and there’s a downturn in the market,” says Charise. “Instead of drawing from your retirement account for income by liquidating investments when the value is low, you can utilize the accumulated cash value, which isn’t affected by market downturns.” While using your cash value will reduce your death benefit, it can also help you weather the storm without depleting your portfolio or locking in losses. As the market recovers, you have the option—but not the obligation—of restoring the cash value. In this scenario, whole life insurance represents far more than just a death benefit. “We’ve seen clients with a wide range of temporary liquidity needs leverage the cash value of their well-established whole life policies; the cash value in these cases serves as a unique balance sheet asset that can provide useful financial options throughout our clients’ lifetimes, but especially during the drawdown stage in retirement.”
The 2008 recession and its aftermath provide a perfect example of this. Many retirees had no choice but to withdraw from their portfolios at the lowest values seen in years, permanently locking in the lost market value. Those with whole life insurance, however, had another option—they could tap their cash value to help meet their income needs instead of selling their investments. And when the markets rebounded in 2009, their portfolios had a chance to recover.
Of course, whole life insurance is just one of many financial tools you can use to help manage risk. Your financial professional can tell you about a variety of options available depending on your age and financial circumstances. The important thing to keep in mind is that no matter how you evaluate risk, the key is to step back and look at the big picture. The more you do, the more you’ll appreciate the view.
Each method of utilizing your policy’s cash value has advantages and disadvantages and is subject to different tax consequences. Surrenders of, withdrawals from and loans against a policy will reduce the policy’s cash surrender value and death benefit and may also affect any dividends paid on the policy. As a general rule, surrenders and withdrawals are taxable to the extent they exceed the cost basis of the policy, while loans are not taxable when taken. Loans taken against a life insurance policy can have adverse effects if not managed properly. Policy loans and automatic premium loans, including any accrued interest, must be repaid in cash or from policy values upon policy termination or the death of the insured. Repayment of loans from policy values (other than death proceeds) can potentially trigger a significant tax liability, and there may be little or no cash value remaining in the policy to pay the tax. If loans equal or exceed the cash value, the policy will terminate if additional cash payments are not made. Policyowners should consult with their tax advisors about the potential impact of any surrenders, withdrawals or loans.