When planning for retirement, it’s important to have a good sense of one’s income sources, expenses, and the various risks to one’s finances over the course of retirement, which could last for two or three decades.
Researchers have identified five major financial risks retirees face: Longevity risk (living longer than expected and running out of savings), market risk (ups and downs in the market affecting account balances), health risk (unexpected health care costs), family risk (financially supporting relatives), and policy risk (potential changes to benefits like Social Security).
Recent research from the Center for Retirement Research at Boston College finds many retirees have an inaccurate sense of which risks pose the biggest threats, which could leave them unprepared. In a survey of about 20,000 people over the age of 50, retirees routinely underestimated their life expectancy and health care costs, while overestimating the effects of the stock market on their finances.
Survey respondents ranked market risk as the biggest risk they face, followed by longevity and health. In what the study author calls an “objective” ranking, longevity risk tops the list, followed by health and market risks.
As people increasingly rely on defined contribution plans like 401(k)s and IRAs for retirement savings, having an inaccurate understanding of these risks can have serious implications for a retiree’s finances.
Defined benefit retirement plans like the one offered by Colorado PERA use strategies that address these risks, particularly longevity risk, to provide retirement security throughout a member’s retired years.
Longevity risk and PERA
PERA’s Defined benefit plan provides a retirement benefit that a retiree cannot outlive. That means when a member retires, PERA will continue to provide monthly income until the retiree dies, regardless of how long they live.
Defined benefit plans accomplish this by pooling funds and thereby sharing risk. All contributions, interest, investment gains and other dollars are held in a trust fund that is used to make benefit payments for members. Because all retirees are drawing income from the same source, they share longevity and market risk. For example, a retiree who lives longer than expected will draw more income from the fund while a retiree who dies sooner than expected will draw less – essentially balancing each other out.
To fund each member’s retirement, Defined benefit plans like PERA only have to plan for the average life expectancy of the group, not each individual’s expected lifespan.
Ensuring the Defined benefit trust fund have enough money to pay retirement benefits for decades to come means making sure PERA has an accurate picture of its membership and potential changes in the future. PERA must be able to estimate how long members will live, how much of a benefit they’ll earn, and other factors.
That’s where actuaries come in. These highly skilled mathematicians have the important task of calculating the plan’s liabilities (how much money is owed to benefit recipients) and determining how much money the plan will need on hand to meet those liabilities.
Among PERA retirees, the average age at which members retired in 2021 was 59, and the average age of death was 83, so PERA may have to pay a retiree benefits for more than 20 years, on average.
Those numbers won’t always be the same, however. Factors such as life expectancy change over time, so it’s important for plans like PERA to periodically review and adjust. PERA embarks on this process every four years with what is known as an experience study, which compares what actually happened in a given time frame against what PERA projected would happen.
PERA last conducted an experience study in 2020, and the Board of Trustees adopted several new assumptions as a result. This process will take place again in 2024.
In addition to longevity risk, PERA can help members plan for other types of financial risk, as well. The PERAPlus 401(k) and 457 plans provide low-cost options to set aside extra money for retirement. This can help with large or unexpected expenses, such as health care or rising costs of goods and services.
By pooling assets and regularly monitoring and adjusting as needed, PERA can help alleviate the stress associated with retirees’ biggest financial risk and continue to provide reliable monthly income they can’t outlive.
Trust fundA fund in which money and/or other assets are held and managed by trustees on behalf of plan participants. PERA maintains trust funds for each of its Defined Benefit Plan divisions (State, Local Government, School, Denver Public Schools, and Judicial).Trust fundA fund in which money and/or other assets are held and managed by trustees on behalf of plan participants. PERA maintains trust funds for each of its Defined Benefit Plan divisions (State, Local Government, School, Denver Public Schools, and Judicial).Defined benefitAlso known as a pension, this is a type of pooled retirement plan in which the plan promises to pay a lifetime benefit to the employee at retirement. The plan manages investments on behalf of members, and the retirement benefit is based on factors such as age at retirement, years of employment and salary history.Defined benefitAlso known as a pension, this is a type of pooled retirement plan in which the plan promises to pay a lifetime benefit to the employee at retirement. The plan manages investments on behalf of members, and the retirement benefit is based on factors such as age at retirement, years of employment and salary history.Defined contributionA type of individual retirement plan in which an employee saves a portion of each paycheck (along with a potential employer match) and invests that money. The employee’s retirement benefit is based on their account balance at retirement. A 401(k) is a type of defined contribution plan.