The fuzziness of retirement math

By Felix Salmon
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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I agree that the uncertainty is HUGE. Not only are the expenses highly uncertain, but the difference between a 4% real return and a 2% real return over a 40 year accumulation period adds up to more than 50% in the resulting nest egg.

Individuals can reasonably answer many of the questions you raise. They can implement a plan to wholly pay off the mortgage before retirement. They can calculate when their kids will be in college, and make it clear that they see their responsibility ending there. They can estimate the cost of their lifestyle.

Still, the best you can hope to do is to aim conservatively for a target that already incorporates a large margin of safety. That way if you fall short, it will hopefully be a gap that can one way or another be bridged.

I’m strongly suspicious of retirement planners because they often don’t use sufficiently conservative estimates. I’d rather not wake up on my 60th birthday and realize that I’m only half way to what I will need.

Posted by TFF | Report as abusive

“Europe’s” pension gap?

Look, you or I, as individuals, can meaningfully think about saving for retirement. That is because it is reasonable to assume that the world will continue on more or less the same course regardless of our individual decisions.

But we cannot save real goods and services, we can only save money (in whatever form you prefer: cash, gold, cows, you name it.) The claim made by money on future goods and services is a risky one contingent on many factors. But one thing is certain: we cannot buy more future goods and services than are produced, no matter how much money we have or in what form. Therefore, it is impossible for “Europe” to retire. If Europe’s future production does not meet future demand, then a “pension gap” will be the least of its worries.

You have made the category error of applying microeconomic thinking to a macroeconomic problem – “the fallacy of composition” is the learned term for this.

Posted by Greycap | Report as abusive

It is difficult to be on target when you don’t know the target. TFF’s plan to overshoot the target will work if your money has the same value you targeted for! How likely is that? Perhaps we have all been too optimistic … There is such a thing, even though I have been called a bummer for saying so.

I agree there is little we can do. As always I hope for the best and prepare for the worst. It means my glass is always half full … even when the champagne is flowing!

Dan Ariely has an alternative method to save that is getting mixed reviews: ple-to-save-force-them/

Posted by hsvkitty | Report as abusive

I’m in the retirement planning business myself and just like in the, credit ratings business, or the Muni bond insurance business, it’s a game where you are forced to tell people that all will be ok when the mathmatics point to a big problem.

IE… with the 9.5% annualized real return I’m forcasting for your portfolio (every year for the next 15) you will have a retirement of milk and honey so long as you both shall live.

Millions of seniors were sold that bill of goods and at least some of those would have actually saved more and spent less had they been advised to do so.

I’m on the Warren Buffett plan myself… work as long as I’m able to do and save like crazy irreguardless of age or wealth. If I die at my desk than I guess my family will make out like bandits…

…personally I hope my kids turn out like minded. I hate imposing on others for so much as a ride to the airport… let alone feeding, clothing, housing, and entertaining me for 20-30 years.

Perhaps it’s my youth talking and I’ll be singing a different tune when I’m 59 but to see all the protests in France over raising the retirement age from a totally unrealistic age of 60 to the somewhat unrealistic age of 62… I mean what planet are those people on?

Best hopes for more planning and less panicing.

Posted by y2kurtus | Report as abusive

not sure that saving for retirement is really possible without a answers to a few simple questions. how long are you going live. how much will it cost to live that long. since we can’t predict the future, you can’t determine how long you will live. and you can’t predict the cost to live that long. you are missing a few pieces to even attempt to. you don’t know what living expenses you will, whether you will have good health and for how long. 401k/IRAs are just pensions managed by non-professionals who can only do it only part time. sounds like a real winning combination. if pensions are having trouble then the others are too. we just aren’t able to really tell

Posted by willid3 | Report as abusive

“How long are you going to live?”

Forever. Or close enough so as to make no difference. Financially there isn’t much distinction between living 30 years into retirement (certainly plausible) and living forever. So you might as well plan for the latter.

“How much will it cost to live that long?”

Start with what you THINK it will cost, then add a 50% safety margin to account for what you didn’t expect. And hope that is enough.

How is this different from any engineering project? You think they try to figure out EXACTLY how many girders are needed to hold up that bridge for fifty years (not having any clue what conditions the bridge will actually face over that fifty year span)? Or do they make their best calculation and then bump the number by 50%?

Posted by TFF | Report as abusive

I am retired, on soc sec and have no bonds. Bernanke devalued the dollar 1% last week and has made it clear he wants growth and normal inflation. He wants the Market to rise. This will give business the confidence to start spending the two trillion dollar hoard it is sitting on. I believe in the country’s future and am extremely bullish. Let me briefly make the case that we are entering the mother of all bull markets. I invite critiques :
1 We have had growing earnings for 9 quarters and a 40% year over year increase in earnings. This trend of ever greater earnings was countered by a fear of a double dip. This fear has dissipated and I will address it below.Stock valuations are based on future earnings.
2 Earnings have grown through 9 quarters of high unemployment and the absence of a robust construction industry. This argues compellingly that they can continue to coexist. Construction has nowhere to go but up and will bring employment with it.
3 The S&P500 earn half their revenues abroad and this number probably needs to be revised upward because of global growth. Asia is surging. This helps to explain how earnings increased through the Recession. I believe the half will increase to two thirds next year. No one is talking about German business confidence, which is at its highest level since 2007-boom times. For decades Germany exported one third of its GDP. Early this year it was over 40%. Based on the outpouring of German glee I suspect that this figure may be approaching 50%. This sun is smiling at us also. The Germans should know much more about global growth than we, who export 11% of our GDP. This will increase. It probably already has. We can reasonably expect growth in year over year earnings to exceed 50% next year.
4 No one is making the case for a double dip. They are extremely rare. The indicators are growing increasingly favorable. In the unlikely event of a slowdown in growth what is to prevent corporate earnings from growing through it as before? We are fully integrated into the world economy which seems to be growing in tandem.
5 the European debt crisis is and has been boo. Riots in Greece in April,and yellow journalism routes the Market by announcing the imminent collapse of the EU. The IMF and the EU bail Greece out with a 139 billion dollar loan in May and the other PIIGS get their own refinancing . End of story . Read Ken Fisher in Forbes, p70. He calls the reports of a crisis “nonesense”
6 US debt. Chew on this. It was at 3 trillion in 1945. What happened? The 50s, our most prosperous decade. No one is adding our underground economy to our GDP. Add another three trillion. The old estimate was 30%. I am reducing that by a trillion for construction.
I want to say a word to the army of soreheads and nut cases who have no skin in the game. Quit running your gators and get your hands on some money and buy large caps that pay dividends and are off their high, like WMT. I aint sellin.

Posted by letsgetgoing | Report as abusive

Seem a lot of wealth people read this site. Well, it is mostly financial news.  I don’t think many people under 40 believe in retirements at all.  They are the next really big bubble.  They seem to be nothing more than ponzi schemes.  In just a few years there will be proposals to raise taxes to pay for retirements, since they are so under funded.  This is already happening, just with more misdirection.  Once they have to actually admit that they need to raise taxes on the young to pay for the old, things will break down rapidly.  I’m the first of generation X.  I’m already pissed.  Generation Y is going to be told that they have 0 fixed retirements, no unions, can’t possibly pay for their children’s college, and will never own their own home.  If they do they’ll be using a reverse mortgage instead of leaving it to their kids.  I don’t (and they won’t) care what the previous generation promised themselves.  You can’t promise yourself someone else’s future.

Posted by tmc | Report as abusive

Agreed, tmc, there is a battle coming when the pension funds ultimately are forced to bridge the gap between their assets and promises. Promises will necessarily be devalued one way or another.

This is a strong reason to rely on a 401k rather than a pension plan or Social Security. At least the ownership of those assets is clear. If *THAT* part of the system breaks down we have anarchy.

Posted by TFF | Report as abusive

It can all be done, and I’ve done it. Mortgage paid off before the eldest started college. Tuition, books, fees, and room/board at state university for four years for both kids. Retired at 57. Okay, but not great, IRAs (+300K each for wifey and me).

HOW? Not being stupid. We raised two kids in a 1,200sq ft. house in the burbs we bought when I first got out of school rather than buy a McMans when my salary went up. I commuted on the bus rather than driving every day. Vacations were camping trips to the National Parks. We said ‘no’ to the kids when the Iwannas started. We clothed the kids from T.J.Max and Ross instead of whatever overpriced trash merchant was the latest fad. We’ve never bought a new car, only ever good used. We never max our credit cards and always pay off the balance. If we can’t afford it and don’t genuinely need it, we don’t buy it. Oh, and ALL my investments are in Vanguard.

