The New Rules of Retirement

John Wiley & Sons

Chapter One

It is coming. You cannot stop it. Neither can the government. It will transform virtually every American's retirement and lifestyle. We already have seen changes in health care, housing, the cost of retirement, the financial markets, pension programs, and much more. Because of key, unstoppable trends that already are in place, in the coming years changes in these and other areas affecting retirement will continue and accelerate. Even those who already are retired have felt the effects of these trends and will feel them in the future.

The trends are not bear markets, recessions, terrorism, war, or any of the other headline grabbers. The effects of those events on retirement will turn out to be relatively small and short-term. I'm not talking about a technology revolution, either. There are larger, more powerful trends at work, trends that are much stronger than any that have tested retirement plans so far.

These trends collectively can be called the Wave. They also are called the Retirement Wave or the Age Wave. The Wave can be summed up as: the aging of the large Baby Boom generation, longer life spans, and fewer offspring. Together, they amount to an aging population that has tremendous effects on the economy, the financial markets, and society. See Chart 1.1.

Where Will the WaveTake Us?

There's no doubt that demographic changes have an effect on the economy and society. Accurately forecasting the exact changes, however, can be difficult. Those who study the effects of population changes don't agree on the consequences of the Age Wave. In addition, there never has been an aging population of this size and scope. An additional complication is that retirement itself is a relatively new development. Forecasting the future of a new phenomenon would be difficult enough in itself. Mix in the effects of the Wave and the difficulty is greatly compounded.

Nevertheless, it is possible to sketch a general picture of the effects of an aging population on society and the economy. Certainly, there are many analysts who have put their forecasts on the record. Let's review the most prominent forecasts. Then, we'll consider what other events or trends should be considered before making a final prediction of the effects of the Age Wave.

Slower Economic Growth

An aging population usually means less robust economic growth. There are a host of reasons for this. One reason is that a higher percentage of the work force is past its peak productive years. With improvements in health care and lengthening life spans, we cannot be sure when the Boomers' productivity will peak. It is likely, however, that most Boomers will continue to work past their peak productive years. Because the Boomers will be a large portion of both the population and the work force, at some point productivity and economic growth are likely to fall as the Boomers age, unless there are offsetting factors.

Savings also are likely to decline as the Boomers age. This is because retirees generally don't increase their savings. They start to spend what they have accumulated. Reduced savings could lead to higher interest rates. Again, that usually means lower productivity and lower economic growth.

Another result of an aging population is that a lower percentage of the population will be in the work force. We will have fewer workers supporting each non-worker. Fewer workers for each non-worker typically leads to slower economic growth. That is because a higher portion of the income and taxes of each worker supports the non-workers. When there are fewer younger workers for each older non-worker, there is less wealth available for other expenditures, some of which would lead to more productivity and economic growth. Social Security and Medicare are the two most prominent programs through which younger workers support older nonworkers. These programs are not funded in advance by taxes. Instead, they are essentially pay-as-you-go systems.

Taxes from those working during the Boomers' retirement years will fund payments to the Boomers. If there are fewer workers when payments to the Boomers are due, tax rates may have to be raised in order to foot the bill. Higher taxes cause lower fiscal efficiency and reduce economic growth.

Payments to the older non-workers possibly might be funded with debt instead of taxes. This increased debt would occur at a time when overall savings are likely to decline. A lower national savings rate coupled with higher debt could lead to higher interest rates or inflation-or both. The result of either higher interest rates or inflation would be lower economic growth.

Whether taxes or debt (or a combination of the two) are used to fund the government payments to seniors, the transfer of economic resources from the working population to the large group of Boomer retirees is likely to result in a decline in economic growth.

Higher Inflation

The United States has been blessed with declining inflation in the years since 1982. The dramatic decline in inflation began at a time when many were forecasting that high inflation was a permanent part of America's future. The disinflation also began when there were large federal budget deficits that many economists said precluded a decline in inflation. Those budget deficits eventually lessened, for at least a few years, but not until long after the disinflation took hold. See Chart 1.2.

There are several explanations for the decline in inflation. International monetary authorities became more educated about the dangers of inflation and how an increasing money supply leads to inflation. As a result, they became more vigilant about preventing inflation than they were prior to the 1970s. Also, the emergence of a truly global economy put a natural lid on prices as companies had to compete with goods and services from all over the world, not just from their own countries. Production in low-wage countries kept prices down worldwide. Technology, competition, and more efficient work methods also combined to increase productivity. This higher productivity allowed businesses to produce more goods and services at lower costs, which holds down prices and inflation.

Some analysts, however, point to demographics as a key to disinflation. They say that since World War II, there has been a close relationship between inflation and the percentage of younger employees. A low percentage of younger workers (those under age 34) is tied to lower inflation. But a high percentage of younger workers is associated with higher inflation. The theory is that younger workers are less productive, and lower productivity leads to higher inflation. As the Boomers entered their early adult years, inflation soared. As the Boomers matured, inflation declined. If the relationship holds, then as the Boomers retire and the work force again becomes younger, inflation should increase.

The tie between demographics and inflation could be coincidence. An alternate theory is that the age of the work force is similar to the age of the voting population. Older voters generally prefer low inflation and more conservative economic policies. Younger voters traditionally are less concerned with policies that keep inflation low. It could be that inflation rose and fell because of the demographics of the electorate.

The answer isn't clear. But it is possible that the aging of the retiree population and growing youth of the work force could lead to higher inflation in the coming decades.

Crumbling Real Estate Prices?

