Retirement – A Luxury Good by David Merkel, CFA of The Aleph Blog
Recently I was approached by Moneytips to ask my opinions about retirement. They sent me a long survey of which I picked a number of questions to answer. You can get the benefits of the efforts of those writing on this topic today in a free e-book, which is located here: http://www.moneytips.com/retiree-next-door-ebook. The eBook will be available free of charge through September 30th. I have a few quotes in the eBook.
Before I move onto the answers, I would like to share with you an overview regarding retirement, and why current and future generations are unlikely to enjoy it to the degree that the generations prior to the Baby Boomers did.
The first thing to remember is that retirement is a modern concept. That the world existed without retirement for over 5000 years may mean that it is not a necessary institution. For a detailed comment on this, please consult my article, “The Retirement Tripod: Ancient and Modern.” Here’s a quick summary:
In the old days, when people got old, they worked a reduced pace. They relied on their children to help them. Finally, they relied on savings.
Savings is the difficult concept. How does one save, such that what is set aside retains its value, or even grows in value?
If you go backwards 150 years or further in time, there weren’t that many ways to save. You could set aside precious metals, at the risk of them being stolen. You could also invest in land, farm animals, and tools, each of which would be the degree of maintenance and protection in order to retain their value. To the extent that businesses existed, they were highly personal and difficult to realize value from in a sale. Most businesses and farms were passed on to their children, or dissolved at the death of the proprietor.
In the modern world we have more options for when we get old – at least, it seems like we have more options. In retirement, we have three ways to support ourselves: we have government security programs, corporate security programs, and personal savings.
Quoting from an earlier article of mine, Many Will Not Retire; What About You?:
Think of this a different way, and ignore markets for a moment. How do we take care of those that do not work in society? Resources must be diverted from those that do work, directly or indirectly, or, we don’t take care of some that do not work.
Back to markets: Social Security derives its ways of supporting those that no longer work from the wages of those that do work. That’s one reason to watch the ratio of workers to retired. When that ratio gets too low, the system won’t work, no matter what. The same applies to Medicare. With a population where growth is slowing, the ratio will get lower. If the working population is shrinking, there is no way that benefits for those retiring will be maintained.
Pensions tap a different sort of funding. They tap the profit and debt servicing streams of corporations and other entities. Indirectly, they sometimes tap the taxpayer, because of the Pension Benefit Guaranty Corporation, which guarantees defined benefit pensions up to a limit. There is no explicit taxpayer backstop, but in this era of bailouts, who can tell what will be guaranteed by the government in a crisis?
That said, not many people today have access to Defined-Benefit pensions. Those are typically the province of government workers and well-funded corporations. That leaves savings as the major way that most people fund retirement aside from Social Security.
One of the reasons why the present generations are less secure than prior generations with respect retirement is that the forebears who originally set up defined-benefit pensions and Social Security system set up in such a way that they gave benefits that were too generous to early participants, defrauding those who would come later. Though the baby boomers are not blameless here, it is their parents that are the most blameworthy. If I could go back in time and set things right, I would’ve set the defined-benefit pension funding rules to set aside considerably more assets so that funding levels would’ve been adequate, and not subject to termination as the labor force aged.
I also would’ve required the US government to set benefits at a level equal to that contributed by each generation, and given no subsidy to the generations at the beginning of the system. Truth, I would eliminate the Social Security system and Medicare if I could. I think it is a bad idea to have collective support programs. There are many reasons for that, but a leading reason is that it removes the incentive to marry and have children. Another reason is that it politicizes generational affairs, which will become obvious to the average US citizen over the next 10 to 15 years.
Back to Savings
As for personal savings today we have more options than our great-great-great-grandparents did 150 years ago. We can still buy land and we can still store precious metals – both of those have a great ability to retain value. But, we can buy shares in businesses and we can buy the debt claims of others. We can also build businesses which we can sell to other people in order to fund our retirement.
But investing is tricky. With respect to lending, default is a significant risk. Also, at the end of the term of lending, what will the money be worth? We have to be aware of the risks of inflation and deflation.
In evaluating businesses more generally, it is difficult to determine what is a fair price to pay. In a time of technological change, what businesses will survive? Will the business managers be clever enough to make the right changes such that the business thrives?
You have an advantage that your parents did not have, though. You can invest in the average business and debt of public companies in the US, and around the world through index funds. This is not foolproof; in fact, this is a pretty new idea that has not been tested out. But at least this offers the capability of opening a fraction of the productive assets in our world, diversified in such a way that it would be difficult that you end up with nothing, unless the governments of the world steal from the custodians of the assets.
With that, I leave you to read my answers to some of the questions that were posed to me regarding retirement:
What is a safe withdrawal rate?
A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.
How should you handle a significant financial windfall?
If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce