In retirement, you’re going to face many risks, such as outliving your money, investment losses, unexpected health expenses, unforeseen needs of family members, and maybe even retirement benefit cuts.
How important are those risks and do retirees properly perceive these risks when making their spending and investment decisions? Those are the questions Wenliang Hou, a former research economist at the Center for Retirement Research at Boston College and now a quantitative analyst with Fidelity Investments, sought to answer in a brief recently published by the Center for Retirement Research at Boston College.
In his research, Hou quantified the magnitude of the objective risks that retirees face as well as retirees’ subjective perceptions of the risks, and then compared the two.
And what he discovered is this: There’s a significant disconnect between actual and perceived risk.
The biggest risk in the objective ranking is longevity (the risk of living longer than expected and exhausting one’s resources), followed by health risk and market risk.
But, at the top of the subjective ranking, Hou wrote, is market risk, which reflects retirees’ exaggerated assessments of market volatility. And then, “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.” he wrote.
According to Hou, the implications of this analysis are threefold.
“First, retirees do not have an accurate understanding of their true retirement risks,” wrote Hou. “This finding highlights the importance of educating the public on the most significant sources of risk.”
Learning what risks you will face in retirement is indeed essential to building a sound retirement plan. And the risks you’ll face are many. Hou’s report focused on five risks but there are at least 15 risks you might face in retirement, according to the Society of Actuaries (SOA). These include, in addition to the five mentioned by Hou: inflation; interest rates; employer solvency; post-employment retirement; changes in housing and support needs; death of a spouse or partner; and divorce, separation and/or remarriage.
A good place to educate yourself about the risks you’ll face in retirement is the SOA’s Managing Post-Retirement Risks: Strategies for a Secure Retirement report. As you create your retirement plan, you’ll want to evaluate whether a risk is relevant to you; how predictable the risk is; the probability of the risk occurring; the consequences of the risk occurring; and how you’ll manage or mitigate the risk. Create, for instance, a table that lists all the risks you’ll face in retirement and then evaluate whether and how you’ll manage the risks that would have negative consequences if you faced them.
Given Hou’s findings, you’ll need to address first and foremost longevity. Now if you know your date of death, this would be an easy risk to manage. But you don’t know your date of death and that means you really don’t know how long your money has to last.
So, is there a way to predict how long your money needs to last? You’ve got some options but none are perfect.
First, you could rely on the law of large numbers. For instance, if you’re 65, you’ll live on average 18.1 more years if you’re a male and 20.7 more years if you’re female, according to the Centers of Disease Control and Prevention. But you really don’t want to rely on those statistics. For starters, those are the averages. Half die before those numbers and half die after. And you really don’t know which half you’ll be in.
Also noteworthy is the fact that half of the U.S. population misestimated their life expectancy by at least five years—either too high or too low, according to the SOA. And the consequences of guessing too high or too low are severe: People who underestimate their life expectancy face a greater risk of outliving their financial assets and experiencing financial stress in retirement, the SOA report and people who overestimate their life expectancy may not prepare properly for the care of financial dependents in the future in the event of their death.
Second, you could try using probabilities to get a sense of how long you might live. For instance, if you’re a 65-year-old couple, there’s an 89% chance that at least one of you will live to 85, a 72% chance that one of you will live to 90, a 44% chance that one of you will live to 95, and an 18% chance that one of you live to 100, according to J.P. Morgan Asset Management’s 2022 Guide to Retirement. Still, it’s not easy, for instance, to predict whether you’ll be in the 44% of couples where one lives to 95 or not.
These calculators will give you a much better sense of your personal life expectancy but again, there’s a chance you’ll live longer or die sooner than what’s predicted.
A fourth option would be to do what many financial planners do. Just use age 95 for your planning horizon. Sure, you’ll run the risk of dying sooner than 95 but the odds of living longer are small. So, in the worst case, your surviving spouse and beneficiaries might enjoy your pot of unused assets.
Hou’s “analysis confirms the importance of longevity and market risk.”
So, how might you manage longevity risk? Well, the answer depends on whether you’ll have enough guaranteed sources of lifetime income (Social Security, a defined-benefit plan, and annuities) to pay for your expenses throughout retirement. And, if you don’t have enough guaranteed sources of lifetime income, you might have to consider using some of the assets in your various retirement accounts to make up the difference by buying an annuity or using a safe withdrawal rate, such as the required minimum distribution (RMD) method.
Using a reverse mortgage is another option to manage and mitigate longevity, according to the SOA.
Read the SOA’s guide to learn how to manage and mitigate other retirement risks, including market risk.
Planning for long-term care
Long-term care is also a significant risk faced by retirees, but one they often underestimate, wrote Hou. “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,” he wrote.
Long-term care is a significant risk and you’ll need to figure out ways to manage and mitigate this risk. If you’re wealthy enough, you might be able to self-insure or, in the parlance of risk managers, retain this risk. At the other end of the net worth/income spectrum, Medicaid might be the answer. And for everyone else in the middle, long-term-care insurance or hybrid annuity/life insurance/long-term care insurance along with Medigap and personal assets might be the answer.
According to American Association for Long-term Care, a 65-year-old couple would pay $4,800 annually for a policy with a three-year benefit starting at $5,000 a month with a 3% inflation compound growth option. But premiums usually increase as people get older.
The odds of needing long-term care is another factor to consider. And here again, it’s a game of probabilities. Studies project that 70% of individuals over age 65 will need long-term care assistance, according to the SOA.
But some other research offers a different take. Very few retirees experience a catastrophic healthcare shock, according to a T. Rowe Price study. True, the likelihood of experiencing healthcare shocks increases with age, particularly after age 80 but very few retirees see a permanent increase in healthcare costs after having a large healthcare expense.
According to the study, almost one in 10 individuals ages 90-99 experienced a healthcare shock of $25,000 or more, but only 24% of men and 34% of women currently age 65 are predicted to live long enough to have to face those odds.
Retirees must try to answer several tough questions about healthcare shocks and long-term care to get a handle on the risk, writes Sudipto Banerjee, a vice president at T. Rowe Price and author of the research:
· Will I live into my 90s?
· Can I financially sustain a healthcare shock of a modest size?
· Will I have enough money if the increase becomes permanent?
Banerjee also provides in his report steps to take to prepare for out-of-pocket healthcare expenses, such as long-term care. Preretirees should:
1. Include realistic healthcare expense estimates in a retirement budget before terminating employment.
2. Thoroughly research ways to pay for potential long-term care expenses, including insurance and relying on a portion of your assets. Remember that long-term care expenses such as nursing home stays and in-home custodial care are generally not covered by Medicare.
3. Choose between enrolling in Medicare Part C (Medicare Advantage) or traditional Medicare. Consider adding a supplemental drug plan (Part D) and Medigap policy with traditional Medicare. Options like these beyond traditional Medicare can increase premium costs but may reduce potential out-of-pocket expenses.
And retirees should do the following:
1. Annually review existing health insurance coverage to ensure that it is appropriate, given the need and individual situation.
2. Consider earmarking assets that can be used to cover an unexpected healthcare expense. Revisit that amount annually.
3. Understand what insurance will and will not cover when it comes to long-term care.
4. Think about end-of-life healthcare. The decision to receive care at home or in a nursing facility can have very different cost implications. Also, skilled nursing home facilities are not always covered by Medicare, and nursing homes that provide custodial care are usually not covered by Medicare.
In the end, getting a handle on the actual versus the perceived risks you’ll face in retirement will give you peace of mind, and will allow you to sleep at night.