If we do the first, we may not be able to do the second. That's the problem we face as individuals and as a society. The longer we live in retirement, the longer we will consume resources we don't produce.
Our apparent choice is very simple. We can save more. Or we can earn a higher return on what we save.
The trade-off seems simple. In fact, the strength, growth, and structure of our entire consumer society depends on high investment returns. Without high returns, we'll have to save more while we're working. Otherwise we'll suffer a major reduction in our standard of living when we retire. Either way, we'll consume less. It's not a question of whether. It's a question of when.
You can understand our collective dilemma by going through an exercise.
Suppose we lived in a simple society with no investment returns. Suppose also that we worked until age 65 and then lived in retirement for 12.6 years. That was our life expectancy at age 65 when Social Security was created.
How much of our income would we have to save?
Easy. Working for 40 years, we'd have to put aside 24 percent of our income each year, leaving only 76 percent for consumption. At age 65 we'd have 12.6 years of consumption put aside.
Life expectancies, however, have been increasing. By 2000 expectancy at 65 was 17.6 years. By 2040 it's expected to be 20.6 years. Without a return on investment you'd need to save about 31 percent of income to provide 17.6 years of income. You'd need to save 34 percent to put aside 20.6 years of income. Since you had to save more during your entire working life, you'd have consumed less while working. And you would continue to consume less while retired.
Note that we're talking about an incredible amount of saving--- 24 to 34 percent of income. Without investment return, ordinary advances in life expectancy would eliminate our consumption-based society.
Fortunately, investments earn returns. The higher the return on investment, the smaller the portion of our income we need to save.
- The 34 percent of income a young person needs to save today if they earn no return falls to 25 percent if they earn the 2 percent real return of bonds.
- It falls to 15 percent if they earn the 5 percent real return a 60/40-stock/bond portfolio is likely to earn.
- It plummets to 9 percent of income if they earn the 7 percent real return of common stocks.
|The Magic Bullet of Investment Return|
|This chart shows the percentage of income that must be saved to provide a sum equal to the number of years of life expected at 65. In each case the amount of income to be replaced has been reduced by the amount of income saved. As a consequence, the amount that can be consumed rises rapidly with real return. The model used did not consider rises in living standard due to productivity or rising costs due to inflation. It also did not consider return on investment after age 65. Allowing for return after age 65 would reduce the required savings rate further.|
|Life Expectancy at Age 65|
|Real Return||12.6 years (1935)||17.6 years (2000)||20.6 years (2040)|
|Source: author life savings model|
Is there a message in the table?
You bet. As individuals and as a society our future is deeply linked to how much we save and how much we earn on our investments. If returns fall below historical norms we either consume less today or we consume less tomorrow.
How much less may be shocking.
Tuesday: Part 2: The Social Security Connection