These statistics mean that the predictions about the pending bankruptcy of public pension and medical care programs likely understate, by a wide margin, the magnitude of the aging problem.
Falling Retirement Age
While we are living longer, we are retiring earlier. In the past, men and women worked until they died or were too ill to work. In 1935, when Social Security was passed, the average retirement age was sixty-nine and the average life expectancy at age sixty-five was less than twelve years. Now the typical worker at age sixty-five lives another 17.9 years, and a far higher percentage of the working population reach retirement.13 Yet the average retirement age has actually gone down from sixty-nine to sixty-three years.14 Over the last fifty years there has been an ever-widening gap between retirement and death, and many today express their desire to retire even earlier.15
In Europe the decline in the age of retirement is even more extreme. In the early 1970s European governments lowered the minimum retirement age from sixty-five to sixty.16 When doing this, most countries created no incentives for those considering retirement to stay in the workforce. A researcher for the Organisation for Economic Co-operation and Development (OECD) found that in eleven of twenty-six developed countries, a person age fifty-five who had worked for thirty-five years would receive the same pension as someone ten years older who had worked an extra ten years.17 The incentives to retire earlier were so strong that Europeans responded en masse. In France, the proportion of men aged sixty to sixty-four in the workforce fell from about 70 percent to under 20 percent, and in West Germany it fell from over 70 percent to 30 percent.18
With the coming age wave the question is no longer whether these trends will continue but when they will be reversed. The question is how much longer people must work, not how much earlier they will retire, and if they do retire early, how much will their living standards have to decline.
The Social Security Crisis
How does the age wave impact government pension programs? I recall a number of years ago reading that the two most popular government programs in the United States over the past century were Social Security and the interstate highway system. Looking ahead, it seems that our highway system is in much better shape than our retirement system. Almost every American has driven on the interstate highway system, but tens of millions of baby boomers have yet to collect from Social Security and Medicare. As the age wave crests through retirement, the pressures put on our governmental pension systems will be worse than the worst traffic jam ever experienced on our interstate highways.
I can picture some of you reading this and thinking, “I don’t especially care about the solvency of Social Security because I have enough wealth saved up in my retirement accounts to take care of my old age.” But the truth is, you had better care. The forces that threaten the Social Security system threaten the assets of all pension plans, public and private. What happens with Social Security, especially the Social Security trust fund, will directly impact the levels of your wealth.
Social Security: A Perpetual Money Machine?
Let us stand back and try to understand what the Social Security system does and what policies can or cannot solve those problems. Social Security was passed in 1935 in the depths of the Great Depression as part of President Roosevelt’s New Deal legislation. Social Security was designed as a “pay-as-you-go” system, which means that Congress decides on the level of benefits and then adjusts the tax rate or wages so that tax revenues will fund these expenditures.19 The pay-as-you-go system worked well for many decades. Congress greatly expanded the Social Security benefits, but the number of workers was always growing to fund the system with moderate tax increases. As a result, retirees usually received far more benefits than they contributed in taxes, even granting a generous rate of return on the amount they paid into the system.
The Social Security system seemed like a perpetual money machine, year after year yielding a return on participants’ contributions that were far greater than they could have received in the private market. Could this continue indefinitely? Believe it or not, it could. Paul Samuelson, America’s first Nobel Prize winner in economics, made this point when he wrote:
The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in.… How is this possible?.… Always there are more youths than old folks in a growing population. More important, with real incomes growing at some 3 per cent per year, the taxable base upon which benefits rest in any periods are much greater than the taxes paid historically by the generation now retired.… A growing nation is the greatest Ponzi scheme ever contrived.”20
Samuelson’s reference to the Ponzi scheme refers to Charles Ponzi, an Italian immigrant who offered investment schemes that promised fantastic returns and paid off early investors with money put in by later investors. When this scam was uncovered, everyone demanded their money and the scheme collapsed.
But Social Security is a legal and a sustainable Ponzi scheme as long as population and incomes are growing. Then there will always be more coming into the system than money paid as benefits. But if the population and income fail to grow, the game is over.
The Social Security Trust Fund
Heeding the threatening demographic trends, President Reagan convened a blue-ribbon panel in 1982 to study the issue and recommend solutions. The commission, headed by Alan Greenspan, recognized that the baby boom was going to cause severe problems with a pay-as-you-go system down the road. As the baby boomers retired, tax rates would have to be boosted dramatically on younger workers to pay the ballooning retirement benefits of the boomer generation. Higher payroll taxes could set the stage for a generational conflict and discourage entry into the labor force at the same time as the number of workers decline.
