How Much Money Will I Need in Retirement?

November 1, 2007 • Commentary
This article appeared in Registered Rep on November 1, 2007.

Most financial plans assume some contribution from Social Security and Medicare. Trouble is, those entitlement programs are expected to go broke, and the way they are “fixed” may adversely affect your clients’ retirements.

Social Security projections show revenue shortfalls emerging as early as 2017, and, worse, the Social Security trust fund could run out by the early 2040s — well within many baby boomers’ lifetimes. Medicare is in even worse shape. Its trust fund is projected to be exhausted by 2019 (and that’s under relatively benign health‐​care‐​cost growth assumptions). Under midrange economic and population projections, official estimates of the two programs’ shortfalls over the next 75 years total $41 trillion — or three‐​quarters of total U.S. household wealth.

Fewer Benefits, Higher Taxes?

With such large financial imbalances, Social Security and Medicare are both likely to be reformed, but it’s hard to say when and how. Based on past reforms and proposals being floated, it seems boomers will shoulder at least part of the burden. Reforms may curb entitlement expenditures by postponing benefit‐​eligibility ages or levying higher income taxes on the benefits of retirees with substantial other income sources. If payroll taxes are raised in the next decade, younger boomers would have smaller disposable incomes from which to save for retirement.

Of course, boomers have significant political clout, and may succeed in preventing future entitlement reforms from directly affecting their own retirement benefits. But the consequence would be much larger tax burdens or benefit cuts for succeeding generations. Some analysts envision a “generational war” over entitlement reforms. Quite likely, such a war will be covert: Younger workers, facing massive tax increases, would choose to acquire less education and fewer skills, work less or emigrate. If that happens, retired boomers would again experience living‐​standard declines — indirectly through slower productivity and economic growth, a key source for sustaining retiree benefit levels and healthcare quality.

Finally, how will looming entitlement shortfalls affect capital markets? Those markets are global, but so are shortfalls in public pension and health care programs. Compared to the United States, most major European economies, Japan and even fast‐​growing China are undergoing even more rapid population aging. All have massive baby boomer cohorts entering retirement, and all face similar political hurdles in enacting fiscal reforms. If entitlement reforms are continually postponed, national debts will increase. Eventually, public confidence in governments’ abilities to pay those debts will cause higher‐​interest rates, rising prices and higher‐​inflation expectations — all inimical to future economic growth. Of course, the timing of such developments is difficult to predict.

This inscrutable brown cloud in our entitlement‐​reform crystal ball implies at least two things: First, massive entitlement shortfalls mean that most estimates of the number of boomer households facing financial jeopardy in retirement is surely understated. Second, many financial planners suggest maintaining a reserve fund, a sort of personal insurance against adverse market developments. But the policy uncertainty associated with entitlements changes the risk attached to saving more: Saving less is risky because the government may default on its entitlement‐​benefit promises. But saving more may be pointless if the government would only impose heavier taxes on future asset incomes or consumption.

What’s called for under the circumstances involves more than just increased savings. The familiar dictum of Risk Management 101: “When uncertainty increases, diversify more” needs to be adopted. But in broader terms, those boomers whose retirements may be in jeopardy are going to have to save a little more, work a little longer, diversify asset portfolios, take greater advantage of tax breaks available today, and last but not least, become politically active. Boomers should push to resolve entitlement shortfalls earlier, and reduce the scope for governments to fool the public by promising unpayable benefits and mismanaging an essentially private function: saving and disposing of our retirement wealth according to our preferences rather than those of politicians and government bureaucrats.

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