Could Your Retirement Be Worse Than You Expect?

Several recent articles about funding retirement are enough to scare even those who think they're on track to live comfortably in retirement.

The future could be one of declining portfolio and housing prices, higher taxes, slower economic growth, and increasing out-of-pocket medical costs. Baby Boomer retirees could find their savings, pension (if any), and social security won't give them the standard of living they expect. Rather than the gold-plated retirement of the last several decades, post-work life could look much more like the day-by-day struggle it once was.

There are several trends contributing to the pessimism. The size of the Boomer generation compared to the generations after it and increasing longevity are the two principal issues.

The Wall Street Journal talked to several forecasters recently about prospects for the coming decades (1). Milken Institute economist Jeremy Siegel looks for a 40% to 50% drop in asset prices due to portfolio liquidation. In other words, as Boomers sell their stocks, houses, and other investments in order to turn them into cash, the jump in supply will drive down the price they get. The problem could be exacerbated by the fact that there will be more Boomer sellers than Gen X and younger buyers. Siegel's view, says WSJ reporter Spencer Jakab, is "echoed by a number of his colleagues."

Some economists think the drop in asset prices won't be so dramatic. Most wealth is concentrated at the top --"the richest 10% of Americans own about 2/3 of financial assets," according to the WSJ -- and assuming they want to pass that on to their children, most of it won't be liquidated.

Another looming problem is paying for retiree's Social Security and Medicare payments. The litany is familiar by now: fewer workers per retiree and longer retirements mean that there will either have to be benefit reductions, payroll tax increases, or a combination of both. The necessary combination of spending cuts and tax increases will be a drag on the economy and another downward force affecting stock prices.

One solution for retirees could be buying annuities, but that comes with its own problems. When someone buys an annuity, they give the seller, typically an insurance company, a large sum of money now in return for guaranteed payments for the rest of their life. The insurance company then has to invest the money and earn enough of a return to meet that obligation. That may be difficult if asset prices are falling and people are living longer.

Longer-lived annuity holders could be a big problem for insurance companies, and they are worried. The problem insurers and their safety net, the reinsurers, face is that they have no way to hedge against their customers living longer than expected. Worst case: a miscalculation now could mean that in thirty years they won't be able to make their annuity payments to their customers.

Swiss Re is the world's largest reinsurer, which means they they insure insurance companies' largest risks. Swiss Re's chief economist recently told the WSJ that this "Longevity risk is ... among the biggest risks we have today."

The last problem is that people may not be saving enough to cover their future health care costs. The National Bureau of Economic Research has sponsored a paper by Dartmouth economist Jonathan Skinner (3), in which he identifies out-of-pocket medical expenses as a potential surprise destroyer of hard-earned savings. He writes that "The combination of eroding retiree health benefits and the risk of catastrophic future out-of-pocket health spending suggests that even conventional retirement planning recommendations could be too low." He continues,

"Growth rates for out-of-pocket health care spending have kept pace with overall health care cost growth, and thus continue to outstrip GDP growth, or may accelerate as firms jettison retiree health benefits. These health care cost projections are perhaps the scariest beast under the bed. Fronstin (2006) estimates that a 55-year-old couple in 2006, planning to retire at age 65, would need to accumulate more than $400,000 during the next 10 years in order to afford supplemental health costs, beyond what Medicare already covers, through age 90.

... saving for retirement may ultimately be less about the golf condo at Hilton Head and more about being able to afford wheelchair lifts, private nurses, and a high-quality nursing home."

A pessimist would argue that Skinner does not go far enough, for in order to remain solvent, Medicare is likely to have to follow private insurance in increasing copays and reducing coverage.

It's all too human to assume that present trends will continue for the foreseeable future. A 45 year-old whose house has appreciated 5% per year for ten years believes they'll be in for a nice profit when they sell it in twenty years. Because most retiree health benefits are covered by Medicare now, a 50 year old does not take health care costs into account when saving for retirement. Another counts on their 401(k) appreciating year after year. It's easy to do ... and wrong.

The downbeat projections could be flat out wrong -- after all, by now the world was supposed to have run out of food and oil, and the U.S. was supposed to be a wholly owned subsidiary of Japan -- but ... what if they aren't? It's certainly easier not to question core assumptions. But doing the hard work of evaluating these predictions and the forces driving them is an opportunity to either get comfortable that your planning is sufficient, or a spur to action. But you'll never know which unless you think them through.

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(1) The 3/28/2007 article, "Boomer Effect: Gloomy Forecasts," does not appear on the WSJ.com website.

(2) Available to subscribers here.

(3) A pdf of the working paper is here.