The proposed solution was to abandon the pay-as-you-go system, raise current Social Security taxes above the current level of benefits, and use the excess to buy U.S. Treasury bonds. These bonds, which accrued interest at the ongoing market rate, would be placed in a special trust fund that could be sold to generate funds when the boomers retired. This would presumably avoid the need to impose crushing taxes on the working population in order to pay retirees benefits.
Congress abided by the Commission’s recommendation and raised Social Security taxes sharply in 1983. The Social Security trust fund was designed to have sufficient bonds to keep Social Security solvent until well past the middle of this century, abiding by the seventy-five-year horizon that the trustees were obliged to use to measure the program’s solvency.
But in the years following the commission’s recommendations, fertility rates dropped, productivity lagged, and life expectancy increased beyond the commission’s expectations. These trends meant the trust fund would not collect sufficient funds to pay the benefits promised. In their 2004 report, the trustees predicted that by 2018 the fund would begin selling its huge hoard of government bonds, and by 2042 these funds would be exhausted. In 2042, unless taxes were raised dramatically, Social Security payments would have to be cut by almost 30 percent.
But even this forecast is too optimistic. The day of reckoning of the Social Security system is actually much closer than 2042, the date when the trust fund runs dry. This is because hundreds of billions of dollars worth of government bonds will have to be sold into the market well before 2042 to meet the surging benefit levels. These sales from the trust fund will hit the market at the same time individual investors are trying to liquidate their own assets to fund their own retirement. This tidal wave of stocks and bonds hitting the market will have a huge impact on asset prices. This is why everyone who has wealth in stocks or bonds must care about what happens to Social Security and the age wave.
Investor Strategies if the Age Wave Hits
If the age wave hits full force, we can expect a significant impact on asset prices. Inflation will increase as the demand for goods by the retirees outstrips the dwindling s
upply produced by the decreasing number of workers. This will make conventional bonds, which pay a fixed-dollar coupon and principal, a very poor investment.21 But stocks will not fare much better. It is true that stocks will weather inflation better than bonds, as corporate revenues will grow along with rising prices, but the shortage of workers will put upward pressure on wages, squeezing corporate profits and lowering the rates of return on equity capital.
Does this mean that investors should retreat to inflation hedges such as gold, silver, and perhaps natural resources? The short answer is no. As indicated in the last chapter, precious metals have provided investors no real return over long periods of time. Natural resources firms will not fare much better. The value of their land and energy reserves may keep up with the rate of inflation, but they will also be caught in the profits pinch as wages rise relative to the return on capital. Returns on real estate will not be any better as the aging of the population shrinks demand.
The best investment if the age wave strikes full force will be Treasury Inflation-Protected Securities, or TIPs. These securities, first offered in the United States in 1997, pay guaranteed fixed coupons and principal that are automatically adjusted by any changes in the price level.
When TIPs were first offered, their inflation-protected yield was 3 percent, a bit less than half the 6.8 percent average long-term real return on stocks. TIPs yields increased to 4 percent during the latter stages of the stock market boom, but they have subsequently fallen below 2 percent. If the age wave hits with full force, expect the TIPs yields to fall much further and their real yield will likely go below zero as everyone fights to preserve their capital. Certainly in a normal environment, TIPs returns are not competitive with stocks or real estate. But if the age wave strikes, these inflation-protected bonds will be the best of a bad lot.
What can be done, if anything, to prevent this depressing scenario from playing itself out both in the economy and in the financial markets? Is increased saving the answer? Higher payroll taxes? More immigration? Or is there something else, something far more hopeful, that can save us from drowning in the age wave? The answers will be found in the next two chapters.
CHAPTER FOURTEEN
Conquering the Age Wave:
WHICH POLICIES WILL WORK AND WHICH WON’T
“Results? Why, man, I have gotten a lot of results. I know several thousand things that won’t work.”
—Thomas Alva Edison
If current trends continue unabated, the developed world faces higher retirement ages, lower living standards, or a future where the old will fight with the young to get the benefits they believe they deserve. In the coming decade, these issues will spur political debate as the stark reality of underfunded public and private pension funds jolts investors and politicians to search for answers.
Pete Peterson, former secretary of commerce and author of the bestseller Running on Empty, advocates three measures: reduce benefits, increase taxes, and establish government-mandated savings accounts. He writes persuasively:
Some of these reforms do require some sacrifices: yes, more taxes than we like to pay, and yes, fewer benefits than we expect. But these sacrifices are truly minor compared to what we have endured before in our history and to what we and our children are likely to endure tomorrow if we fail to live within our means.1
But are these really the only answers to the aging crisis? Clearly, reducing benefits will “solve” the problem, but that is a solution by default. And I believe the other measures advanced by Peterson also fall short. In fact, many of the espoused solutions to the aging crisis, such as increasing payroll taxes, increasing immigration, and even increasing the savings rate, will do little to alleviate the problem, and some, such as increasing taxes, will make the situation worse.
