[Insight & Opinion] Why Retirement Financial Planning Is So Challenging

Unstable Cash Flow Due to Longevity Risk
Withdrawal and Management Strategies Must Be Established Simultaneously
Health-Related Costs Should Also Be Hedged Through Insurance

From the perspective of risk management, the difficulty of retirement financial planning ranks at the highest level. Although it is not an easy task, investment risk, commonly expressed as volatility risk, can be managed to some extent by diversifying investments across various targets and time points. There is also the method of purchasing at a low price to secure a margin of safety. However, the situation is more complex in retirement financial planning. In addition to volatility management, longevity risk and sequence risk are added.

Longevity risk, now a widely recognized term, refers to the risk arising from living a long life. Economically, longevity risk means higher costs. The longer one lives, the more living expenses are needed during that period, and health often deteriorates in the late elderly stage (after age 75). More importantly, cash flow must not dry up and must be secured until the time of death to avoid retirement bankruptcy.

Sequence risk can be directly translated as ‘order of returns risk.’ Suppose A has investment returns of +27%, +7%, -13% over three years, and B has returns of -13%, +7%, +27%. A and B have the same 7% average annual return over three years, only the order differs. The problem arises when withdrawals are made. There is a huge gap between withdrawing after a 27% return at retirement and withdrawing after a 13% loss. It is not only the first year that matters; it affects retirement funds for a considerable period afterward. According to experts’ simulations, asset management 10 years after retirement determines overall old-age life. Ten years of management decides the retirement life.

Retirement financial planning is complicated because, as lifespan increases, withdrawals and management must be done simultaneously. For example, if one retires at 60 and lives until 90, they must withdraw money and invest for 30 years. Until now, most financial planning assumed accumulating the necessary retirement funds by age 60 and then living by withdrawing that money afterward. However, as lifespan lengthens, traditional financial planning has lost its footing. Now is the era where the tasks of withdrawal and management must be performed simultaneously.

First, individuals need to properly understand the meaning of risks arising from increased longevity. In addition to traditional risk management methods, longevity risk and sequence risk must be considered together. To this end, health-related costs should be hedged through appropriate insurance, and various assets generating cash flow should be combined to prepare for longevity risk. Withdrawal strategies must also be established. However, not many people can perfectly accomplish these tasks. The state or financial companies managing pensions must step forward. Financial companies should not remain merely at the level of attracting customer funds but provide education, content, and more advanced software. Consulting services that can hedge longevity risk through various strategies are also necessary.

It is not easy to prepare for longevity risk and sequence risk with just one product or asset. Only public pensions, which pay pensions until the time of death considering inflation rates, are completely free from these two risks. However, it is almost impossible to cover living expenses in old age with public pensions alone because the income replacement rate is low. Individually, one must create self-pensions by utilizing retirement pensions, private pensions, and existing assets to generate cash flow. The state and financial companies should spare no resources, including education, to enhance the capacity of citizens to manage risks arising from living longer.

Sanggeon Lee, Head of Mirae Asset Investment and Pension Center