People in the U.S. used to know how to do that. Screw the ones that forgot.

Posted by ARJTurgot | Report as abusive

Sounds like a wonderful life, ARJ. Hope I’m where you are in 20 years. (And am definitely trying to follow your plan.)

Posted by TFF | Report as abusive

greycap hit this perfectly. Future production has to fund future consumption. Its a bit of a zero-sum game, individuals can save better as a whole but the whole still has to consume off the production of current workers. And that is related to demographics, no matter how well funded pensions were they were of hit a rough patch (more savings equals higher stock prices and lower dividends for example).

SS could never work because there was no real way for the government to save SS taxes, it ends up affecting monetary polciy and growth for a society as a whole to try and save cash. The best we can do is make sure all infrastructure is pre-built before the boomers retire so that we don’t need construction workers and the excess labor can move to services for the elderly.

Posted by sditulli | Report as abusive

Dylan Grice has some interesting thoughts (via ZeroHedge) rice-what-weimar-republic-popular-delusi ons-can-teach-us-about-japans-upcoming-h yperi

America is in a better position than most of Europe or East Asia, because of demographics, but the storm will impact us strongly. The real crisis across the developed world is demographics, something that ivory tower types like Krugman discuss almost never.

Japan’s GDP per worker has actually been growing faster than ours for many years. But meanwhile their workforce has been shrinking and herein lies the problem.

Within a decade, their worker-retiree ratio will be 1 to 1. This is absurd and requires massive benefit shrinkage or else there will be national collapse.

Much of Europe has a similar problem. What does this mean for us? The global glut of savings seen now will turn into a global shortage of savings. All those Japanese and Germans who upset us by saving so hard will be doing the opposite, drawing down their savings to fund their retirements. They aren’t engaged in some vicious mercantilist war. They just have very distorted population pyramids and they are sensibly saving for their retirements all at once and will then draw down their retirements all at once. This is the great global hurricane coming. What happened in 2008 was not so severe as what is coming. A global savings shortage will be the real economic storm.

Expect high interest rates. These times of very low interest rates are reflective of global savings abundance, a kind of one-shot demographic dividend. When these trends reverse, interest rates must shoot up. Bonds will be massacred. Growth will be hindered everywhere. With money in short supply, inflation can be expected and owning tangible things (such as a house with a low fixed-rate mortgage) will be very beneficial.

Low consumption in the future will be critical, so it is a good idea to get spending (houses, energy efficiency improvements, lasting furniture) out of the way now, in preparation for much lower spending in the future. Energy efficiency investments are a great way to spend now on guaranteed, untouchable income stream in the future. Low-debt stocks will be a good bet too. For a young person, investing now in valuable skills that will bring an income stream in the future is terrific. Parents and relatives, send everyone you know and love to engineering school, med school, grad school in the sciences, business and so on.

And especially, have several children now!! They represent a big cost now and a huge income stream for your family and America in the future.

Posted by DanHess | Report as abusive

Right on ARJTurgot ! “If we can’t afford it and don’t genuinely need it, we don’t buy it.” What a concept!

America seems to be the land of entitlement where people adopt a sense of need and greed, rather then act to save now and for the future.

Hints on how to make math less fuzzy…

Paying off your house should be a priority, not having a mortgage and debt rather then equity … and so few will own their homes by retirement. It should make sense now, not just when you retire. (well, for thos who make their house a home that is…)

Saving does not have to be all about deprivation. Neither does living within your means. And it is never too late to start. Pay off the debt. Forget that the math is fuzzy as it always has been and always will and just act. Throwing your arms up and inaction isn’t going to solve future problems or make that math less fuzzy. Preparation is.

Wrap your credit cards in elastics and freeze them in a block of ice and don’t touch them until they are paid off and then only in dire need. Take the same $$ that was used to pay credit card and use it for savings et voila… you are now a saver and wiser to boot!

Budget. I know it is passée word, but it is about to come back in style

You can do it yourself but do remember financial planners are pie in the sky if not and… they take their hefty slice. Go for a nice basket of diversity with transparent fees.

PS owned my first house and started retirement savings in early 20′s. I am not rich, not wealthy by any stretch, as I am on a reduced pension and work only part time, but I am happily semi retired in mid 50′s and service no debt other then a small mortgage to be paid off before my other pensions kick in.

Posted by hsvkitty | Report as abusive