How Life Expectancy Impacts Retirement Planning

Increases in productivity are responsible for increasing living standards over the last few centuries. In turn, productivity is enhanced by improvements in technology, which enable us to produce more output from the same number of inputs. Technological innovations can take various forms including better products, production techniques, and more efficient consumption.

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Increases and Tradeoffs

These developments have been responsible for increases in human longevity throughout the 20th century and into the 21st. For the first half of the 20th century, technology mostly triumphed over diseases that had killed people prematurely – in infancy, childhood, and young adulthood. In the last half of the century, technology began chipping away at diseases of old age, increasing average life expectancy for people aged 65 and older.

Technological advances and productivity improvements have vastly improved man’s lot in life. Yet they come with tradeoffs. Every improvement brings new problems along with its solutions to old ones. This truism has given rise to the term “the price of progress.” This even applies to increases in human longevity. With longer life comes the problem of how to fund it.

Life Expectancy and Retirement Planning in the Old Days

It may not seem obvious that longer life creates problems as well as happiness. The best way to clarify these tradeoffs is to compare retirement planning in the old days with today’s version. Fifty years ago, average life expectancy barely exceeded seventy years; life expectancy at age 65 was roughly 74. Before retirement, people were advised to begin the wholesale transition of their assets from growth-oriented equities to fixed-income assets such as bonds. The process was completed at retirement. Social Security’s official retirement age was 65; its early retirement started at 62.

There was little reason to hold equities after retirement. The risk was substantial; one severe market downturn could ruin a retirement portfolio weighted towards stocks. The potential benefits were small; with less than a decade to go before death, on average, there was insufficient time for the long-term superiority of equities to assert itself and not enough time to make up for large losses incurred.

Inflation is a deadly enemy of those on fixed incomes, but inflation was not a mortal threat to retirees then. At that point, the U.S. had experienced hyperinflation only in wartime. A retirement that lasted less than 10 years was unlikely to be ruined by inflation; at worst it was an inconvenience.

The Transition to a New Era in Retirement Planning

Things started to change in the 1960s. Scientific advances, begun after World War II and continued into the 1950s, began to pick up speed. This process was gradual, though. The highly-visible developments affecting retirement planning began with changes in economic history and policy.

The advent of Keynesian economics brought an avowed intention to enforce “full employment” by means of expansionary federal-government policies. After achieving temporary success, the increases in the money supply required to drive the policy began to produce inflation. Despite imposition of various kinds of wage and price controls, the inflation worsened and became a three-alarm fire in the 1970s.

Investors – encouraged by the same Keynesian economists responsible for the inflation – turned toward equities in the belief that, since higher prices represented more money to the companies that raised them, stock prices would increase at least pari passu with inflation. They did not. Instead, investors found it difficult to gauge the relative value of stocks because they could not distinguish an increase in revenues due to inflation from an increase due to higher consumer demand for the company’s products.

Fixed-income investing was no picnic, either. Expanding the money supply lowered short-term interest rates, which harmed those people on fixed incomes and dependant on interest income for income. The lower interest rates increased bond prices due to the inverse relationship between these two variables. Fixed nominal yields were vulnerable to increases in inflation, which lowered the purchasing power of the interest payments. Inflation was an equal-opportunity menace, decimating the pensions received by middle-class workers and the bond coupon payments received by the high-rent, rentier class. Thus, retirees had a vested interest in a change in policy.

Social Security redistributed income by taking in taxes paid by younger workers and transferring it to benefit recipients. Unfortunately, lower birth rates meant that the steady stream of young workers – the source for Social Security payouts – was beginning to flag.

The 1980s saw the conquest of inflation, the return of economic growth, and – not coincidentally – a dramatic resurgence of the stock market. It also saw several innovations in financial markets, among them the birth of the money-market mutual fund and the introduction of competition into heretofore-compartmentalized and artificially controlled markets such as banking and securities. “Defined benefit” retirement plans (primarily pensions) were overshadowed by “defined contribution” plans (such as IRAs and 401k plans) in which the plan owner controls the allocation and direction of investment. Almost half of America acquired ownership of stocks either directly or indirectly.