Understanding why these proposals won’t work is the subject of this chapter. But don’t throw your hands up in despair. There is a solution. You shall see that our economy, in contrast to what Peterson claims, is not “running on empty.”
Modeling the Retirement Age
To study the impact of these proposed solutions I built a model of the world economy using population data from the U.N. Demographic Project. The model assumes that over time the output produced by the workers in an economy is sufficient to cover not only their own consumption but the consumption of the retirees as well. The model shows how the retirement age must rise to ensure enough goods are provided for all the retirees. When combined with assumptions about productivity growth, consumption patterns, and the aging of the population, the model provides a rich opportunity to study the dynamics of the world economy into the future.
On our current path, workers will have no choice but to work many more years than they do now if they wish to maintain their standard of living during retirement. Figure 14.1 shows how much longer Americans will have to work to achieve that goal.
Between 2005 and 2010, the trend of earlier retirement that has prevailed through modern history will be reversed. In the next several decades, not only will the retirement age be forced to increase from sixty-two to seventy-three, but that increase will be greater than the increase in life expectancy. Therefore, the time workers spend in retirement will decrease by nearly 25 percent. Because of their more severely aging populations, in Europe and Japan the retirement age must rise even faster.
These projections are based on a conservative estimate of the increase in life expectancy made by the U.N. demographers. If life expectancy increases at a more rapid rate, which many experts expect (see this page), then the retirement age in the United States may need to rise to eighty or even higher.
Consequences of Earlier Retirement
Although some accept extending their working years as a natural consequence of a rising life expectancy, few realize how dramatic these changes will be. Since the Industrial Revolution, workers have achieved shorter workweeks and longer retirements, and they view these developments as inherent benefits of economic progress.
FIGURE 14.1: PAST AND PROJECTED U.S. LIFE EXPECTANCY AND RETIREMENT AGE
In Europe, which has an older population than the United States, some of the public and private pension plans start paying retirees benefits in their fifties. A shift to a retirement age of seventy or more would be a dramatic turn of events. Even if workers accepted the increase in the retirement age, there are legitimate questions whether the older workforce would be competitive in the labor market and whether they could achieve the same productivity levels that are expected from younger workers.
The fact that demographic trends in the United States are significantly better than those in Europe or Japan should give Americans no solace. For many goods and services, the price is determined in a world market, and the retirees in Europe and Japan will be active bidders. Prices will be determined by the total demand for goods from retirees worldwide, not just demand in a single country.
What happens if Americans still insist on retiring at sixty-two, the current retirement age? Real asset prices will fall as boomers try to convert their stocks, bonds, and real estate into consumption goods. Retirees will not be able to generate nearly enough income from the sale of their assets to maintain a standard of living that they reached during their working years.
I estimate that if the current retirement age is maintained, the living standard of retirees who retire at midcentury will decline drastically to only 50 percent of the living standard they achieved at the end of their working life. Clearly few will accept this outcome, and many will be forced to return to work to raise their income.
A final option that could maintain retirees’ living standards would be to sharply raise taxes on the future working-age population to transfer monies to the burgeoning number of retirees. But younger workers will demand to know why they are subsidizing retirees who have inadequately prepared for their own future. This will inevitably create a generational conflict that will manifest itself in a bitter political battle, pitting the large number of nonworking retirees against a
smaller number of workers.
The three painful choices described here—increasing retirement age, accepting lower standards of living, or raising taxes on the working young—are inevitable unless other measures are taken. What can be done?
Greater Productivity Growth
Policies that increase the productivity of workers have the greatest potential to mitigate the impact of the age wave. Productivity, or output per hour worked, is the basic measure of our standard of living.2 Increases in productivity raise incomes and boost the amount of goods and services available to both workers and retirees.
Productivity growth mitigates the problems caused by the age wave because, while workers both produce and consume more goods, the consumption of retirees remains relatively stable during retirement. This means the output associated with the productivity increases can be spread across a greater number of retirees.
Government pension programs reflect retirees’ consumption patterns. While working, pension benefits are linked to average wages, but after retirement, pension benefits are indexed only to inflation. This is how Social Security and the great majority of private and governmental pension systems work around the world.3 A boost of productivity acts like an increase in the number of workers and offsets the population imbalances caused by the age wave.
The Future for Investors Page 20
