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Putting Retirement at Risk: Has Financial Risk Exposure Grown More Quickly for Older Households than Younger Ones?

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University of Massachusetts Boston ScholarWorks at UMass Boston Gerontology Institute Publications Gerontology Institute 2014 Putting Retirement at Risk: Has Financial Risk Exposure Grown More Quickly
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University of Massachusetts Boston ScholarWorks at UMass Boston Gerontology Institute Publications Gerontology Institute 2014 Putting Retirement at Risk: Has Financial Risk Exposure Grown More Quickly for Older Households than Younger Ones? Christian Weller University of Massachusetts Boston, Sara Bernardo University of Massachusetts Boston Follow this and additional works at: Part of the Elder Law Commons, Finance and Financial Management Commons, Gerontology Commons, and the Retirement Security Commons Recommended Citation Weller, Christian and Bernardo, Sara, Putting Retirement at Risk: Has Financial Risk Exposure Grown More Quickly for Older Households than Younger Ones? (2014). Gerontology Institute Publications. Paper This Occasional Paper is brought to you for free and open access by the Gerontology Institute at ScholarWorks at UMass Boston. It has been accepted for inclusion in Gerontology Institute Publications by an authorized administrator of ScholarWorks at UMass Boston. For more information, please contact Putting Retirement at Risk: Has Financial Risk Exposure Grown More Quickly for Older Households than Younger Ones? Professor Christian E. Weller Department of Public Policy and Public Affairs University of Massachusetts Boston 100 Morrissey Boulevard Boston, MA And Senior Fellow Center for American Progress Washington, DC And Sara Bernardo Department of Public Policy and Public Affairs University of Massachusetts Boston Abstract Financial markets have been characterized by boom and bust cycles since the 1980s, while the responsibility for managing retirement wealth has increasingly shifted onto individual households at the same time. Policymakers and experts have expressed concern over rising risk exposure among older households, who appear to be increasingly exposed to the growing financial risks just as they near retirement. We consider household data from the Federal Reserve s Survey of Consumer Finances from 1989 to 2010 to analyze the correlation between age and risk exposure. We test if older households risk exposure has indeed grown over time, if it has increased more than that of younger households, if changes in the demographic composition of older households have contributed to older households rising risk exposure and the degree to which increases in risk exposure can be traced to a growing concentration of household assets held in stocks and housing and to rising household indebtedness. Our results indicate that risk exposure has grown more for older household than for younger ones, that demographic changes among older households have contributed to additional increases in older households risk exposure and that the growth of older households risk exposure is driven more by rising risky asset concentration and less by greater indebtedness. I. Introduction Household wealth, most of which is intended to pay for people s retirement, has become increasingly volatile since the 1990s due to substantial asset price swings and because households have become increasingly exposed to these price swings. Households held larger shares of their savings in risky assets and they became more indebted. Greater risky asset concentration and more indebtedness mean that the greater up and down movements in stock and house prices could do more damage to household wealth than would have been the case with less risky asset concentration and indebtedness. Alternatively, even if markets had not become more volatile households would lose more money than in the past, simply because of greater risk exposure more money held in risky assets and greater indebtedness. Several observers have expressed concern about the growing risk exposure of older households during this time period. Some have highlighted that many older households have few assets outside of their homes. Others, including Sen. Herb Kohl (D-Wi), chairman of the U.S. Senate s Special Committee on Aging in 2009, expressed concern about the substantial losses that some older households nearing retirement suffered in the stock market drop of 2008 because they still held large shares of their retirement assets in stocks (United States Special Committee on Aging, 2009). And, several experts worried about the rising indebtedness of older households (Copeland, 2013; McGhee & Draut, 2004). Risk exposure risky asset concentration and indebtedness -- has risen for all age groups (Weller, 2013) and summary data show that risk exposure among older households has grown more quickly than among younger ones, as we discuss below, which contradicts previous research on household risk exposure. Older households should have less