Retirees face many financial risks, such as outliving their money, investment losses and unexpected health expenses, but a new study finds that they may be overestimating some risks while underestimating others.
In How Well Do Retirees Assess the Risks They Face in Retirement? by Wenliang Hou, a quantitative analyst at Fidelity Investments and former research economist at the Center for Retirement Research at Boston College, the study develops a lifecycle model of a typical retired household facing five categories of risk:
- longevity and the risk of living longer than expected and exhausting one’s resources;
- market risk associated with volatility and risks in the housing market;
- health, such as unexpected medical expenses and long-term care needs;
- family, such as divorce or death of a spouse; and
- policy risk, such as changes to Social Security.
The study then systematically values and ranks the impacts of these various risks from both the objective and subjective perspectives by quantifying the magnitude of the risks that retirees face and then comparing the two.
The analysis uses data from the Health and Retirement Study (HRS), a biennial longitudinal survey of a representative sample of U.S. households over age 50, which interviews approximately 20,000 respondents every two years on subjects like health care, housing, assets, pensions, employment and disability. For the objective risks, the study relies on several sources of data, including mortality data, market indexes, medical spending data and family transfers. The HRS asks respondents to assess the probability of various outcomes, ranging from 0 to 100 where zero means absolutely no chance and 100 means absolutely sure to happen.
Objective and Subjective
According to the findings, the biggest risk in the objective ranking is longevity risk, followed by health and market risk. In contrast, the subjective rankings show that market risk tops the list, which reflects retirees’ exaggerated assessments of market volatility, Hou notes.
As such, the analysis finds a disconnect between how actual and perceived risks are ranked:
- Actual: (1) longevity, (2) health, and (3) market.
- Perceived: (1) market, (2) longevity, and (3) health.
With longevity risk topping the objective results, the study explains this is because it affects the planning horizon for the retirement period. Based on the analysis, Hou estimates that a single person would be willing to give up 27% of his initial wealth to eliminate longevity risk. Similarly, a married couple would be willing to give up 33% of their initial wealth to avoid longevity risk.
In contrast, perceived longevity risk and health risk rank lower, because retirees are pessimistic about their survival probabilities and often underestimate their health costs later in life. In fact, the study found that expectations barely change as age increases, suggesting that older people underestimate medical spending and younger people overestimate it.
“Due to the pessimistic and relatively certain subjective life expectancy compared to what the life table implies, the magnitude of the longevity risk is smaller in the subjective analysis—equal to just 15% of initial wealth,” Hou notes. “A shorter expected life span also intensifies the market risk expectation because of a shorter investment horizon and reduces the subjective health risk due to a lower chance of facing the uncertain medical expenses in late life.”
The implications of this analysis are threefold, says Hou. First, he explains, retirees do not have an accurate understanding of their true retirement risks, highlighting the importance of educating the public on the most significant sources of risk. The analysis also reinforces the importance of longevity and market risk, underscoring the need for lifetime income either through Social Security or private sector annuities, he suggests. Finally, long-term care is also a significant risk faced by retirees, but one they often underestimate.
“Better designed public programs and private products, possibly integrated with life annuities, could be encouraged to protect retirees with limited financial resources from this potentially catastrophic risk,” the Fidelity analyst emphasizes.
