How Accurate Are Retirees’ Assessment of Risks?

Aug 18, 2020 / Amanda Chase, Horsesmouth Assistant Editor

Retirees with limited financial resources face numerous risks, including outliving their money (longevity risk), investment losses (market risk), unexpected health expenses (health risk), the unforeseen needs of family members (family risk), and even retirement benefit cuts (policy risk). This study systematically values and ranks the financial impacts of these risks from both the objective and subjective perspectives and then compares them to show the gaps between retirees’ actual risks and their perceptions of the risks in a unified framework. It finds that 1) under the empirical analysis, the greatest risk is longevity risk, followed by health risk; 2) under the subjective analysis, retirees perceive market risk as the highest-ranking risk due to their exaggeration of market volatility; and 3) the longevity risk and health risk are valued less in the subjective ranking than in the objective ranking, because retirees underestimate their life spans and their health costs in late life.

This paper develops a life cycle model of a typical retired household facing the five categories of risk discussed above. To perform the parallel analyses from both the objective and subjective perspectives, this study first applies the objective risk distributions from the empirical data, such as life tables and historical market returns, and, in a second step, estimates the subjective risk distributions from the survey data in the HRS. Using the method of utility-equivalent wealth, the parallel analyses quantify the five risks to generate two rankings—one for objective and one for subjective risk. The biggest risk in the objective ranking is longevity risk, followed by health risk and market risk. Policy risk ranks at the bottom, because Social Security reform is unlikely to have a significant impact on people who have already retired.

At the top of the subjective ranking is market risk, which reflects retirees’ exaggerated assessments of market volatility. Perceived longevity risk and health risk rank lower, because retirees are pessimistic about their survival probabilities and often underestimate their health costs in late life. The results highlight the importance of educating retirees on the sources of their retirement risks. Moreover, this paper provides a unique angle to encourage the use of annuities to hedge both the longevity risk and market risk and to emphasize the demand for long-term care insurance to cover the risk of high medical costs in late life.

More work needs to be done to improve the estimation of the subjective risk distributions. For example, which type of distribution would best represent the risk expectations in people’s minds? How can the estimation of the rounding standard be improved using the survey data? And could a learning paradigm be embedded in the analysis that would allow retirees’ expectations and resulting decision-making to evolve as they experience real-life risks?

You can find the full Center for Retirement Research study here.

 

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