risk exposure than younger ones to begin with since they have fewer years left before retirement to recover 1 potential wealth losses (Bodie, Merton, & Samuelson, 1992). Moreover, slower growth of Social Security benefits (Holst, 2005), disappearing defined-benefit pensions (EBSA, 2014), more health-related labor income disruptions (Rosen & Wu, 2004) and rising labor market risks (Rix, 2012) should all have led to less risk tolerance (Malmendier & Nagel, 2011). All of these changes have been more pronounced among older households than among younger ones during the 1990s and 2000s. Social Security s age for full benefit receipt rose for older cohorts, but stayed the same for younger ones, older households tend to be in worse health than younger ones and labor market risks, especially long-term unemployment, is higher and has risen faster among older households than among younger ones (GAO, 2012). Older households could theoretically still have increased their risk exposure due to financial market innovations that facilitate risk management, but this increase should have started from lower levels of risk exposure and should have grown more slowly than was the case for younger households. There are two possibilities to resolve this apparent contradiction between the data and theoretical predictions. First, the summary trend data could reflect compositional changes in older households relatively faster growth among households with a greater risk tolerance than among those with lower risk tolerance. Second, the summary trend data could mirror structural factors that put older households at a particular disadvantage in managing their wealth to avoid rising risk exposure. One factor may be household inertia, especially an inattention to the growing concentration of assets in stocks and housing as prices rose rather than reallocating assets to other, safer investments. Understanding trends in financial risk exposure among older households is of particular policy relevance. First, improving risk management tools such as financial advice may be particularly pressing if risk exposure of older households has risen faster than for younger households. 2 Second, understanding financial risk exposure by age and other household characteristics give policymakers a better sense of their target audiences to incentivize improved risk management strategies. Third, a detailed analysis of risky asset concentration and indebtedness also helps to identify priorities for policy intervention. The rest of the paper is organized as follows. Section II discusses the relevant literature, followed by a discussion of the data and the empirical analysis in section III. Section IV concludes. II. Literature review Financial risk exposure creates the chance that households will have lower than expected savings if financial market risks materialize, e.g. during a stock or housing market downturns near retirement. The literature generally shows that the most important reasons households save is to finance retirement and to have liquidity to pay for unexpected events (Bricker et al., 2012). The largest proportion of total household savings in home equity, stocks, bonds and cash are intended for retirement (Browning & Lusardi, 1996; Munnell, Webb, & Golub- Sass, 2012), while emergency savings play a much smaller role and bequests play a negligible role in people s decision to save (Bricker et al., 2012). 1 Understanding trends in risk exposure has only gained in importance over time as the need for individual savings has grown. People can expect to live longer, older households face more labor market uncertainty (Rix, 2011), the growth of Social Security benefits has slowed due to a rising normal retirement age and fewer workers have access to employer-sponsored 1 The fact that households frequently leave inheritances does not contradict their ex ante intentions. Inheritances are a byproduct of optimal planning with individual savings, when households do not or cannot annuitize their savings (Fornia & Almeida, 2008). Households will need to plan to spend their individual savings, including their home equity, over the maximum life expectancy to avoid running out of money in retirement, but they will on average only live for the average life expectancy, i.e. a large share of households will pass away before they have spent their money, even with optimal planning. 