I have just finished reading The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy, the new book authored by Boston University Economics professor Laurence Kotlikoff and well-known financial journalist and advisor, Scott Burns. This is a truly important book, and I hope that it will be so widely read as to inspire a meaningful widespread dialog among individuals, families, and policymakers.
The central premise of The Clash of Generations is that we, as Americans, have essentially created a Ponzi scheme in which current and past workers have been promised future financial benefits in the form of Social Security, Medicare and Medicaid that are vastly beyond the accumulated value of what they have contributed. The result is that future generations of workers are now expected to pay the tab. The authors assert that our children and grandchildren are being stuck with a truly monstrous financial burden in order to fulfill the utterly unsustainable promises made to current retirees and near-retirees. Kotlikoff and Burns conclude that the level of unfunded financial commitments being forced onto future generations is quite capable of essentially impoverishing future generations and killing any economic growth. While this argument is not new, Kotlikoff has studied these problems for much of his career and brings a truly authoritative perspective to bear (Kotlikoff and Burns previously published a book devoted to these issues, as well).
Is America Bankrupt?
The book starts with an assertion that the United States is bankrupt. The way that the authors make their argument is really important. The U.S. is not bankrupt on the basis of current debts incurred, but rather on the basis of promises made with regard to future financial commitments.
This is an important distinction. The official debt of the U.S. is currently $11 trillion. The authors’ analysis suggest that when you add up all of the financial commitments that the government has made in the form of Social Security, Medicare and Medicaid, the total unfunded financial liabilities of the U.S. (what they refer to as the fiscal gap) totals $211 trillion!
The key idea here is that promises of future benefits to be paid to retirees are comparable to debt. Take a moment to think about this, because this idea may be one of the most contentious political and social issues that we will face as a nation in the years ahead. We are already seeing clashes between the claims of bondholders and pensioners in bankrupt municipalities. Promises made to future and current Social Security, Medicare and Medicaid recipients are very similar to pension commitments made by states and municipalities. These commitments must be viewed as equivalent to debt.
An additional problem is that our financial commitments to retirees are overwhelmingly inflation-indexed. While the government can repay its traditional nominal bonds in inflated dollars (thereby easing the burden somewhat) this is not the case for the financial commitments in terms of entitlement spending.
Kotlikoff and Burns find that the aggregate value of contributions by the last several generations is vastly below the level of benefits that these generations will receive in their retirement years. The answer, to date, has been to reduce benefits and increase taxes on future generations of younger workers. If this system of unsustainable financial commitments to seniors is not fixed soon, Kotlikoff and Burns predict that the economy will collapse.
The authors find that we are currently paying a total of more than $30,000 per year per old person via Social Security, Medicare and Medicaid. Within twenty years, they estimate that this cost will have risen to at least $40,000 (per senior). How much of our economy does this represent? The authors, using projections from the Congressional Budget Office (CBO) calculate that the costs of these three programs will equate to 13% of our Gross Domestic Product (GDP) by 2030 and total government revenues will equal 19% of GDP. In other words, senior benefits will consume two-thirds of all government revenues by 2030! It is truly hard to conceptualize just how big these numbers really are. The authors try to put this in perspective by estimating that we would have to immediately and permanently raise taxes by 64% to cover the future financial commitments that our government has made to older Americans.
National Savings Rates
The second problem that the book focuses on is the exceedingly low savings rate in America today. The authors explain that our national savings rate has dropped fairly continuously from 16.1% in 1951 to 0.1% in 2010. If we, as a nation, are not saving then we are also not investing.
Domestic investment is what pays for our ability to produce goods and services, including educating our children, building infrastructure, and investing in businesses. Low savings rates mean low investment which in turn results in low economic growth and lower wages. Indeed, we know that real wages (e.g. after inflation) have been stagnant for decades.
So who is responsible for the dismal national savings rates? The authors conclude that “virtually all of the decline in our nation’s rate of savings is due to increased consumption by the household sector.” Their analysis of how and why household consumption has increased so much is where their narrative gets unique. They have found that the average person aged 65 and above received total benefits of about $17,500 from Social Security, Medicare and Medicaid in 1980. In 2010, the average benefits received by a person aged 65 and above averaged $34,000. Both of these figures are in 2010 dollars. In other words, the average real benefits received by Americans aged 65 and above have doubled in real terms since 1980.
