Defining and measuring risk capacity

Abstract

This paper provides a definition of risk capacity and the underlying variables that contribute to it­ specifically the ability for the client to adjust goals; revenues from external sources like pensions; and the downside flexibility of the investment portfolio based on withdrawal strategies and portfolio construction. This paper proposes a specific metric to the measure risk capacity as opposesd to more qualitative approaches. The metric considers not only success/failure in achieving goals and terminal wealth, but looks at the frequency of shortfalls and the depth of any gaps. Using Monte Carlo simulations the proposed metric is then tested against various scenarios and illustrations using portfolios, annuities, GMWBs with adjusted returns, inflation and mortality assumptions.