3 retirement benefits, especially defined benefit (DB) pensions (Copeland, 2013b) 2 than in the past. Market and investment risks Individual savings directly expose households to market risk and investment risks. Market risk exposure follows from large asset price swings, e.g. for stocks and houses (Baker, Krugman, & DeLong 2005; Campbell & Shiller 2001) and because of purchase and sale timing (Campbell et al. 1999; Weller & Wenger 2009). Investment risks exist because the complexity of investment decisions opens the possibility the households make decisions that result in suboptimal outcomes (Bernartzi & Thaler, 2007). Economists consider stocks and housing to be riskier financial assets compared to bonds and more liquid assets. Households benefit from equity stakes in stocks and housing because of the potential future flows of income the may receive as owners. Income from stocks comes from both the stockowner s claim on corporate income -- dividends less taxes -- and capital gains realized as a result of price appreciation when the stockowner sells the stock for more than the purchase price. Similarly, income from housing comes from saved rents and from home price appreciation if they sell the house for a higher price than what they purchased the house for. Incomes earned on stocks and housing and capital valuations can fluctuate over time, putting household assets at substantial risks. Stocks and housing entail similar risks that are not found in bonds or other liquid assets. Investing in bonds guarantees, within some limits, the bondholder the future interest payment and the face value when the bond matures. Therefore, if the bond is held until maturity, the owner knows for certain the return she will receive. 2 This assumes that DB pensions expose households to less market risk than individual savings do since DB pensions can smooth asset market fluctuations over time. 4 Storing wealth in the form of home equity exposes households to higher liquidity risks than if wealth is stored in other assets. Like other non-cash equivalent assets, in order to use home equity to purchase goods and services, it must be transformed into cash. The ease with which a portion of home equity or the total value of home equity can be liquidated depends on several, often highly correlated, market conditions. First, households may need to sell their home in its entirety in order to move into a residence that is more appropriate for their changing needs. If the need to sell coincides with a market downturn, households may lose a large share of their wealth in the process given that the interaction between housing and labor markets creates pro-cyclical illiquidity in housing assets. House-price swings are often regionally concentrated and regional house-price swings are highly correlated with labormarket conditions (Johnes & Hyclak, 1999; Chan 2001). The pool of potential buyers in the local labor market falls when unemployment goes up and when house prices consequently fall (Dröes & Hassink, 2009). Thus, households may not be able to sell their homes when they need to or they may have to sell at a lower price than anticipated. Illiquidity of housing assets further exacerbates market risk. Households may need to sell their home in its entirety, e.g. because credit markets are underdeveloped (Meyer & Wieand, 1996; Englund, 2002), rather than in small shares, at an inopportune time to move into a residence that is more appropriate for their changing needs (Dröes & Hassink, 2009). Similarly, homeowners may not be able to diversify their assets when housing prices increase if they face financial constraints (Englund, 2002). And, the interaction between housing and labor markets creates pro-cyclical illiquidity in housing assets. House-price swings are often regionally concentrated and regional house-price swings are correlated with labor-market conditions (Blanchflower & Oswald, 2013). The pool of potential buyers in the local labor market falls when unemployment goes up and when house prices consequently fall (Dröes & Hassink, 2009). The illiquidity of housing assets presents costly obstacles for households 5 attempting to effectively manage their risk exposure. Houses are hence comparatively risky assets at any point of investment and house prices tend to be more volatile than bonds, while the rate of return earned on housing assets does not fully compensate for the greater risk as compared to bonds. 3 Both stocks and housing constitute risky assets. This does not mean that renters automatically have less financial market risk exposure than homeowners. Homeowners should have fewer stocks relative to their assets than renters to compensate for their higher housing market risk exposure (Cocco, 2005). A selective risk exposure measure that considers only stocks would undercount the risk exposure of homeowners, for instance, and a selective measure that looks only at housing risk ignores by definition the risk exposure of renters. Changes in financial risks over time Market and investment risks associated with stocks and housing have risen over time. For one, both houses and stocks come with the substantial risk of a fall in value and lower returns than expected (Baker, Krugman, & DeLong 2005; Campbell & Shiller, 1998; Chen, 2001; Dröes & Hassink, 2009; Englund, Hwang, & Quigley, 2002; Meyer & Wieand, 1996). There was a widely acknowledged rise in stock and house price volatility since the 1990s (Campbell & Schiller 1998; Akerloff & Schiller 2010; Baker, Krugman, & DeLong 2005; Weller & Sabatini 2008), increasing the chances of lower than expected sale prices and returns after market run ups. The data also show accelerating market risk growth after 2000 compared to the 1990s. The period after 2000 saw both stock and housing market booms and busts, while the earlier years experienced only a stock market boom (Baker, Delong & Krugman, 2005). The size of the market swings was thus even more pronounced after 2000 than before. 