Will You Be Able To Retire?

Today we turn our attention to the question of retirement: Will the Boomer Generation be able to retire on time? Will Social Security go bankrupt? Is Harry Dent in his book The Roaring 2000s right when he asserts that we will have a boom until approximately 2008-9 because Boomers are saving and spending? And then watch as things go bust (an actual depression) because Boomers start selling stocks and retiring?

We are going to examine a remarkable paper by Rob Arnott (Chairman of First Quadrant) and Anne Casscells (of Aetos Capital). Arnott is circulating the paper privately prior to its publication in a financial journal. He has graciously given me permission to discuss it. Its long term implications are very critical for all of us to understand, especially the Boomer Generation, of which I am a part, and which makes up a large portion of my readership. I think it is one of the most important reports I have read in a few years.

(There are two caveats to which all must agree prior to reading this: first, you cannot shoot the messenger [meaning Arnott, Casscells and especially me]. Secondly, I am distilling a lengthy paper with a great deal of back-up data into a few pages. Do not hold Arnott and Casscells responsible for my efforts. As soon as the full paper is available publicly, I will provide a link to it.)

We will look at the conclusions first, explain why they came to be and then explore the implications.

First, the good news: the Boomer Generation is going to live longer and be healthier than any previous generation. Each succeeding generation, as did our fathers, has lived longer than their parents and will continue to do so.

The bad news is that Boomers, ON AVERAGE, who are expecting to retire at 65, will not be able to do so. Your individual situation is up to you, but the average Boomer will work until he is at least 70, and probably 72 or 73. The good news, again, is that we are all healthier. I, for one, do not intend to retire at 70 or even 75. Again, this is an average, and with proper planning many will be able to retire earlier.

(Richard Russell, writer of the daily Dow Theory Letters is my hero, going strong and writing more brilliantly than ever at 78. I shall not imitate him by getting up at 3 AM, however, even in my dotage. I consider him one of the most important financial writers of our times. You can subscribe at www.dowtheoryletters.com.)

Secondly, this delayed retirement is not a financial problem, but a demographic problem. Thus the solutions are not simply financial, such as save more money or raise social security taxes.

Third, Social Security is not the primary problem. Long before we get to the predicted funding crisis of 2017 or 2029 or 2040 (depending upon which politician you listen to), we have a market driven demographic crisis.

Finally, I am going to suggest this is not a crisis at all, in the true sense of the word. It is merely an adjustment in expectations. It may even be a blessing.

Fantasy Island

Arnott and Casscells contend that the markets will force this increase in the retirement age. This will happen whether or not politicians adjust the age for social security benefits. To explain what they mean by the market forcing the Boomer generation to retire later, I am going to resort to a simplistic analogy. We will examine the merits and weaknesses of the analogy afterward. As you read, please know I am aware of many weaknesses in the story, but am trying to get over a major point that is critical to this argument. (The numbers I use are for illustration purpose only, to help you understand the concepts. They are not meant to be literal.)

Economists like to use an island economy to illustrate a point, and I will do so as well. Let's assume an island, where 15% of the people are retired, 65% of the people are working and 20% of the population are children. The elderly and the children depend upon the workers to produce the goods and services they need, in addition to the goods and services the workers need. That means there is a ratio of about two workers for each dependent. The retired swap assets they have saved for the services they need.

Now, let's add something to the water that makes workers want to have more children. Slowly, over time, the number of dependents per worker goes up. The population now needs even more goods and services. Each worker can be more productive, and that helps, as they create more ways to produce goods cheaper and faster. Fortunately, whatever they added to the water also makes people live longer, so that people can work a little longer. It is not much longer, just a few years, but it makes enough of a difference to keep things progressing.

The reason working a little longer makes such a difference is that the retired population consumes about 3 times as much goods and services as the children. So even as the percentage of the children in the population rose, it does not require nearly as much community effort to produce the needed goods and services for the young as it does to support a retired person. The combination of increased productivity and the older working a little longer made for generally increasing prosperity.

Notice that it is not the amount of money the retired population saved. The critical factor is that someone had to do the work so that things and services could bwe bought. Society produces X amounts of goods and services. If there is more demand for these goods and services by retired people than actual goods and services produced, then:

The price of these services goes up, or; The value of the assets the retiring generation wants to trade for services and goods goes down.

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The earlier generation had to work just a little longer to have enough assets to retire on and produce the goods which society needed. Because they worked longer, they produced more goods and services which had the effect of holding down prices, and allowed them to save more for retirement.

If supply of overall goods and services drops, then prices will rise. Retirees require goods and services. If there are not enough of them to meet demand, prices will rise. This will make it difficult for people to afford to retire on their savings, and thus they continue to work.

Now, an interesting thing began to happen 18 years or so after the miracle drug was added to the water. Their kids began to enter the workforce, and the number of dependents actually fell, as more kids entered the workforce than the number of people who decided to retire. The retirement age actually fell slightly even as those retiring lived longer. This was because there were more workers producing goods and services.

Then another funny thing happened. Someone changed the water again, and the Boomer generation stopped having as many kids per family as their parents. Because there were so many in the Boomer generation, there were still lots of kids, just not as many per family. Even as more and more of their parents retired, the ratio of dependents to workers did not change.

The Boomer generation continued the tradition of their parents and became increasingly more productive. The amount of goods and services needed to maintain the population did not get out of proportion to the number of workers. Things became stable.

The parents of the Boomers, as they retired, exchanged their savings for goods and services produced by the Boomers and their children. The workers were willing to take these assets at ever increasing prices for their products, because there was plenty to go around. This was partially because there was not a lot of demand from young dependents.

Then it became time for the Boomers to retire. Most of them had been saving for retirement. Knowing they were going to need their savings for retirement, they slowly began to get out of riskier investments long before the time came for them to actually retire. But they still expected to retire at the age their parents had, or around 65, even though they expected to live at least 5-7 years longer, and 15 years longer than their grandparents.

But the Boomers had made one big miscalculation. They forget to have enough kids to support their retirement. As time went on, the working population had to produce more goods and services just to keep everybody supplied. The number of dependents per worker rose by 50%, until there were 1.5 workers for every retiree/dependent.

The workers saw the time they had to work rise each year, just to produce everything that was needed. This got old very quickly. The remaining workers got tired of working 60 hour weeks, instead of the 40 hour weeks their parents had worked, just to produce the same amount of needed goods and services.

The workers went to the Boomer generation and said, "We want more for our work. Either give us 50% more money for what we produce, or we are going to give you 33% less goods and services for what you give us. But we will not work 60 hours a week any longer for the same amount of your assets as we once took for only 40 hours. If you don't like this, you are quite healthy, and can work a little longer before you retire. Take it or leave it."

The Boomer generation was quite upset. This wasn't the deal they thought they had. They had been promised by their leaders they could retire at 65. Now they found they did not have enough assets to pay for the goods and services they needed. It did not matter how much they had saved. There were only so many goods to go around, and the workers set the price of the goods, plus they had control over the price they were willing to pay for the assets the Boomer generation had spent a lifetime saving.

There was only one solution, as they needed the goods and services to live. They had to go back to work.

Supply And Demand is the Main Culprit

Before we can examine the implications of the story and data, you must get in your mind one main point: this problem is one of supply and demand. It has nothing to do with how much a generation saves or how much a generation gets on Social Security.

Crudely, if there are more rabbits than wolves, you will see an increase in wolves. If there are not enough rabbits, you will see a decrease in wolves. There is a balance in nature, and there is also a balance in economics.

Arnott and Casssells show that when you look at the dependency ratio (the number of workers for each dependent), and adjust for the fact that it takes more to support a retired person than a child, there is a strong correlation and in fact a causation between the average age of retirement and the number of workers still in the work force.

As the parents of the Boomer generation have retired, there have been less children demanding resources so that the dependency ratio of workers to children and retirees has been stable. That trend stops in a few years, and they predict the average age or retirement will begin to increase, starting in just a few years, and rising to 69 by 2015 and over 70 by 2020, and if the ratio holds, to 73 by 2050.

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Literally, if every one of the Boomer generation retired at age 65, there would not be enough people left in the work force to deliver the pizzas, provide health care, police services, etc. Ironically, one of the bright spots of this report is that it means unemployment for the next generation probably goes down over time as more and more retire, and someone must take their place.

In places or countries with a shortage of workers, labor costs go up. That means the labor component of goods and services goes up, which raises prices and/or lowers profits.

This process will play out over the next 4 decades. It will be slow and inexorable.

The Boomer generation will demand goods and services, and because there are not enough workers, the economy will not be able to supply enough and workers will demand more of the saved assets of retirees for what they produce. This can come as increased prices for the production, or as a drop in the value of the saved assets or both.

If today one share of Cisco will buy you a meal at Denny's, will it buy you a meal in 2020? People investing in Cisco today hope that the price of those shares will rise to where it will buy several meals. They expect stocks to rise 7% a year. However, in 2020 when there are not enough workers to produce everything that retirees wants, the Law of Supply and Demand means that it will take more Cisco shares to buy a dinner than we currently plan on. Unless, of course, we can find more workers.

What Happens If You Don't Compound at 10% Over the Next 10 Years?

Let's look at it another way. If I am right and we are in a long term secular bear market, and the average stock does not rise over the next 8-10 years, let alone at 7-9% year, then how many people will be able to retire on schedule?

How many people go to their financial planner and assume a 7-8% or more growth in their stocks so that they can afford to retire? What happens to the forecast if the growth rate is only 2-3%? We will find people coming to 65 and finding they need to work and save a few more years.

In the same way that our grandparents had to work a few more years (on average) than our parents, our Boomer generation will have to do the same.

You see, the part of the story where our kids come to us and want 50% more for their work doesn't happen. We never get there, because slowly our generation, on average, is forced to work longer. Supply and Demand balance the scales slowly. There is no crash into the wall, no strike by the younger workers forcing an abrupt change. The market adjusts things slowly.

The data Arnott and Casscells show is that this adjustment is in the retirement age. Will it be forced by a rise in costs or inflation? Or will it be forced by a fall in the price of assets? Or some combination of both?

I can make a cogent argument for all three, although I would choose the combination scenario, which fits into my Muddle Through scenario.

What Could Make a Difference?

One factor which could totally alter this scenario is that we dramatically increase immigration. A selective and aggressive immigration policy could make a big difference. But it would have to be at a level much larger than today's one million or so immigrants. The paper suggests that at the height of Boomer retirement, we would need 4,000,000 immigrants per year.

Right now, that is politically impossible. But in 15 or 20 years I can imagine a set of circumstances which would favor more open immigration.

Another thing that could change would be emigration, or an exodus of retirees from the US. If you are living on a fixed income, and can double your lifestyle by moving to sunnier climes, then I think more and more of the adventurous will choose to do so. There will be plenty of people who will be able to retire far before 70, when they are capable of an active life, and will choose to do so in Costa Rica, Mexico, New Zealand or any of a score of countries that offer good services and low costs. With modern communications and cheap travel, there is no reason not to put that into your personal equation.

I do not understand how anyone can retire on a Social Security income alone. It is simply not enough anywhere in the US. But that same income goes a long way north of Puerto Vallarta in communities filled with retirees. Right now, Social Security income will buy you a lot in Argentina or Brazil.

Social Security Solutions?

I assume you know by now there is no Social Security lockbox, except in the rhetoric of politicians. Social Security is a transfer program. It transfers income from workers to retirees. When you pay into Social Security, you get nothing but a government promise. You do not own any assets, as opposed to what you own in your 401k.

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Do I believe that politicians will honor that "guarantee?" Of course. They wouldn't be politicians otherwise. But I think the terms of the deal will change on the margins. They will slowly raise the age of retirement and probably do some sort of means testing. Further, the dependency ratio tells us that current Social Security payments won't be enough (surprise, surprise!)

We all know that there is a "crisis" coming in 2030 or thereabouts. But as the dependency ratio rises, costs of services, especially those in demand by retirees will rise faster than Social Security increases. (See my argument on health care a few weeks ago.)

If they raised Social Security taxes enough to allow retirees to afford to retire, the percentage of income would be huge. It is not politically possible. The solution is that retirement ages will rise over time, pure and simple.

Or politicians may punt and let the market do it for them. Let's say Social Security is privatized. If Arnott and Casscells are right, then the market returns on the money saved would not be enough to retire on, so people would need to work longer. The fact that retirement costs more makes the retirement age rise, without politicians having to do anything. The more cynical part of me suggests that this may happen, so that the current generation of politicians, who will "fix" the system, will already be retired when the problem becomes apparent.

Be Honest With Yourself

The most important implication of this study is that the average retirement age will rise because it will cost more to retire. When you are planning for your retirement, you need to factor in a reduced return on your stocks and investments and an increased cost in terms of your assets for what you want to buy.

If you are expecting investment returns like those of the 90's to get you to your desired retirement income level at a specific age, you are probably dreaming. You are going to be disappointed. You are going to get to that hoped for retirement age, and still need to save some more and work longer.

But that is not all that bad. Average life expectancy is rising 3 months for every year over the last part of the century. That means in the last 28 years, life expectancy has grown 7 years, and by over 14 years since WWII. The quality of that life has increased dramatically as well. If our generation gets to live a lot longer, and if one of the conditions for that increased lifespan and quality of life is working a little longer than our parents, then that is a trade I make very day.

In fact, studies show working a little longer is good for you. Retirement is bad for your health.

As I have written for the last three years, stock market returns, especially from one way mutual funds, are going to be dismal for this decade. If you have not done so, you need to begin to adjust your portfolio to absolute return type strategies. Bonds, of course, come to mind, but I am also referring to dividends, certain types of hedge fund strategies and other income opportunities which offer guaranteed income. The returns from these may be less spectacular than what you want, but they will be steady. Making risky investments or hoping that the stock market will come back so you can make your retirement goals is not healthy. "Reaching for Yield" is often a ticket to disappointment.

It is better to put a realistic plan together, and either save more or plan to work longer. If you already have enough, then don't let some stock broker tell you that you must be in the stock market. Secular bear markets are times to be conservative. As Dick Russell says, "He who loses least in a bear market wins."

Deflation? Inflation? Gold?

In the short term, I still believe deflation is the issue confronting us. I sat with Wayne Angell, the former Fed Vice Chairman, at lunch in San Francisco this week, prior to his speech to the Public Pension Funds Forum. Angell, who for 8 years had his office next to Alan Greenspan's, probably knows his mind as well as anyone. He now makes his living trading interest rate futures and doing some consulting. He believes we will see long term rates fall further, and thinks long term rates for treasuries will drop below 4%. He told the conference that deflation would be a serious problem, but that he believes the Fed will do whatever it takes to make sure we do not slip into serious deflation.

These efforts should bring back inflation at some point, and when it does, the Fed will raise rates. But that is not in the cards for the near future. Angell says that Greenspan is not through cutting rates if the economy stays soft. (I leave to another time the discussion as to whether it will do any good.)

While the retirement data does not mean we will definitely see inflation rise over time, I think it is likely, as the dollar falls over the next few decades and demand outstrips supply on local services. But not this year, and not next year. A reversal of the deflationary pressures in the world is going to take a long time. It is not altogether clear when this will happen, so investments in one way funds (those that depend on the market going up, like mutual funds) is an aggressive investment strategy.

