The fuzziness of retirement math

September 28, 2010
Europe's pension gap.

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Aviva has a huge new project up online on what it calls Europe’s pension gap: the problem that the continent’s pension systems are inadequate to the needs of an ageing population. Between them, Europe’s pensions systems need extra funding to the tune of a whopping €1.9 trillion a year, it concludes — a sum which is impossible to raise, and which is only growing.

There’s definitely a problem here. But equally it’s a very hard problem to quantify, because the statistical data needed to do so simply doesn’t exist. The Aviva report is based on the assumption that “on average, people need 70% of their pre-retirement income to provide an adequate standard of living in retirement” — but if you try to work out where that number comes from, you rapidly run into a very fuzzy mess.

For one thing, the average seems to encompass a large variation across income groups, with low-income people assumed to need 90% of their pre-retirement income, dropping to just 55% for high-income people.

But more importantly, the number is entirely normative: it’s the amount that the OECD and Aviva reckon that people should target if they want an adequate standard of post-retirement living. It’s not empirical.

In order to come up with solid answers to important questions, we’d ideally need to be able to look at large populations around the world, and measure their pre-tax and post-tax income and consumption levels both before and after retirement. We’d look at what kind of drop-offs in such levels are normal, and what are excessive; we’d ask retired people whether their income is adequate to their needs; and we’d look at how all these things are changing over time.

But in reality, none of this is possible: the statistics simply don’t exist. In Europe, the national statistical offices and tax authorities do give some, conflicting, information on post-retirement income — but only in the UK and Ireland. There are also still pension schemes which are explicitly based on a percentage of final income; that percentage seemed to rise over the 1980s and stay steady over the 1990s before falling back a bit in the 2000s, but even those numbers are hard to pin down with any accuracy.

And then on top of all that are questions which by their nature are unknowable: what are future investment returns going to be? What are future annuity rates going to be? What kind of tax rates will retirees pay in future?

What’s more, by the time that people have a pretty good idea what their final salary is going to be, it’s far too late to set up a retirement plan which will generate x% of it post-retirement. For that, you need to start early — ideally in your 20s, but certainly in your 30s or early 40s — and when you’re at that stage in your career, you have no idea how much you’re going to ultimately end up earning, or how much consumption your future self will consider an adequate standard of living.

Big-picture trends, however, are not good. For one thing, there’s demographics: the population is ageing, which makes it harder for the working population to support the retired population. What’s more, the rate of unencumbered homeownership is falling: people are less likely to own their houses outright at retirement and more likely to still have a substantial mortgage. And on top of that, people are having children later, and child-related expenses can continue right up to, and even after, retirement.

Oh, and did I mention rising medical costs?

Some things don’t change. You’ll probably need a smaller home once you’re retired; you won’t have commuting costs; you certainly won’t need to continue to make pension-fund contributions. And there will be some kind of state pension, too, although its size is uncertain.

But the fact is that all of these factors are so unknown, or unknowable, that to a first-order approximation all we can reasonably do is save as much as possible, and hope for the best. Any retirement planner who tries to work backwards from a fixed sum needed at age 65 is making so many assumptions that the number is almost guaranteed to be meaningless. But that kind of silly exercise is how retirement planners make their money. So it’s not going to stop any time soon.


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