What Kotlikoff and Burns then show is that these older Americans are consuming considerably more in real terms than they used to as well. Their conclusion is that older Americans are receiving ever-increasing benefits from the government and are ramping up their per capita consumption accordingly. They are saying that the very low household savings rates are due to a massive transfer of wealth from young people to support old people and that these old people are consuming this wealth transfer, thereby collapsing the national savings rate.
How Did We Get This Way?
How can this situation have gotten so far out of balance? Kotlikoff and Burns suggest that politicians have simply and shamelessly pandered to older people who, as a group, aggressively promote their interests and vote accordingly. In 1983, the Social Security administration added a plan to gradually raise the age at which people would receive full benefits from age 65 to 67. This one change, accompanied by no reduction in benefits growth for older people, equates to an average 25% reduction in real benefits received by those who would receive full benefits at age 67. The younger workers are expected to pay into the system for two additional years (ages 65-67) and then will have fewer years to draw benefits (because they start later). In aggregate, this is a large effective reduction in benefits for the young. The results, in aggregate, are that older people can expect to receive much more in benefits than they have paid in to Social Security, Medicare, and Medicaid and young people can expect to pay in more than they will receive in benefits. While Kotlikoff and Burns do not go into these numbers, I summarized the research in a blog post titled, “Social Security and Retirement: The Reality” that I published in 2011. A great deal of this issue comes down to fairness between generations. The authors estimate, for example, that today’s 20-year olds will need to pay 3.3% of their lifetime earnings to cover the under-funding of Social Security, Medicare and Medicaid by previous generations, along with their own contributions, to these programs needed to sustain them.
Is this fair and reasonable by any standard? I should say not.
What Do We Do Now?
Kotlikoff and Burns have made the case that America is in a perilous situation, having promised a lot of resources to older generations with the expectation that the current generation (and their younger counterparts) will be willing to contribute an ever-increasing amount of their earnings, while seeing their own expected benefits decline.
The authors propose sweeping policy reforms on everything from banking and taxes to health care. These policy proposals formed the basis of Mr. Kotlikoff’s efforts to run for president as a third party candidate. The authors fully recognize that it is quite unlikely that any of these reforms will be adopted, given the current political climate. For this reason, they also lay out a basic action plan for individuals.
Their solution is the we must do the following:
1) Save much more of our incomes
2) Invest in the lowest-cost index funds available
3) Shop for retirement plans with the lowest possible fees
4) Understand our economic lifecycle
While the topics discussed in the book are almost entirely about the worsening of Americans’ financial prospects, there is a silver lining. Investing today, has actually become dramatically cheaper and these lower costs can have a dramatic impact on an investor’s lifetime wealth accumulation. I discussed this issue in “The Changing American Workforce: Can They Still Retire?” a blog post in August 2011.
The authors argue that a global market-cap weighted portfolio is the best way to go, following the narrative of investing in low-cost index funds in a simple asset allocation. Following earlier work in a book titled, Spend ‘Til The End, Kotlikoff and Burns also discuss how choices and decisions at various points in your life can have substantial benefits in terms of optimizing your standard of living. By following these steps, we can improve our prospects quite substantially. That said, without some kind of major overhaul to our entitlement system, the average American faces a bleak economic future.
While it’s tempting to discount the risk of the problems identified in this book (as policymakers and voters have tended to do over the years) I believe that the issues that they raise are perhaps the most critical policy challenges since the authors first presented their arguments on these topics, I believe that the issues that they raise are perhaps the most critical policy challenges that we face in America today. I am not alone. The book has garnered positive reviews by George Akerloff (2001 Nobel Laureate in Economics) and William Bernstein, the highly influential investment advisor and author, among others. I simply cannot recommend this book highly enough. There is no political, social, or financial topic that is nearly as important for us and for our children than the unsustainability of our economic entitlement system and how each of us prepares for our financial futures.
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