Financial assets are expected to play an increasingly larger role as a source for retirees’ income, which increases their financial fragility, according to the Center for Retirement Research.

In its latest report “Will the Financial Fragility of Retirees Increase?” CRR notes that the “increased dependence on financial assets” makes retirees more vulnerable to market downturns, especially if they have inadequate savings.

Retirees are becoming more dependent on financial assets to maintain their standard of living because of the shift in retirement savings from defined benefit pensions to defined contribution plans and because Social Security is expected to replace a smaller share of earnings due to the increase in the full retirement age (now 67 for those born between 1960 and 1967), according to the report.

Gen Xers and trailing boomers, the youngest boomers born between 1956 and 1964, are potentially the most vulnerable because they are the most dependent on financial assets as a share of their income at age 67, according to the report, which cites a 2012 study by Barbara Butrica and Karen Smith of the Urban Institute and Howard M. Iams, a researcher at the Social Security Administration. 

Financial assets account for roughly 85% of the income of the wealthiest Gen Xers and trailing boomers, according to that study. The comparable share for middle-income Gen Xers and trailing boomers is about 40% and for low-income Gen Xers and trailing boomers 27% and 20%, respectively.

Also vulnerable are those retirees who haven’t saved enough during their working careers to support a certain standard of living in retirement, and their numbers are growing, according to the report. “Retirement incomes going forward will replace a smaller share of retirement incomes than they do today.”

Replacement rates for the wealthiest Gen Xers and trailing boomers at age 67 are down 21% and 18%, respectively, according to projections from Social Security’s Office of Retirement Policy. For middle-income and lower-income Gen-Xers and trailing boomers, the expected replacement rates are down about 9% and 6%, respectively.

Moreover, these replacement projections may understate the actual deficits because ”they assume that households annuitize most of their savings at an actuarially fair rate … but very few retirees annuitize and even those who do cannot get actuarially fair rates,” the report notes.

This growing dependence on financial assets and reduced income replacement projections have implications for future retirees and their advisors:

  • They increase the importance of asset allocation and drawdown percentages from retirement savings. “Whatever the safe withdrawal rate and asset allocation, the risk of running out of money rises if retirees draw out more or invest a different amount in equities,” the report notes. It adds that the traditional 4% drawdown rule may be “too high given rising longevity and potential declines in investment returns.”
  • They also means more retirees may have to trim spending so that they don’t outlive their savings. The typical elderly household uses 80% of its expenditures for housing, health care, food, clothing and transportation, but a big financial shock such as a sudden increase in health care costs or loss of income when their spouse dies could easily leave them with insufficient funds to cover basic expenses. Women widowed between 2002 and 2004 typically received 62% of a couple’s Social Security benefit and only half an employer’s pension benefit when they need 79% of a couple’s income to maintain their standard of living, based on federal poverty thresholds, according to another study cited in the report.

“The most effective response for households approaching retirement is to increase their retirement income and reduce their fixed expenses,” the CRR preport concludes. It suggests that those future retirees work longer, annuitize wealth and take out a reverse mortgage to increase their retirement income and downsize to reduce fixed expenses and increase financial assets. “Whether the prospect of increased financial fragility leads them to change their behavior remains to be seen.”

— Related on ThinkAdvisor: