The Centenarian Boom: Providing for Retirement in a Long-Lived America

More than one million centenarians will be living in the United States by the middle of this century. Not until 1960 were there more than one million Americans over age 85. These statistics measure a remarkable transformation in the prospects of growing old in America. At the dawn of the 20th century, the average newborn American could expect to live 47 years. Barely half of 20-year-old men lived to age 65. Nearly half of women who reached age 65 were widows. As the 21st century opens, men who are 65 years old can expect to live another 16 years, women of that age another 20. Improved standards of living and public and private health care services have made long lives routine.

Not only has long life become normal, financial security—once available only to the very rich—is now the lot of most Americans. “Security” is not the same as “wealth.” While poverty among elderly couples is lower than among any other age group, most of the retired elderly live on modest incomes, and a sobering 25 percent of elderly widows and widowers even now live in poverty. But their primary source of income—Social Security—is rock solid. Until the middle of the 20th century, retirement was simply unaffordable. Most men worked until they died or suffered terminal illness. Rising incomes, a maturing Social Security system, and private pensions for many have brought retirement within the financial reach of nearly all and made it financially secure for many.

Over the next half-century, with the aging of the legions born after the Depression and World War II, the population of the very old will soar. Life expectancies of 65-year-olds are projected to rise another 2 years by 2050—and plausible medical breakthroughs could boost that forecast. While population aging is certain, less clear is whether the growing ranks of the very old will continue to live out their lives in relative economic security or will face increased economic risk.

How Heavy a Burden?

Some commentators warn that the swelling ranks of the elderly will impose heavy burdens on a barely growing labor force. This fear is unfounded. To be sure, the ratio of retirees to active workers is almost certain to rise. But the share of Americans under age 65 who are not working and whom workers must also support is projected to fall. Workers will have proportionately fewer nonworkers to support than they did during the 1950s and 1960s. In those years, although dependency ratios rose to historic highs, far above any the United States will see in the 21st century, living standards soared. Overall, the number of mouths each worker has to feed is projected to rise only about 6 percent over the next 40 years and little thereafter.

Supporting a growing population of the elderly will pose no aggregate problem for the nation, if output per worker grows even at the modest annual rate of 0.9 percent assumed by the Social Security actuaries. At that rate, output per worker will rise 46 percent by 2040, dwarfing the demographic burden. With even modest growth, the nation can both support retirees and improve living standards for the nonelderly.

But being able to do it and doing it are not the same thing. Whether the elderly will have the resources to enjoy extended retirements in reasonable financial security is not a matter of affordability for the nation. It is a matter of prudent personal planning and wise social policy.

Saving for Retirement

Early in the last century, people worked until they died. The arithmetic of retirement saving was depressingly simple—people needed only enough saving to pay the undertaker. As life expectancy and incomes increased, additional saving became necessary if people were to live in the manner to which they were accustomed before retirement. Unfortunately, individual saving has always been difficult. Few workers have voluntarily saved much. When incomes were low, retirement saving was unaffordable. As incomes rose, saving was less attractive than the enticements of current consumption.

Two public policies have facilitated retirement saving. The first is Social Security. It now provides $300 billion in benefits each year to more than 37 million retirees and to their spouses or survivors. The second, paradoxically, is the personal income tax. It defers tax on employers’ deposits in qualified pension programs until workers actually receive the pension. This provision makes it far more attractive to have one’s employer save for one’s retirement than to do it oneself. Individuals also receive tax breaks if they deposit funds in special accounts, such as Individual Retirement Accounts, 401(k) plans, and Keogh plans. But people need not actually save to receive these tax breaks, as they can transfer previous savings or borrow to finance deposits into favored accounts.

These tax breaks are relatively new. Until World War II large personal exemptions shielded all but a few from the income tax and most who paid the tax faced low rates. In this environment, deferral could do little to encourage pensions. But the higher rates and lower personal exemptions after World War II converted deferral of pension contributions into a powerful incentive for employers to set up qualified pension plans.

