© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the January 2006 edition of BENEFITS CANADA magazine.
When guiding pension plan members towards good investments, the right risk questionnaire can make all the difference.
By Richard Deaves

One of the most important decisions an investor needs to make is how to allocate money among various asset classes with different risk and return characteristics. This is a challenge even for the financially astute. That’s why many Capital Accumulation Plan(CAP)members fall somewhat short in this area; typically they are assisted in finding the asset allocation that is right for them with a risk questionnaire.

The idea is that members spend ten minutes filling out a short form, after which they are steered into model portfolios that provide them with the “right” amount of risk-taking. But this is a risky proposition for members and sponsors. The amount of risk that one should take on in their investment portfolio is a function of the ability to withstand reversals—that is, risk capacity—and the comfort level that one has with risk-taking, or risk tolerance. Some people, especially those coming from a financial planning mindset, argue that a risk questionnaire should only assess risk tolerance. They feel the purpose of the process should only be to facilitate a frank discussion of risk-taking with a client, at which time risk capacity, horizon, taxes, etc. can be brought into the equation.

In a CAP context, however, it is common to combine in a single short questionnaire the topics of both risk capacity and risk tolerance assessment. Here the purpose is the recommendation of a specific asset allocation to the member.

Often such questionnaires are quite short. Take for example the risk questionnaire made available to the plan members of Washington-based TIAA-CREF, the largest defined contribution (DC)plan in the world. It consists of six questions, and—depending on how one answers them—a cumulative score maps the member into one of four model portfolios(conservative, moderately conservative, moderately aggressive and aggressive)with equity exposures ranging from 30% to 75%.

How should risk tolerance and risk capacity impact risktaking? Uncharacteristically, financial economists are in broad agreement on risk capacity. The major determinant of capacity is age, with older people normally being less able to withstand risk. The reason is that as people age and approach retirement, they have less time to recover from down markets.

It is quite typical for financial planners to recommend an equity share that declines 1% per year as people approach retirement. There are times, however, when even the young should tone down their equity exposure: if they have a very risky job; or if they are saving for a specific short-term goal(such as for a down payment on a house).

The purpose of risk questionnaires is to guide people to appropriate outcomes. But what constitutes a good questionnaire? To be sure, age and proximity to retirement should play a leading role. Time permitting, it may also be judicious to bring in such factors as income and other investments.

Normally, a good portion of the questions will attempt to uncover a respondent’s personal risk tolerance, with a view to adjusting upwards or downwards the amount of risktaking that an examination of capacity alone would indicate.

Two attributes of questionnaires are desirable: validity and reliability. Validity is the extent to which a questionnaire actually measures what it claims to measure, while reliability is an indication of how consistent its results are. To strive for reliability, the trick is to ask appropriate questions in sufficient quantity. Quantity matters since the impact of a misunderstood question will be magnified if it is only one of a few.

As for validity, there can be a negative impact on investors if respondents have difficulty understanding key concepts. For example, one flaw with all risk questionnaires is that they are based on the notion that respondents understand risk itself. In fact, there is abundant evidence to the contrary as evidenced by recent industry reports.

People have great difficulty in seeing that risk is very much horizon-specific. In one experimental study, employees at a firm offering a DC pension were asked to allocate their money between two funds, labeled “A” and “B.” Despite the neutrality of the language in the survey, the information presented for these funds was based on historical data for a broad U.S. stock market index and five-year Treasury bonds. The experimental treatment was to display to one group a return distribution for each asset class in terms of one-year returns, and, to the second group, return distributions in terms of 30-year returns.

The authors of the study theorized that because of “loss aversion”—which simply means investors hate to see a loss show up in their portfolio—the average allocation going to the stock fund would be much higher among those people who were shown 30-year return distributions compared to those individuals shown a one-year time horizon. The experimental evidence proved them right.

One common type of question seen in many risk questionnaires asks people how they would feel about and react to significant short-term portfolio losses. Continuing to use the TIAA-CREF survey referred to earlier, one of its questions reads:

Let’s assume that you own a stock fund that has lost 15% of its value over the past year, despite previous years of solid performance. The loss is consistent with the performance of similar funds during the past year. At this time, would you:
a. Sell some of your shares?
b. Sell some, but not all of your fund shares?
c. Continue to hold all of your fund shares?
d. Buy more shares to increase your investment in the fund?

Despite providing a few hints to the investor that they shouldn’t be too eager to flee, this sort of question validates in the investor’s mind that it is appropriate to fixate on shortterm volatility when the real concern should be horizonspecific risk vs. return. One can argue that such questions have to be asked, because if those people who are excessively nervous about volatility are corralled into serpentine investments, their tendency to feel “snake-bit” when the market inevitably moves south may cause them to radically and permanently adjust their equity exposure. This is a valid concern.

Is there a solution to this problem? Education is a solid first start. Members can be taught not to fixate on shortterm volatility if they are many years from retirement, and to focus on meeting their long-term goals. Through guidance, they are more likely to choose an asset allocation that is appropriate to their situation.

The problem is that many people do not take advantage of educational programs. Often the only point of contact is through the risk questionnaire(perhaps followed by a brief discussion with knowledgeable staff).

One approach worth considering is “embedded education”: providing some perspective to the member within the body of the risk questionnaire. For example, when a question illustrating the possibility of short-term volatility is included, it can be framed by some information on the historical typical outperformance of equities vs. debt instruments over long horizons. Ideally, the member will see that a reasonable amount of risk-taking is judicious.

The point of the exercise is to make investing less risky for CAP members so they will be more likely to be amply provided for in their golden years. A beneficial byproduct is that sponsors will be less likely to face litigation from disgruntled future retirees.

Richard Deaves is professor of finance, DeGroote School of Business, McMaster University in Hamilton, Ont. deavesr@mcmaster.ca