Risk Capacity Should Not Be Determined by Expected Legacy

When creating asset allocation—whether through bucketing or a fixed asset allocation—a common mistake is to base a retiree's risk profile on the expected legacy value.

If projected legacy is low or negative, one might conclude that the retiree has lower risk capacity. Conversely, a high projected legacy might be interpreted as evidence of greater risk capacity.

There is a fundamental flaw in this approach: it introduces circularity.

The proper relationship is: Risk Profile (Risk Capacity + Risk Tolerance) → Asset Allocation → Legacy

Legacy is an outcome of the asset allocation, while asset allocation is based on the retiree's risk profile.

If risk capacity is then made dependent on legacy, we create: Risk Profile → Asset Allocation → Legacy → Risk Capacity → Risk Profile → ...

For example, if expected legacy is high, one might conclude that risk capacity is high and therefore reduce the debt allocation. The portfolio becomes more aggressive, potentially increasing expected legacy even further. That higher legacy could then be used to justify an even higher risk capacity.

The opposite can happen when expected legacy is low. One might conclude that risk capacity is low and increase the debt allocation. The portfolio becomes more conservative, potentially reducing expected legacy even further, which could then be used to justify an even lower risk capacity.

The result is a self-reinforcing feedback loop that can make the portfolio either excessively aggressive or excessively conservative.

Risk capacity should instead reflect the retiree's actual ability to withstand investment losses. Factors could include health, ability to earn additional income, stability of other income sources, human capital, other financial or non-financial assets, liabilities, liquidity, and the ability to reduce or replace portfolio withdrawals.

For example, someone who can easily replace portfolio income through employment or other resources has greater risk capacity than someone who depends entirely on the portfolio to maintain their standard of living.

If projected legacy is lower than desired, the appropriate response should not automatically be to reduce the asset allocation. Doing so can reinforce the very problem we are trying to solve.

Instead, one of the most direct levers is spending:

Lower spending → Higher potential legacy

Legacy should be treated as an output of the retirement plan, not as an input for determining the retiree's risk capacity and asset allocation.