Baby Boomers and Lack of Retirement Planning

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Last night on Frontline, I watched the beginning of a Hedrick Smith documentary with the basic premise that many baby boomers have not prepared adequately for retirement and hence are going to come to an unpleasant reckoning when they reach the point where they want to leave the labor force and have “quality time” with family, only to find out that they can’t afford to do that. In other words, whatever pension or other retirement plan that these people have, they will often find at this reckoning point that the plan is inadequate either because of stock market vicissitudes, self-delusion, or inattention to the saving activity and managing the portfolio funds that are to finance retirement.

That data on savings in this country, particularly in the last year or so, is truly abysmal. (See this chart from the Department of Commerce, Bureau of Economic Analysis.) The only way to rationalize zero or negative savings rates is to have personal wealth increase without needing to save, i.e., there are capital gains to be had on already held assets. In the mid to late 1990’s this happened, of course, due to the massive run up in the stock market, fueled by the astonishing growth in technology stocks. More recently, it appears to be the boom in housing prices that is the primary driver. Some economists, notably Robert Schiller, have warned there may very well be a bubble in housing prices. This makes the low savings rate all the more disturbing.

The documentary starts off with a focus on the United Airlines bankruptcy and restructuring under which many of the long term United employees lost a substantial fraction of their pension benefits and many of those who continue to work for the company today have had to do so with lower wages and benefits, while upper level management and the lawyers and bankers who crafted the re-org made out like bandits. Unfortunately, in my view, this later point of corporate greed triumphing at the expense of the ordinary Joe in the company, while good for creating empathy with those employees who have been disadvantaged by the process, is really a distraction from what I think is the fundamental point.

That point is the death of defined benefit pension plans in the private sector, because companies that have them and have a substantial number of senior employees can strategically profit from gaming ERISA and the bankruptcy laws, by forcing such a restructuring. Hence a modern company will not offer this type of retirement plan, opting instead for 401Ks or other defined contribution options. Under the defined benefit plan (assuming the company does not go under) the employee is “taken care of “ and doesn’t have to worry about retirement except in the event of a premature severance from the firm. (Thus these plans served as a way to bond the employee to the firm.) In contrast, under a defined contribution plan, with the contributions optional and left up to the employee, then of course the employee does have to worry about contributions and about how those contributions map into an adequately sized nest egg.

Because I love Excel and to make little models in it that illustrate issues such as these, I made up this spreadsheet to give an idea of what is going on. Let me explain a bit of that here.

First, you are setting the time path of income during the lifetime of the individual over which savings occurs. (One of the points of the documentary is that many people are not forward thinking on this issue so while in their twenties and thirties they don’t save for retirement. They only begin to think about retirement in their forties when they’ve been working for quite a while and the day they stop working begins to seem like a possibility. However, do note that if they are paying off a mortgage they are indirectly saving through that vehicle, by building up equity in their home.)

To set the time path, income is fixed at three different times along the trajectory: at the beginning, at the end, and somewhere in the middle. The duration till the endpoint is also set as well as where that middle point lies. With that information, the graph then plots a quadratic function consistent with those set points to give the entire income trajectory till employment ceases. You can change parameters to see how the graph changes. The graph moves after you let go of the relevant spinner button. One of the key variables to play with is the Years of work.

Having set the income path during the working lifetime, I next assume that savings per period is a certain percentage of income and one can set that percentage for the entire working cycle. In other words, I’ve assumed it fixed throughout the working lifetime. That is not realistic when contributions are optional, but it makes us able to vary the savings rate easily over the entire trajectory rather than adjusting it on a year by year basis. The penultimate parameter is the interest rate, which should be interpreted as the real interest rate, meaing the market rate net of the inflation rate. But it doesn’t mean that the investor is in bonds rather than stocks. If the investor has a portfolio of stocks, this should be interepreted as the average annual return on that portfolio. The interest rate determines the interest income generated by the nest egg.

Then, putting your cursor in the lower window and scrolling down, you should be able to see how th nest egg accumulates. In any period the contributions toward increasing the nest egg are the current savings out of income plus the interest return on the previous asset value of the nest. Thus the nest grows faster the higher the interest rate or the higher the savings rate. Regarding the former, it is certainly true that high interest rates can cover up other sins with respect to preparing for retirement. And, conversely, there is the temptation to overestimate the rate of return so as to offset the need to save vigorously for retirement. Regarding the latter, the fact that actual savings rates are much more modest suggests that collectively we don’t understand the issues at stake.

Finally, you can look at the the income per period during retirement, which is the bolded number in blue found in cell C10.. This is a function of the size of the nest egg at the end of the working lifetime, the interest rate, and the number of years during retirement. The per income per year during retirement is calculated in a manner similar to the calculation of the monthy payment in a fixed rate mortage. In other words, there are a pre-specified number of periods and a fixed payment per period such that over the duration the payments are set to pay off the loan and outstanding interest charges but to provide no surplus beyond that. If the interest rate were zero, then this annual payment would simply be the final nest egg number divided by the number of periods in retirement. With a positive interest rate, however, and since the nest egg that does not get paid out all at once, the asset earns interest and hence that gives more to distribute. Equivalently, we can think of dividing the nest egg among a fewer number of periods. Cell D10 gives this dividing factor. It is interesting to observe how that value changes with the interest rate.

What, if anything, does this have to do with learning technology? I’m sure some of my readers found the previous few paragraphs a bunch of econ mumbo jumbo. So let me get away from technical details and move to the main point. If there are a lot of people approaching retirement who are not adequately prepared, these people will look to enhance their income in the labor market. To the extent that these people can’t do this by staying in their old jobs, or returning to their old jobs, they may very well demand education to assist them in finding different type of work.

So the Baby Boomers’ debacle may turn into a big reward for Higher Ed, cementing a demand for online programs that heretofore seemed real but hard to identify, as these Boomer’s are looking to improve their incomes in their next careers, and additional educational credentials are viewed as the path for achieving this goal. Think of the possibility of an equivalent ot the GI Bill, targeted at encouraging these Baby Boomers back to school so they don’t have to work at McDonalds or WalMart in their second careers.

Advocating for education of this sort is the upside of the under saving problem. The downside is noting that the retirement age will have to be be pushed back because these folks won’t be able to retire otherwise. I wonder if the politicians will steer clear of the education part, because of this uncomfortable fact.