3 For a discussion of the relevant literature, see Weller and Sabatini (2008). 6 Furthermore, households increasingly have had to handle financial risks in their savings on their own, raising the chance of investment risks that could amplify the consequences when market risks materialize. The share of households with a defined-benefit pension has declined since the early 1980s and the share of households with defined-contribution plans has grown (Weller & Wolff, 2005; Wolff, 2011). Defined-benefit pensions typically come with more protection from both market and investment risk than is the case for most definedcontribution plans, since they offer guaranteed income flows throughout retirement and are managed professionally for all participants in the plan (Bodie, Marcus, & Merton, 1988). Households will in theory reduce their risk exposure with defined-contribution plans as compared to defined benefit pensions as long as they believe that defined benefit pensions offer greater risk protections than defined contribution plans. Household leverage, or the ratio of household debt to income, also accelerated after The years after 2000 saw an unprecedented household debt boom that vastly accelerated household leverage compared to the 1990s (Barba & Pivetti, 2009). Even with unprecedented deleveraging after the 2007 crisis, households still held larger amounts of debt in 2010 than in any years before 2000 (Cooper, 2012). Risky asset concentration as risk exposure measure Households can theoretically protect themselves from financial risks through diversification. They can reduce the risk of substantial losses by putting their assets into different asset classes, so that only a part of their money is invested in risky assets. The share that households should theoretically invest in risky assets depends on their age, education, risk tolerance and total wealth (Merton, 1969; Haliassos & Bertaut, 1995; Guiso, Sapienza, & Zingales, 2008). Younger households, better educated households and households with greater risk tolerance, all else equal, should have larger risky asset shares than their counterparts. 7 But, where should households put their money to diversify their assets away from risky assets? Basic financial economics suggest that optimal diversification requires the rates of return of different assets to be ideally uncorrelated with each other (Markowitz, 1970). Importantly, asset prices within one asset class stocks, bonds or real estate tend to be highly correlated in large part because asset markets tend to follow fads (Campbell & Shiller, 2001; Baker, DeLong & Krugman, 2005). Therefore, diversification requires putting money in different asset classes, not in different assets within the same asset class. Price movements for stocks should be independent of those in savings bonds, for instance. Households consequently should diversify away from stocks and housing to bonds and liquid assets. Rates of return across asset classes could show some correlation, though. Returns on stocks and bonds can theoretically move in tandem as lower stock prices often reflect a weakening economy, which goes along with lower interest rates. But, empirical evidence shows that this correlation is weak, especially over longer periods of time (Campbell & Shiller, 2001). There is, however, some evidence that rates of return correlate between risky asset classes stocks and houses. Both house and stock prices often fall when the economy turns sour and rise when the economy improves (Case & Quigley, 2008; Case, Quigley, & Shiller, 2003). The possibility of a correlation between the rates of return across risky asset classes, not just within each risky asset class, only highlights the importance of diversification into safer assets, specifically bonds and liquid assets (Markowitz, 1970). But, psychological obstacles, e.g. inability to fully process complex information, inability to stick to a financial plan, status quo bias in financial decisions, and herd behavior often lead to systematic mistakes (Benartzi & Thaler, 2007; Campbell, 2006; Bernheim & Rangel, 2005). Households hence may not systematically diversify their assets to meet their preferences and financial needs. 8 The alternative to systematic diversification is that households do not regularly move out of risky assets nor invest more in risky assets when risky asset prices fall (Mitchell et al., 2006). Considering that risky asset prices rose for most of the period from 1989 to 2010 the years, for which we have data risky asset concentration should have risen up until the Great Recession started in 2007 alongside stock and house price increases, if households were inattentive to changes in their risky asset concentration. Growing risky asset concentration over the decades leading up to the Great Recession reflects not widespread financial savvy that allowed households to time the boom market, but rathe
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