Behavioral Risk and Designing Retirement Income Strategies

Many factors are in play when you’re designing retirement income strategies. A recent analysis from T. Rowe Price argues that investors’ preferences and tolerance for risk should be most prominent.

In “Incorporating Behavioral Risk Preferences in Retirement Income Strategy Design,” T. Rowe’s Anna Dreyer, Associate Director of Research, Multi-Asset; Luiza Pogorelova, Multi-Asset Quantitative Investment Analyst; and Som Priestley, Multi-Asset Solutions Strategist, discuss research they conducted on investor preferences and how prominently they figure in designing retirement income strategies.

Dreyer, Pogorelova and Priestley looked at the impact that investors’ preferences and demographics have on optimized withdrawal strategies that could be followed in retirement. For purposes of their study, “preferences” incorporates attitudes toward consumption risk, liquidity, longevity risk and legacy. “Demographics” incorporates salary, expected salary growth, contribution rates, retirement dates and mortality schedules, and they define it as “the interaction between salary and expected mortality.” They studied the effect of “income-dependent mortality assumptions” on the best withdrawal strategy that should be followed during retirement.

Dreyer, Pogorelova and Priestley report that they found that “the effect of using a salary-dependent mortality schedule depends more on an investor’s risk aversion than it does on demographic characteristics or the specific withdrawal strategy under consideration.” They found that while lifetime earnings and longevity are connected, how a retiree will adapt their retirement spending strategy and how important adjusting for a longevity gap ultimately will be determined by an investor’s risk tolerance. And the importance of investor preference goes even farther, they contend, arguing that it “also extends to other dimensions of the retirement income challenge.”

In more concrete terms, Dreyer, Pogorelova and Priestley write that investors who are risk-neutral tend to focus only on expected values, such the mean of a distribution of possible outcomes. Investors who are risk-averse, however, are sensitive to volatility concerning expected retirement consumption – which, they say, means that such an investor expects to have a shorter lifespan and is cautious in changing his or her withdrawal strategy.

Action Steps

Dreyer, Pogorelova and Priestley say that the importance of investor preference “highlights the need for a robust analytical framework when assessing investors’ retirement income options.” They further say that their findings bring into sharper relief how important it is to have a comprehensive framework that addresses demographics, risk preferences and their interaction when one is designing retirement income strategies. “Our findings highlight the need for proper modeling of investor risk aversion and other preferences when designing retirement income strategies,” they write.

Dreyer, Pogorelova and Priestley say that “a comprehensive and cohesive framework is necessary when analyzing the full implications of a retirement assumption,” since connections between assumptions can change outcomes significantly. And most important, they say, “We believe that investor preferences should be the primary drivers of strategy design.”