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Retirees are facing challenges not seen in other generations. People are living longer, and potentially outliving their money, they are managing their own investments, and dealing with unforeseen health and family risks. Risks are unavoidable for the most savvy or inexperienced investor. How these risks are addressed and assessed will make a big difference in future retirement goals.
A new paper, How Well Do Retirees Assess the Risks They Face in Retirement, from the Center for Retirement Research at Boston College, addresses this very question and breaks it down into a lifecycle model of a typical retired household. Five risk categories are addressed, including:
- Longevity Risk – The risk of living longer than expected and exhausting resources
- Health Risk – Retirees can face unexpected medical expenses and long-term care needs. As one ages out-of-pocket expenses rise quickly
- Market Risk – Risks such as market volatility and the housing market if the retiree has recently downsized
- Family Risk – This can include divorce or death of a spouse, and children becoming ill or unemployed
- Policy Risk – Social security is the primary income source for many retirees. The program's trust fund reserves are projected to be depleted by 2035 and people may experience a 20-25% benefit reduction after that.
The paper addresses responses to the Health and Retirement Study (HRS), a biennial longitudinal survey of a representative sample of U.S. households over age 50.
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As for survival probability, the question depends on the age of the respondent. If the age is less than 65, the question is asked for the chance of living to age 75; if the age is 65-69, the target age asked is age 80, and so on. At age 65, 66% of men believe they will live to age 80, where as 75% of women believe that. At age 69, 70% of men believe they will live until 80 and 78% of women believe that.
In terms of market volatility, respondents, since 2010, have been asked two more questions: the chance of gaining 20% or more over the next year and the chance of losing 20% or more. On balance, notes the report, individuals' expectations about volatility are much larger than the volatility of actual returns for the Wilshire 5000 Price Index, which bounces between the plus and minus 20% range, but generally stays positive.
Similar questions for respondents' expectations of their home value have been asked since 2010. Similar to the stock market responses, the house price responses show a significant overestimation of market volatility.
HRS respondents are asked the probability of spending $1,500 or more in the coming year, in terms of their medical expenses. Depending on their answer, they are then asked about other thresholds such as $500, $3,000, and $8,000. Interestingly, expectations don't change much as age increases, suggesting that older people underestimate medical spending and younger people overestimate it.
The data and question on family transfers was removed from the survey but based on 2006 data, individuals underestimate the possibility of a family transfer. Finally, The relevant question for this area of risk is respondents' expectations that the benefit they receive from Social Security will be cut at some point over the next 10 years. The average answer is about a 40% chance in the 2016 HRS, which is somewhat lower than other surveys.
The report says the three main sources of objective risk, from highest to lowest, are longevity, health, and market. It is not surprising that longevity risk tops the list, because it affects the planning horizon for the retirement period. Health risk ranks second, mainly due to the unpredictability of medical expenditures in late life, particularly the cost of long-term care. Market risk is third, thanks to retirees' relatively long – about 20 years – investment horizon.
Unfortunately, the report shows that retirees do not have a realistic or accurate understanding of their retirement risks. Education is a key driver at fixing that issue, as is a method of creating lifetime income either through Social Security or private sector annuities. Finally, the report notes that better-designed public programs and private products could be encouraged to protect retirees with limited financial resources.
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