Abstract
Saving enough money to pay for one’s living expenses in retirement is daunting. But even if households save diligently, the money they put away may not be available when they need it because of a financial market crash just before retirement. Households typically want to invest their savings in something to earn a rate of return that will help pay for their retirement. Earning a rate of return generally comes with some financial risk—the possibility to lose part of the investment. People may invest their savings in stocks and hold a lot of money in housing, for instance, and stock and house prices may fall just before households need the money, leaving them with a lot less income to spend than anticipated. This is the essence of risk when it comes to savings. The question here is not whether taking risks is okay but what households can do to protect their savings from too much risk.
How would you personally define what a secure retirement means to you?1
“Guarantees that what you put there will be there.” (White man, 41 years old)
“As little debt as possible, don’t have to live on a monthly budget but the main thing as little debt as possible.” (White man, 34 years old)
“Job security while I am young.” (White woman, 44 years old)
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Notes
Dean Baker, J. Bradford De Long, and Paul R. Krugman, “Asset Returns and Economic Growth,” Brookings Papers on Economic Activity 2005, no. 1 (2005), 289–330, doi: 10.1353/ eca.2005.0011;
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Benjamin H. Harris, “Tax Reform, Transaction Costs, and Metropolitan Housing in the United States,” State and Local Finance Initiative (Washington, DC: Tax Policy Center, Urban Institute and Brookings Institution, 2013).
For a discussion of the relevant literature, see Christian Weller and Kate Sabatini, “From Boom to Bust: Did the Financial Fragility of Homeowners Increase in an Era of Greater Financial Deregulation?” Journal of Economic Issues 42, no. 3 (2008), 607–632.
See, for instance, Jacob S. Hacker, The Great Risk Shift: The New Economic Insecurity and the Decline of the American Dream (New York, NY: Oxford University Press, 2008).
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Neoclassical economic theory suggests that, based on expansions of the so-called life cycle hypothesis, the existence of labor market uncertainties should translate into households building up precautionary savings that they can rely on when earnings unexpectedly fall. That is, savings should move with earnings to some degree. But, the link between earnings and savings is not necessarily straightforward. Households theoretically should borrow more money if they experience unexpected earnings declines. But, many households may face credit constraints that prevent them from borrowing when they lose their job or see their wages fall. Households may cut their spending and maintain some or all of their saving when they face labor market risks. For reviews of the life cycle, see Martin Browning and Annamaria Lusardi, “Household Saving: Micro Theories and Micro Facts,” Journal of Economic Literature 34, no. 4 (December 1996), 1797–1855;
Martin Browning and Thomas F. Crossley, “The Life-Cycle Model of Consumption and Saving,” Journal of Economic Perspectives 15, no. 3 (2001), 3–22, doi: 10.1257/jep.15.3.3. More recent theoretical development further suggests that behavioral obstacles may prevent households from optimally saving, possibly exacerbating savings fluctuations when earnings decline. For a review of the relevant literature on psychology and economics,
see Stefano DellaVigna, “Psychology and Economics: Evidence from the Field,” Journal of Economic Literature 47, no. 2 (2009), 315–372, doi: 10.1257/jel.47.2.315.
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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 (João F. Cocco, “Portfolio Choice in the Presence of Housing,” The Review of Financial Studies 18, no. 2 [2005], 535–567, doi: 10.1093/rfs/hhi006). A selective risk exposure measure that considers only stocks should 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.
Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments 16 (New Haven, CT: Yale University Press, 1970).
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For summary discussions of the wealth effect, see Congressional Budget Office, “Housing Wealth and Consumer Spending” (Washington, DC: CBO, 2007);
James M. Poterba, “Stock Market Wealth and Consumption,” The Journal of Economic Perspectives 14, no. 2 (2000), 99–118.
For additional details on trends and group differences in financial market risk exposure, see Christian Weller, “Making Sure Money Is Available When We Need It” (Washington, DC: Center for American Progress, March 2013); and Christian Weller and Sara Bernardo, “Aging with Risk: Has Financial Risk Exposure Grown Faster for Older Households since the 1990s?” (forthcoming).
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Guy Debelle, “Macroeconomic Implications of Rising Household Debt,” BIS Working Paper No. 153 (Basel, Switzerland: Bank for International Settlements, 2004), 1–41.
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© 2016 Christian E. Weller
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Weller, C.E. (2016). Americans’ Growing Risk Exposure. In: Retirement on the Rocks. Palgrave Macmillan, New York. https://doi.org/10.1057/9781137575142_2
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