A Client Whose Risk Tolerance and Risk Capacity Point in Opposite Directions
Daniel, 62, retired last month from a utility. He receives a $64,000-a-year pension with a 2% COLA and no survivor benefit, and will claim Social Security at 70, currently projected at $46,000 a year. His investable portfolio is $1.9 million, and he owns a $520,000 rental duplex outright that nets $21,000 a year before maintenance surprises. He spends $118,000 a year. In March 2020 he sold his entire equity allocation near the bottom and stayed in cash for 14 months; during the 2022 drawdown he called your office weekly and asked whether he should 'just get out.' On the risk-tolerance questionnaire he scores 28 out of 100, described as conservative, yet he says he needs 6.5% returns and wants a 60/40 portfolio. Your Monte Carlo analysis shows 91% success at 60/40 and 82% at 35/65 over 30 years - but if the first three years return −15%, −8%, and +4%, the probabilities invert to 74% and 88%.
1. Reconcile Daniel's risk tolerance with his risk capacity and recommend an allocation. Show your reasoning.
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His capacity and his tolerance genuinely conflict, and both are real constraints.
Capacity is high. Once Social Security starts at 70, the pension ($64,000) plus Social Security ($46,000) covers $110,000 of his $118,000 spending, plus $21,000 of net rental income. The portfolio is funding an eight-year bridge and a modest gap, not the whole retirement. Capitalizing the pension at roughly 4.5% gives a bond-equivalent asset of about $1.4 million, which means the household balance sheet is already heavily weighted to fixed income before a single bond is bought. A 60/40 portfolio is closer to 35/65 on a total-balance-sheet basis.
Tolerance is low and, more importantly, revealed. Selling at the March 2020 bottom and calling weekly in 2022 is the strongest evidence you have. A plan he abandons is worse than a plan with a lower expected return.
Recommendation: roughly 45/55 to 50/50, with the equity sleeve globally diversified and the fixed income laddered Treasuries and high-grade corporates rather than a single core bond fund. Then show him the inverted Monte Carlo: at 35–45% equity he gets 88% success in the bad-first-three-years path versus 74% at 60/40. Frame the recommendation around the scenario he fears, not the average one. Put the behavioral protocol in writing: no changes outside scheduled reviews, and a 30-day cooling-off period for any request to liquidate.
2. How would you address sequence-of-returns risk and the Social Security decision?
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Sequence risk is the dominant threat because he is drawing $118,000 a year starting now, in the middle of an eight-year gap before Social Security begins. Three levers:
1. A spending reserve. Carve two to three years of net portfolio withdrawals - roughly $300,000–$350,000 after the pension and rental income - into a T-bill and short-CD ladder, held outside the equity allocation but counted inside the total portfolio. That reserve is what he is really buying: it means he never has to sell equities into a decline to fund groceries, which is exactly what broke him in 2020 and 2022.
2. Delay Social Security to 70. The $46,000 at 70 versus roughly $32,000 at 62 is an inflation-indexed, government-backed increase of about 40%+. Framed as an annuity purchase, bridging the eight years from the portfolio costs about $256,000 and buys an inflation-protected income stream that no bond can replicate. It also dies with him - the pension has no survivor benefit either - so confirm his marital status and whether a survivor needs protection.
3. Do not double-count the rental. The $21,000 net is income, but it is also an illiquid, concentrated, locally correlated asset. Treat the duplex as part of the real-asset/equity sleeve, not as a bond substitute, and stress-test a two-month vacancy plus a $15,000 roof.
3. Daniel asks whether he should sell the duplex to fund a higher equity allocation. How do you evaluate that?
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Evaluate it as a portfolio question, not a real estate question. Start by pricing what he owns: $21,000 net on $520,000 is a 4.0% gross-ish cap rate before capital expenditures, vacancy, or property management. That is a below-market return for illiquid, undiversified, single-asset risk, and it is the strongest argument for selling.
But the sale has real costs: transaction costs of 6–8%, depreciation recapture taxed at 25% on prior depreciation, capital gains at 20% plus 3.8% NIIT, and the loss of a step-up in basis at death if his heirs would otherwise inherit it. If he has owned it for 20 years, recapture alone could consume a meaningful share of the proceeds.
So the decision hinges on three unknowns: his basis and depreciation history, his willingness to 1031 into a more diversified property or a DST, and whether he actually wants to be a landlord at 70. Run the numbers before advising. If the after-tax proceeds are $420,000 and the goal is to diversify, the sale converts a 4% illiquid asset into a liquid portfolio at a similar expected return with far better diversification - a good trade if the tax cost is modest.
If he keeps it, formalize the decision: an annual reserve for capex equal to 1% of value, a documented vacancy assumption, and a line in the IPS stating that the duplex is counted in the growth sleeve. Leaving it unclassified is how concentrated positions get forgotten.