Consider 30-year-old workers whose investments yield 6 percent annually and who face a 28 percent marginal tax rate. If their employers set up pension plans that earn the same rate of return, the workers’ pensions will be 75 percent larger after all taxes have been paid than if the employers pay out the same contribution to the workers who do the saving themselves. Furthermore, many pension plans create powerful financial incentives for workers to retire after particular ages. Pensions under many plans stop growing after the worker reaches a certain age or works a certain number of years. The worker’s wage for continued work drops from the stated wage to the difference between the wage and the pension. In combination, these two public policies, together with sustained economic growth and prosperity, have made possible progressively earlier retirement ages. As of 1996, half of all men were out of the labor force by age 62.

Whether these trends will continue is in doubt. Social Security has matured and now faces a projected long-term deficit. Pension coverage has not increased in years. What is not in doubt is that if life expectancies continue to increase—and if retirement ages do not—workers will have to save a larger share of what they earn themselves or the cost of public and private pensions must increase if workers are to live in financial comfort during retirement.

How Much to Save?

Few people appreciate just how much they need to save to maintain their living standards after retirement. Consider, for example, people who start working at age 20, whose earnings grow annually 2 percentage points more than inflation each year, who retire at age 62, and who die at age 80. (Such workers closely approximate the average prevailing today.) If they earn 3 percent more than inflation on tax-sheltered savings—about the average yield on government bonds—they have to save 20.3 percent of earnings every year from the time they start working until they retire to maintain their preretirement income. A decision to retire two years earlier would boost the required saving rate to 22.6 percent. If life expectancy increases to age 90 or to 100, the required rates for age 60 retirees rise to 27.8 percent and 31.2 percent, respectively.

All these examples assume that people start saving as soon as they start working and save at a constant rate throughout their careers. In fact, most people save little in their 20s and 30s. Many go into debt. They begin saving in earnest for retirement only when they move into their 40s or even their 50s. At these ages, children are grown, intimations of mortality may be too insistent to ignore, and careers may have reached a plateau. People who wait this long to begin saving for retirement are likely to find the goal unattainable if they must rely only on their own saving. Workers planning to retire at age 60 who expect to live to age 80 but who wait to age 30 to start saving must save 28.9 percent of their incomes to meet their targets—and those who wait to age 40, 35.4 percent. Clearly, retirement saving should start early.

Three considerations modify these required saving rates. One reduces them: most people do not feel they need as much income during retirement as they earned late in their careers. The recommended target is about 60-70 percent of preretirement income. But two other realities increase required saving. First, many people enter the labor force with debt—college loans, for example—and most incur some debt soon thereafter—to buy and furnish their first house or apartment, for example. At age 30, many workers are paying off these debts and are not yet able to begin saving for retirement. Second, many elderly people fear that they will outlive their assets. People can avoid this risk by purchasing annuities from insurance companies. But individual annuities are expensive. Loading charges—off-the-top fees—average about 20 percent of the cost of an annuity. About half of these fees covers administrative costs, and half covers the added costs that companies incur because annuity buyers tend to live longer than average—so-called “adverse selection.” Furthermore, private annuities typically do not contain inflation protection. It is hard to get away from a simple fact—preparing for retirement in one’s early 60s takes more saving than most people now do voluntarily and, unless human psychology undergoes dramatic change, more than they are likely to do in the future.

Public Saving Incentives

This is where public policy comes in. Social Security and company pension plans are based on the principle that mandatory saving is necessary to help people overcome the temptations of gratification from immediate consumption. Social Security and traditional private pension plans also incorporate mandatory annuitization, which assures an income stream that lasts until the worker dies. Social Security automatically provides spouses who have not earned benefits in their own rights a benefit equal to at least half of their spouses’ benefits, and after the primary earner has died the survivor receives the full benefit. Private plans now also typically offer at least partial benefits to widows, under the so-called “joint-and-survivor” option. Social Security also provides full protection against inflation by adjusting benefits for changes in the consumer price index.

Today Social Security is running large annual surpluses well in excess of $100 billion and rising. Current revenues and accumulated reserves are sufficient to pay benefits under the current benefit formula for the next 30 years. But Social Security has a projected long-run deficit. If no changes are made in earmarked taxes or the assets in which Social Security reserves are invested, revenues in about 35 years will be sufficient to pay about 70 percent of currently legislated benefits. Relatively small tax increases or benefit cuts, if made soon, could restore long-term financial balance. But some people advocate significant structural changes in the system, as well as measures to close the deficit.

