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Sunday, 17 May 2009

The End of the Age of Retirement

Bismarck’s Pension Policy

In 1889 Otto von Bismarck’s German government introduced the first old age pension scheme providing retirement benefits to people over 70, later reduced to 65. The aim of this wasn’t to provide a deserved holiday for old folks at the end of their lives but to ensure a safety net for those made incapable of working by the disabilities of extreme age. At the time the average Prussian lived to 45.

Since then, while lifespans have increased and the likelihood of illness in early retirement has declined, the retirement age hasn’t changed. In the developed world, where the most generous pension entitlements are offered, bitter demographic reality will soon see the end of the Age of Retirement: the idea that people stopped work and had a holiday before they died will one day seem like a curious feature of our peculiar times.

Demographics

Within developed nations there’s a clear trend – people are living longer and having less children. In 1950 there were 16 American workers for every retiree but by 2030 there’ll only be 2. The ratio in Italy is predicted to have declined to 0.7 workers per pensioner by the same date. 70 million American Baby Boomers, out of a total population of around 280 million, will reach retirement age between 2011 and 2028. At least 25% of these will live past 85. Across the developed world people are having less than the 2.1 children needed per couple to ensure population growth.

Under these circumstances how realistic is it to expect governments to continue fully funding pension and healthcare entitlements? They won’t simply announce this, of course, they’ll change the rules gradually in the hope that the frogs won’t notice that the water in the pan is starting to boil.

Bismarck’s Pension Trap

If the retirement age originally set by Bismarck had increased in line with longevity we’d now be looking at giving up work at 95. State mandated retirement is a fine example of what happens when the law of unintended consequences and perverse incentives collide. It’s modified people’s behaviour on a grand scale and reversing this will have severe implications over the next century. Worse still, anyone under fifty – and probably many who are older – who hasn’t prepared themselves for the changes is going discover what happens when an unfunded policy meets a shortage of taxpayers. It isn’t going to be pretty.

Most states don’t pay for retirement entitlements out of a pot of tax money saved by the retirees themselves. The money that today’s pensioners contributed was spent on their predecessors. It’s the taxes of today’s workers that are paying for today’s pensioners and as the baby boomer generation retires there’s increasingly going to be more of the latter and less of the former.

Company pensions don’t necessarily offer a solution. Many of these will fail to pay out because of the same demographic problems – too many pensioners, not enough employees. These are supposedly protected by government schemes which will simply add to the overall pensions underfunding problem.

Where have all the Children Gone?

Worse still, the concept of retirement and the expectation of pensions have led people in developed nations to abandon their investment in the traditional pension policy: children. We may curse and moan about the burden that children place on our finances but they were, historically, a person’s best chance of a vaguely comfortable old age.

One, completely unintended, consequence of the increase in state pension benefits has been the entirely rational economic decision of people to have fewer children. Why take on the horrendous additional cost of raising taxpayers when the state will provide for you in their stead? Which is fine as long as other people do the job of producing the next generation of taxpayers for you: this is where government policy meets group psychology and everyone loses.

The twin trap of increasing longevity and decreasing birthrates is forcing developed nations into a demographic dilemma from which there’ll be no easy escape. Caught in the middle are likely to be a generation of baby boomers, bereft of children and whose expectation of a state or even a company funded retirement will be rudely and roughly overturned. Being old is one thing, being old and poor is entirely another.

The Pension Gap

In this situation something has to give. People’s retirement savings have taken a big hit in the last couple of years with the result that many expectations of an early retirement are already being abandoned. The US based 2009 Retirement Confidence Survey shows that 28% of respondants have postponed retirement to increase their financial security. That’s likely to become an increasing theme over the coming years.

Gaps in pensions will need to be bridged either by working longer or by private savings. Many of those who have tried to save for themselves have failed to do so successfully. It’s not just those who’ve been badly let down by stockmarket charlatans who’ll have the biggest problem. People who’ve been putting their faith in property are likely to have a big shock – declining populations mean lessening requirements for homes.

In the meantime we’ve seen a huge expansion of the money supply by governments trying to prevent a financial crisis turning into a deflationary disaster. We’re now asked to believe that they will apply the brake of increased interest rates and the removal of excess money from the system at exactly the right time to avoid rapid inflation. Well, these are the same people that couldn’t spot that allowing sub-prime borrowers access to $1.5 trillion in home loans at the very peak of the property boom was a bad idea. Pardon me if I don’t hold out too much hope that they’ll get things right next time.

Rampant inflation, of course, is really bad for people on fixed incomes – like pensioners living off annuities. How stockmarkets perform in this environment can only be guesswork but masses of Baby Boomers retiring and taking out fixed income annuities would only drive the markets one way. However, if retirement has to be delayed, savings increased and the value of annuity incomes is destroyed by inflation that’s likely to be good for stocks.

Preparing for Retirement

For people now approaching retirement there’s not an awful lot of choice. Assuming that governments or even companies will continue to provide pensions that increase their value in real terms is very risky. Probably they’ll use the onset of inflation as a way of driving down the cost. Fixed income will likely be a very bad place to be for a number of years.

For those of us in middle age there’s at least some time to take note of the demographic trends and prepare ourselves. Assuming that we’ll retire at Bismarck’s 65, pick up inflation protected benefits and be able to sell our houses for enough money to fund a golden age of cruises, holiday homes and golf club memberships isn’t very wise. Doing some sensible paying down of debt and investing in the stockmarket in a way that will guarantee capturing the maximum returns for the minimum risk is a better bet. Something like globally oriented index trackers, maybe?

The young need to start thinking about having lots of children and saving lots of money. They’re likely to do neither – the way we’ve brought them up means that they simply don’t understand the challenges ahead. The pension trap is going to cause big intergenerational tensions – old people with lots of votes are not likely to take kindly to having the pensions they’ve worked for their whole lives taken away from them. Young people are not going to be happy about having huge taxes levied on them to pay for old people.

It promises to be an interesting century.

Related Posts: Going Dutch, The Benefits of Sound Money, Why the Growth of India and China Means Our Kids Should Do Media Studies

2 comments:

  1. Fantastic post, most people don't put much thoughts into this matter until they realized they are in their 40's to 50's and starts to panic about planning for their retirement needs. http://financial-planning-advice.blogspot.com/

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  2. Excellent post indeed, really describes the issue very well, one which few people understand, and fewer and fewer governments will be willing to take on for a risk of votes.

    ReplyDelete