As these trends continued throughout the 1990s, average life expectancy at age 65 continued to increase. The significance of this advance for retirement planning was obscured by the large increases in portfolio values of many Americans whose defined contribution plans grew markedly in value. This increase was so sizable, in fact, that many Americans planned to retire early – a neat trick considering that the combination of early retirement and longer life bumped up the amount of wealth necessary to sustain retirement.

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From “Virtuous” to “Vicious” Cycle

Economists characterize events of the 80s and 90s as a “virtuous” cycle, in which good things reinforce each other and most change is for the better. In the last decade, however, the picture reversed and the cycle turned “vicious.” With the precipitous recent decline of stock prices, stock-market growth over the decade entered negative territory. The fall of real-estate values also reduced the net worth of many Americans. The focus changed from early retirement to just getting through retirement without running out of money. While it is true that increasing life expectancy would have presented some problems even in a world of continued economic growth, actual events and trends have vastly magnified the size and scope of the problem. Accelerating health-care costs were the clincher in the vicious cycle, since medical expenses tend to mushroom in the last years of life.

Today, the retirement security of Americans is threatened as never before. Middle-aged and older Americans have substantial chunks of their retirement wealth tied up and “pre-annuitized” in the Social Security system and company pensions. Social Security is imploding as its economic viability and political popularity are rapidly eroding. Many companies strive to escape their pension liabilities; indeed, those liabilities are currently unfunded in the aggregate.

Many Americans have mourned the loss in value of their 401k and IRA accounts. Ironically, this is the most soluble problem facing them – stocks can gain value relatively quickly provided that the climate is favorable for economic growth. Unfortunately, there is little reason to rejoice about those prospects.

Remedial Retirement-Planning Steps

One step many people can and will take is to defer retirement. The Social Security system has already changed the basic retirement age from 65 to 67. Deferring Social Security benefits until the latest possible moment is one way of making those benefits last as long as possible. Similarly, waiting until the last possible moment to begin taking income from your wealth is one way of making it last until your death.

A second sensible step is to lock in a guaranteed benefit of some kind. At this point, annuities underwritten by private insurance companies are perhaps the soundest way of doing this. Currently, private annuities serve primarily a high-cost market – high-income, long-lived annuitants. This drives up annuity prices, making them less attractive. This approach would be strengthened by a reform that privatized Social Security in ways similar to the Chilean and European reforms.

Another sound action would be to annuitize only a portion of retirement wealth – ideally, a portion sufficient to fund coverage of basic expenses such a food and shelter. Remaining wealth could be diversified so as to gain from an eventual economic recovery, thereby allowing a more comfortable retirement. Equity-oriented investments like mutual funds would form part of that diversified portfolio.

Summary

Longer life expectancy is universally considered a good thing. Yet it can create problems as well as benefits. The most pressing problem is how to make retirement wealth last throughout the retiree’s life.

In the old days, shorter life expectancies caused few problems. The standard strategy was to unload equity investments gradually until, at retirement, fixed-income asset such as bonds comprised almost the entire portfolio. Inflation might be troublesome, but retirees did not rate to live long enough for it to ruin their retirement.

Changes in the economic climate and policy shook this conservative strategy to its foundations. These tended to overshadow the steady, gradual increase in life expectancy at age 65 that characterized the second half of the 20th century. The virtuous economic cycle beginning in the 1980s built up a large store of retirement wealth in Americans’ IRA and 401k accounts, tamed inflation and brought competition to the financial system.

The virtuous cycle was replaced by a vicious one in the first decade of the 21st century. Now the increase in life expectancy carried with it potentially devastating tradeoffs. The decline of the Social Security and private pension systems are a roadblock to economic security for middle-aged-and-older Americans. Accelerating health-care costs, which particularly menace the last years of life, are another major threat. The decline in Americans’ retirement accounts, although not a fatal blow to their retirement prospects, completes the picture of disarray that confronts the retirement-planning efforts of Americans today.

Among the tactics to combat this vicious cycle are deferring retirement, using private annuities judiciously to guarantee funding for basic needs, and keeping an unannuitized, diversified portion of the portfolio that can benefit from economic growth.

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