The Importance of Incorporating Income Risk Into Financial Planning

Traditional financial planning often assumes that income remains stable or grows predictably. But there are numerous risks to income—career disruptions, economic downturns, and technological advancements—that may significantly affect investors’ ability to achieve long-term financial goals. Assuming an investor will earn predictable long-term income can be short-sighted, as it can limit their ability to meet long-term objectives and develop a truly holistic investment strategy.

So, how does an investor plan for income risk? For many investors, it leads them to lower equity exposure and a higher saving rate.

My new report, “Shocks to Income in a Lifecycle Model: An Undervalued Risk,” provides insights into how to personalize financial plans based on an investor’s age, financial wealth, level of education, and employment sector. The appropriate adjustments to investment strategies depend on the specific sources of income volatility and how they correlate with equity market performance.

Using data from the Panel Study of Income Dynamics, the report leverages lifecycle models—an approach gaining traction among practitioners for its ability to deliver comprehensive strategies aligned with modern financial planning needs.

What Qualifies as an Income Risk?

Income risk typically falls into one of the three categories: transitory shocks, permanent changes, or correlation with equity returns.

• Transitory income risks are short-term events that affect earnings temporarily but do not alter the investor’s long-term income trajectory. Examples include performance bonuses (yes, risks can be positive) or brief periods of unemployment (less than six months). Once these events pass, income typically returns to its previous trend.
• Permanent income risks, on the other hand, have lasting effects on an investor’s earning potential. These include career advancements like promotions, extended unemployment that makes returning to the workforce more difficult, or structural changes that displace certain job functions (for example, automation and artificial intelligence). These risks can create significant divergences in long-term career and income paths.
• Correlation with equity returns is a risk that’s often tied to the investor’s job and industry. For instance, professionals in finance may experience income patterns that closely track stock market performance, while people who work in healthcare or education typically face less market-sensitive income streams. For investors who are exposed to this kind of risk, incorporating hedging assets is key. And understanding the correlation between income and equity returns is essential for aligning financial portfolio risk with overall net-worth exposure.

What To Know About Asset-Allocation Adjustments to Income Risk

Adjusting by Age

The adjustment that income risks bring to an investor’s financial strategy largely depends on the investor’s wealth and age.

As shown in the chart below, accounting for income risk means that younger investors—who typically have lower levels of accumulated financial capital—should consider a more conservative equity allocation. At this stage, they have limited overall risk capacity, so it’s prudent to reduce their exposure to risky assets.

The same principle applies to investors approaching retirement. They typically have greater accumulated wealth and a higher capacity to bear risk than younger investors, but the possibility of income-related downside risks (such as job loss) can still jeopardize their financial security. Recognizing these risks should merit a more conservative asset allocation than would be recommended under the assumption of stable, risk-free income.

It may seem counterintuitive that income risk-adjusted planning leads investors aged 30–39 to hold a higher equity allocation. However, it is because these investors, under risk-aware planning, tend to accumulate more financial wealth over time, resulting in greater risk capacity.

In fact, when adjusting the model outputs for wealth (as shown in the chart below), equity allocations are consistently lower for those who account for income risks, compared with those who do not.

Adjusting by Employment Sector

An investor’s employment sector plays a critical role in defining the nature of their income risks and how those risks correlate to equity returns.

Consider two contrasting examples: individuals employed in the financial sector versus those in public service.

• Financial sector professionals typically face higher income volatility and a stronger correlation between their earnings and stock market performance. As a result, they should generally adopt a more conservative equity allocation to avoid compounding risk across income and investment.
• Public service employees, on the other hand, usually have steadier income that is not correlated with equity performance, allowing them to adopt a riskier portfolio allocation.

The chart below compares equity allocations between investors from the financial services and public service sectors. The most pronounced differences appear among younger investors, for whom future labor income—or human capital—represents a larger share of their net worth.

By contrast, between ages 40 and 49, the difference in equity allocation narrows significantly, as both groups are generally advised to hold a higher equity exposure.

Investors employed in sectors such as transportation, retail, wholesale trade, and manufacturing should consider adjusting their portfolios similarly to those in financial services. These industries often show higher income volatility and stronger correlations with market performance, warranting a more conservative equity allocation.

In contrast, individuals working in education, healthcare, utilities, professional services, or management services typically experience more stable income. Like public sector employees, they may have greater capacity to take on equity exposure in their investment portfolios.

What To Know About Saving-Rate Adjustments

Once investors recognize their income risk(s), they may decide to increase their saving rate, because maintaining a consistent standard of living—even during periods of low income—requires increasing your financial assets. By accumulating more wealth during high-income years, investors can better smooth spending over time and protect against income disruptions.

The chart below illustrates that for younger investors (between ages 25 and 29), differences in saving behavior are minor as their capacity to save is low.

However, earnings and saving capacity usually increase after age 30. This is when incorporating income risks into financial planning leads to meaningfully higher saving rates. Investors who account for these risks should accumulate at least 15% more financial wealth over time, which can translate into saving rates that are 3% higher than investors who do not.

As investors approach retirement, the difference between investors who included and the ones who omitted income risks from their financial planning shrinks again. At this stage, income risk plays a smaller role in an investor’s net worth.

Incorporating income risk into financial planning leads to more robust strategies that adapt to the complexities of personal financial planning. By aligning asset allocation and saving behavior with the variability of income across time and sectors, financial plans can be better positioned to support long-term goals.