In 1998, President Clinton initiated a national discussion on how best to close that deficit. In 1999, he proposed to allocate general revenues to Social Security and to permit the trustees of the Social Security trust fund to invest a small part of that trust fund in private securities. Various members of Congress introduced a wide variety of proposals, many of which would allocate general revenues or a part of current payroll taxes to newly created individual accounts. The plans differed in the range of choices that individuals would have over investments and the terms under which they could withdraw funds.

Public opinion polls indicate deep divisions and an absence of consensus. The debate remains unresolved, but will loom large in the 2000 presidential campaign. The prospects for early action to close the projected deficits are uncertain, in large part because the system is now running enormous surpluses that are projected to continue for many years. But early action is highly desirable because adjustments must be phased in gradually to spare retirees and older workers abrupt changes to which they would find it difficult to accommodate.

Modifications in private pensions are making it increasingly important to maintain an assured core benefit such as that provided by Social Security. Private pension plans are moving from traditional “defined-benefit” plans to “defined-contribution” plans. Under defined-benefit plans, companies establish reserves to support pensions keyed to earnings and years of service. If investment returns on the reserves are lower than expected, companies bear the risk. Under defined-contribution plans, companies make fixed contributions, which workers sometimes may supplement. Variations in investment returns lead to changes in reserve accumulation—and in the pension amounts that retirees receive—thus shifting to employees the risk that companies once bore.

Against this background, the reliable defined-benefit Social Security plan is increasingly important. Shifting Social Security to a defined-contribution plan would expose workers to financial market risks on most or all of their retirement income. Of course, Social Security is also exposed to risks. If projected revenues fall short of projected benefit costs, Congress enacts tax increases or benefit cuts for current and prospective beneficiaries. But this risk is broadly diffused among workers and current and future beneficiaries. In contrast, the financial market risks under defined-contribution plans fall exclusively on individual workers and retirees who are usually poorly equipped to handle them. Whatever the outcome of the debate, some form of mandatory saving will be necessary to provide a base of income to support the aged and disabled.

Apart from preserving Social Security as a defined-benefit plan, the major issue in public policy is whether to try to reverse the trend to earlier retirement. By retiring at age 68 instead of age 60, workers can cut the proportion of income they have to save to maintain their preretirement income until age 80 from 22.6 percent to 13.6 percent. People may indeed choose longer working lives. After all, as longevity has increased, health has improved. Simultaneously, the physical demands of many lines of work have decreased. Furthermore, a projected slowdown in growth of the labor force may increase employer interest in retaining older workers. These forces will probably make workers increasingly amenable to working longer. Public policy might abet these tendencies, for example by raising the age of initial entitlement to Social Security benefits from the current age of 62 or by using tax regulations to discourage provisions in private pension plans that encourage workers to retire at particular ages.

But reversing the trend toward early retirement will entail difficult trade-offs. Many of the two-thirds of American workers who claim benefits before age 65, the so-called “normal retirement age,” suffer from declining health or impairments well short of disability but sufficient to make work onerous. Furthermore, a major factor in the move to early retirement has been the increase in incomes. Wealthier people buy more of many of the good things in life, including leisure, part of which can come at the end of life. Unless public policy is designed to shift incentives, workers are likely to continue the century-long trend to spending an increasing share of their lives in retirement.

Prudence, Private and Public

In the end, the United States need have little economic difficulty accommodating the “centenarian” boom and the associated population aging. The keys are adequate saving by individuals and prudent fiscal policy by government. Adequate individual saving requires some form of compulsion to help people overcome the natural human frailty that leads them to save too little when young to cope with seemingly remote contingencies. Sound fiscal policy requires that government balance its own budget so that private voluntary saving and pension saving in the private and public sector are available for investment at home or abroad. The emergence of a geriatric society will doubtless produce myriad social and personal problems. But it need not pose economic problems for the nation or for individuals provided that we make plans now to deal with it.