This also argues for gold over the long term, as it has been a stable store of value. Your Cisco share might not buy a meal at Denny's but your gold will probably buy the same dinner and maybe even dessert.

Whither the Stock Market?

Let's look at a few themes I have written about this year. Earnings quality is poor, and we are becoming more conservative about how we calculate earnings. Valuation, which we touched on last week, is still far above the average. The risk premium of stocks over bonds is getting better, but is still far from average. Deflation from overseas pressures is still a huge factor in the profit picture, creating little pricing power for US corporations. Capacity Utilization is poor, dropping another 0.8% this month to 74.4%, which is quite weak. This means there is little capital spending by business.

On top of this, Boomers who are nearing retirement are not going to wait until they retire to begin to sell stocks, especially if the see them as increasingly risky. All of this taken together means more downward pressure on stocks. We are still a long way from the bottom, both in absolute terms and in terms of time.

Harry Dent May Be (Probably Is) Wrong

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Finally, I promised an analysis of Harry Dent's main proposition that the growth in the Baby Boomer generation was the reason consumer spending and the stock market rose. He says this trend will continue until 2008, when the Boomers start to retire. He shows lots of charts which show a high degree of correlation.

But correlation is not causation. The price of butter in Bangladesh can be highly correlated with the S&P 500, but there is no fundamental connection. The reason spending went up was that Boomers had fewer kids, and thus more discretionary money than their parents. They also had more to save, which boosted the price of assets.

Thus, in my opinion, the correlation should be with the dependency ratio that Arnott and Casscells present us with. That means that, looking at their graphs and data, the negative effect from the Boomer Generation does not wait until 2008 but is beginning now, or at the most a few years from now.

The Economy is Not the Market

Once again, I need to emphasize that the economy and the stock market are not correlated over time. There are plenty of periods where the economy grows and the stock market is stagnant. We are in one now. This decade will see growth in GDP over time, although we will likely have another recession or two. This is the Decade of the Muddle Through Economy.

Investors can make decisions today that will allow them to prosper through this decade. No one is holding a gun to your head to make you take a buy and hold strategy in your mutual funds or stocks. You need to buy stocks which will pay you to hold them (dividends) or public funds which can go both long and short like David Tice's Prudent Bear Fund (BEARX), which I have written about in the past, or certain types of hedge fund strategies which do not depend on a bull market to make money, if you qualify as an accredited investor.

Houston, We Have A Party

I leave in a few minutes for my Rice University 30th Class reunion. I remember being an undergraduate and seeing those guys who graduated in the 1940's and thinking how old they looked. I am sure I will be shocked to see how my guy friends have aged just like those old guys from 1942 did. The ladies will still look as lovely as ever, thank you.

On Sunday morning at an obscene hour, I leave for New York to analyze yet another hedge fund, and then Monday will do the keynote luncheon address at the Hedge Fund Investments Styles and Strategies conference. My speech is called "Getting Absolute Returns in a Secular Bear Market." I will then come back and not leave until I finish my book-in-slow-progress, Absolute Returns , except for a vacation or two with my wife. I will be posting draft chapters as I finish them at www.absolutereturns.net.

Late next week, subscribers to my free Accredited Investor E-letter (on hedge funds and alternative investments) will get a new edition. If you are an accredited investor (basically $1,000,000 net worth, but complete definitions are available on my web site), you can go to www.accreditedinvestor.ws and subscribe for free. The letter is growing rapidly in popularity as we continue in this secular bear market, and if you qualify, I strongly suggest you subscribe. If you would like to know more about me, you can go to http://www.johnmauldin.com which ahs a link to all the above sites.

Have a great week, and think about how much fun it will be to get older if you invest in friends and family, where there are real dividends and no taxes.

Your not even thinking about retiring at 70 analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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