Retirement – From Brutish To A Brouhaha: Shifting Winds And The Demographic Payback by Michael Aked, Research Affiliates

Key Points

  1. The obvious remedies (e.g., higher taxes, higher savings rates) for the problems related to a rapidly falling worker-to-retiree support ratio are unlikely to be embraced by U.S. constituencies, leaving governments’ and corporations’ abrogation of their pension promises to retirees as the most likely future scenario.
  2. Using the more complex lifetime savings models as a guide, we adopt a simple and straightforward model to analyze the impending retiree support problem.
  3. Demographic shifts are playing a major role in the current high valuations of developed market assets, putting near-term and current retirees in the precarious position of facing very low long-term yields on their investment portfolios.
  4. Dissatisfaction by both retirees and workers with their respective financial positions will fuel more intense social distress over the next decades as pension reform inaction comes home to roost.

Concerns over the U.S. retirement system are well known. We need not look far to see what our nation’s future will be if we continue to “kick the retirement system can” down the road, particularly in light of our nation’s 3-D hurricane of debt, deficits, and demographics (Arnott 2009 and Hsu 2011). Japan has been crushed by its growing mass of retirees, the nation’s “lost decade” now a quarter-century in length. Europe, also in the midst of demographic change, has been dangerously burdened in recent years with a rolling series of crises, strikes, and dramatic displays of political chicken. The United States, just like Japan and Europe before us, will soon be swept away on the prevailing winds of demographic change and the deepening socioeconomic problems that follow on. We must take heed.

In this article, we explore simple analogs to necessarily complex models used to better track the “when” of the growing economic challenges of an aging population. In particular, we look at 1) net savings rate and adjusted workforce experience and 2) global adjusted workforce experience as a means of assessing the economic pressures of a rapidly falling worker-to-retiree support ratio. Lastly, we analyze the required retirement age to maintain stable net retirement savings.

Battening Down the Hatches

If we are observant, one thing is obvious—the demographic problem of an aging population will not resolve itself by continued pursuit of traditional Keynesian demand stimulus. We must look further. Remedies for the pending pension and medical care challenge are limited:

  1. Higher taxes or evisceration of non-retirement spending
  2. Higher savings and investment rates
  3. Abrogation of the pension/medical promise
  4. Reduced payouts or larger co-pays
  5. Steady rise in the retirement age
  6. Means testing

Voters do not appear to support higher taxes as a means of redistributing income from workers to retirees as the worker-to-retiree support ratio falls. Workers do not support delayed retirement or changes in benefits. Policy makers, fixated on stimulating demand, are unlikely to draft programs that incentivize higher savings and investment rates (i.e., deepening of capital as a means to replace the lost income of retiring workers). Unfortunately, continued inaction will inevitably lead to abrogation by both governments and corporations of their respective pension/medical promises—perhaps the most drastic and disruptive of the possible solutions.

From Brutish to Balmy

Developed countries, generating around 80% of global gross domestic product (GDP) but home to only 20% of world population, have undergone a stark demographic transition over the last 150 years. Their citizens have migrated from lives characterized as “solitary, poor, nasty, brutish, and short” (Hobbes [1651], 2013) to lives in which retirement is a benefit all can enjoy for a generous number of years. The challenge now is how to honor the promises made to retiring workers as the number of workers drops in relation to retirees. Emerging nations will confront a similar challenge in the next two decades.

The life span of a U.S. citizen has increased substantially over the last century. In 1900, infant mortality stood at 15%. For those children who survived the first year of life, the average life span was just under 59 years. At age 25 an adult had a 55% chance of reaching 65 years, and those who achieved that milestone had typically only another decade of life. Over the next 50 years, life expectancy rose three months for every year that passed. If the reduction in infant mortality is also considered, the gain was an extra 4.5 months a year. Today the probability a U.S. citizen will reach age 65 is 92%, and once achieving that, will enjoy, on average, another 18 years of life.

Figure 1 compares the annual death/migration and birth/immigration rates of the U.S. population from 1905 to 2015. The birth/immigration rate, at 2.5% a year in 1900, has steadily declined to less than 1.5% today. The rate of death/migration has likewise trended lower, but at a much slower pace. Interestingly, the declining trend in births—a function of more children surviving into adulthood because of medical and health-related innovations, such as penicillin and clean water, as well as the higher cost associated with raising children—has been significantly more impactful than the declining trend in deaths.

From Brutish To A Brouhaha Retirement

These sweeping demographic changes do not bode well for the U.S. Social Security and Medicare systems, whose efficacy and viability have been thoroughly analyzed, and rightly so. Retirement savings accounts, whether individually owned or government controlled, constitute one of the largest pools of investment assets. In 2011, it was estimated that this global asset pool stood at 72% of the GDP of the Organisation for Economic Co-operation and Development (OECD) countries. Although many of the factors that drive flows into and out of retirement savings—such as government policy, employment rates, and investor sentiment—are inherently uncertain, the flows driven by long-term demographic trends are more predictable. To understand how agents in an economy can be expected to smooth their income in anticipation of retirement, we need to look at lifetime savings models.

Lifetime Savings Models

Basic models of individual behavior have been in place since Fisher (1930) penned his thoughts on intertemporal choice, also referred to as income smoothing. Since then, many others have contributed their thoughts and research in this area, including Modigliani (1970, 1976, 1998); Merton (1971); Bodie, Merton, and Samuelson (1992); Bodie and Crane (1997); and Bodie, Treussard, and Willen (2007).1

Others have added to the literature by constructing models for the economy as a whole, such as the successive improvements to the Fisher model by Allais (1947), Samuelson (1958), and Diamond (1965). The result is known as the overlapping generations (OLG) model. The OLG model encompasses a multigenerational approach and addresses intergenerational equity.  Recent work by Fehr, Jokisch, and Kotlikoff (FJK) (2007) builds on years of model parameterization and research. Their article “Will China Eat Our Lunch or Take Us to Dinner?” incorporates the global economic effects of labor and capital supplied by China. The FJK model is complex, as 24 pages of output tables attest. The plethora of numbers comes to one conclusion: it is not if, but when and how, the United States will pay for the unavoidable demographic transition to a more-aged society.

For an economy to adequately support a growing percentage of retirees, structural adaptations such as capital deepening, higher taxes, delayed benefits, or some combination of the three must occur. This acknowledgement is not new,

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