What are your biggest concerns about retirement security? They probably don’t match reality

A lot of people may wonder if their retirement plans were permanently damaged by this year’s stock market drop. The 21% first-half decline has increased anxiety. It’s not easy to make up such big reversals. But stock-market swoons aren’t the main peril that should concern retirement-focused Americans, according to a study by the Center for Retirement Research at Boston College. Rather, two other issues could cause bigger problems — unexpected healthcare costs and outliving one’s money. The study acknowledges that planning for retirement is difficult because there are numerous hazards, including the three cited, that are difficult to estimate. And there are other risks, such as unforeseen financial demands from family members, which the study describes as family risk, and the possibility that retirement benefits including Social Security could get cut, known as policy risk. Wenliang Hou, a quantitative analyst at Fidelity Investments and a former research economist at the center, wrote the study. He assessed the major risks facing retirees, concluding that outliving one’s money is the big one. He also noted that most Americans seem to focus their attention elsewhere. In other words, there’s a disconnect between perceived and actual risks in retirement planning, in his view.

What people should worry about

Based on his analysis of various research studies, Hou ranked longevity risk as the major retirement challenge, followed by unexpected health costs and then market risk. In addition to stock volatility, the latter also includes possible housing-price declines. He placed family risk fourth. This could include the financial impact of divorce, the death of a spouse or adult children needing handouts. Then came policy risk, which largely reflects the danger that Social Security retirement benefits could drop by 20% to 25% by 2035. That’s when the program’s current surplus, the trust fund assets, are expected to run out if Congress doesn’t shore up the system before then. Hou relied on several sources to devise these rankings, including life-expectancy tables, historic volatility measures for the stock market and housing, medical-cost data and research on family transfers — what people 65 report that they give to adult children or other family members or friends.

What people worry about instead

But these rankings conflict with what Americans say they’re more concerned about. The public ranks market risk at the top, followed by longevity and health risks. Then come family and policy worries. To determine this, Hou relied on responses from the Health and Retirement Study, a survey of roughly 20,000 respondents ages 50 and older, conducted every two years by the University of Michigan. The comprehensive survey addresses topics including health care, housing, assets, pensions, employment and disability. Among the key findings, according to Hou, is that Americans including retirees tend to underestimate how long they might live and underestimate their health-care costs later in life. Both factors can lead to people outliving their money. One interesting finding about health care costs is that expectations barely change even as respondents increase in in age. This suggests that “older people underestimate medical spending and younger people overestimate it,” he wrote. Unexpected, out-of-pocket medical spending can include that for insurance premiums, drugs, hospital stays, nursing home care, doctor and dental visits and more. A 65-year-old couple retiring this year should plan on about $315,000 in combined out-of-pocket health costs over the rest of their lifetimes, according to a Fidelity estimate.

Overestimating investment risks

Another key finding: Americans and retirees tend to exaggerate stock market volatility, viewing long-run price fluctuations as more severe than they really are. The Health and Retirement Study asks various questions about how Americans perceive stock-market risk. The main question is whether respondents think stocks will be worth more next year than they are today. Others involve the chance of gaining 20% or more over the next year, or losing 20% or more. “On balance, individuals’ expectations about volatility are much larger than the volatility of actual returns,” Hou wrote. Using the broad Wilshire 5000 index as a guide, he noted that annual returns tend to bounce between 20% and minus 20% but generally stay positive. Similar to their stock market responses, Americans also tend to overestimate the volatility of housing prices, he added.

Dealing with retirement obstacles

The Boston College study didn’t offer many retirement-planning suggestions, though the paper did underscore the need for greater education. Also, Hou cited lifetime income sources as a possible solution. These can involve annuities or Social Security, which largely acts as an annuity. Predictable income, especially with COLAs or cost-of-living adjustments as with Social Security, can help retirees avoid stock market risk while also hedging for the possibility that a person could outlive other income sources. As for greater education, two obvious examples pertain to stock market risk and life expectancies. Younger retirees around age 65 or so might not think they will live into their 80s, 90s and perhaps beyond, but the overall odds suggest that most will. Consequently, younger retirees still can expect to have relatively long investment horizons of 20 or more years, Hou noted. That’s important because stock risk tends to dissipate over time. Since 1950, the market as represented by the Standard & Poor’s 500 index has dropped as much as 39% in a single year, according to JP Morgan Asset Management. But over rolling 10-year periods, the worst loss was 1%, and the market has never logged a negative return over any 20-year stretch within that time frame. Stock market resiliency is worth noting for anyone worried about long-term damage to their retirement finances, especially during a tough year like the current one.