Owning a home has been the great American investment for decades. Housing prices exploded as the Baby Boomers entered their home-buying phase of life. The best financial advice for the early Boomers and their parents was: Buy the most expensive home you can afford and borrow all you can to finance it. People who followed that advice were rewarded throughout the 1960s and 1970s. The real estate boom paused in the late 1980s and early 1990s, then resumed. More recently, second homes and vacation homes joined the boom. Once again, that seems to be because of the Boomers. Many now have the money and time to enjoy second homes.

How will the next phase of the Boomers' life cycle affect real estate prices? The first generation of American retirees reached a point in life when many of them wanted less real estate to be responsible for and maintain. People get less active as they age, and some luxuries become burdens. Traditionally, as people age they sell large homes to move into smaller homes, condominiums, or some kind of senior housing coupled with medical assistance, such as assisted living or a nursing home. Many Boomers believe that a large portion of their retirement income will come from tapping their home equity through downsizing. They plan to sell their homes and use part of the equity to buy a smaller home and the rest to fund retirement.

The question many ask is "Who will buy the Boomers' homes?" If there are fewer people in the following generations, how could there possibly be enough buyers for the homes sold by the Boomers? Couple the smaller number of potential buyers with the possibility of higher taxes and lower economic growth, and the subsequent generations won't be able to pay the prices Boomers have come to expect for their homes.

Some economists have tried to forecast the effect of the Wave and the subsequent "Baby Bust" generation on home prices. In 1989 one study predicted that housing prices would begin falling by about 3 percent annually over the next 20 years. It predicted a real (after inflation) 47 percent decline in home prices by 2007. In 1993 a study sponsored by the National Institute on Aging reached similar conclusions. In that study, economist Daniel Mc- Fadden developed a model that identified 1980 as the peak for average U.S. home prices, adjusted for inflation. This model forecast that in 2020 home prices would be 19 percent below their 1995 levels, adjusted for inflation. By 2030 the decline should be 30 percent.

Others argue that even if there are enough younger people and immigrants to buy homes in the future, they will neither want nor be able to afford the homes the Boomers want to sell. Being older when they bought homes, the Boomers could afford large homes. In the 1990s, mini-mansions with two- and three-car garages were the home of choice in many suburban areas. Younger workers, possibly facing lower economic growth and higher tax rates, might not be able to afford such homes. With smaller families, they might not want the large homes.

A decline in housing prices could seriously undermine the financial health of the Boomers and the U.S. economy. Home equity is a major portion of the wealth of many Americans. For many older Americans, home equity is the only wealth they own or, at least, it is a substantial part of their net worth. For many people, home equity is a big part of their retirement plans. A number of those Boomers living in expensive urban areas plan to sell their homes at retirement and move into less expensive homes. They expect part of the sale proceeds to be available to help pay for retirement. Many others count on their home equity as an emergency reserve to be tapped in their later years or when needs arise. A home might be sold or mortgaged against to pay for nursing home care, for example.

If the aging Boomers sense that their homes won't be as valuable as anticipated, they are likely to reduce spending. That would reduce economic growth. The Boomers also might rush to sell their homes, hoping to salvage whatever value they can before the slide accelerates.

Home mortgages also are the largest part of the U.S. debt market. Major changes would be forced on the debt markets if demand for mortgages declines and people start prepaying mortgages in anticipation of housing price declines. Mortgage interest rates could drop dramatically. That would be good for those who want to borrow. But for older Americans who might use safe, interest-paying investments for their income, lower interest rates could be a disaster. If housing prices were to slide below the value of the outstanding debt, lenders would have to write off bad loans and take over ownership of homes for which there would be few buyers and steadily declining prices.

Homes and other real estate are an important part of the retirement nest eggs of many Americans. A decline in home prices or even a significant slowdown in appreciation could disrupt many financial plans.

The Great Financial Market Liquidation

The stock and bond markets in the United States began their greatest bull market in 1982. It continued through March 2000, with a few short interruptions along the way. The bull market coincided with the time that the Boomers became established in their homes and entered their peak earning years. Consequently, this is the time when one would expect this generation to increase its saving and investing.

It could be coincidence that stocks and bonds became attractive investments just at that time. Maybe the Boomers simply followed the markets and began investing heavily in stocks and bonds after those investments generated a few years of solid returns. Perhaps the Boomers would have invested heavily in real estate if inflation had remained a problem. Or it could be that the Boomers' life cycle caused them to buy more stocks and bonds during that period, and this flood of cash was a major cause of the bull market.

Whatever the cause of the bull market, what happens to stocks and bonds as the Boomers get older? In many instances, these investments were purchased to fund retirement. Presumably in retirement the investments will be sold to pay for living expenses. If so, over time the Boomers will be cashing in their investments. As with real estate, one has to wonder who will buy the Boomers' stocks. Further, the Boomers aren't the only ones in the markets. There are a number of employer-sponsored pension funds controlling trillions of dollars in stocks and bonds. As the work forces of these employers age, these funds will be taking in less money than they send out in benefits. That could mean they will sell stocks to make benefit payments.

Using demographic data, economists John Shoven and Sylvester Schieber prepared a forecast of stock market cash flows (Center for Economic Policy Research, Publication No. 363, September 1993). They found that cash should continue flowing into the markets until 2010. After that, they forecast that the markets will become stagnant. Finally, beginning in 2025 the value of America's pension plans should decline as they sell investments to pay benefits to the Boomers. The decline of pension fund values and stock market cash flow is estimated to accelerate through 2040.

If cash flow helps determine the prices of stocks, Boomers might need to revise their retirement plans.

Continues...

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Excerpted from The New Rules of Retirement by Robert C. Carlson Excerpted by permission.
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