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02/01/95

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Baby boomers face uncertainty regarding retirement income

STANFORD -- First they strained the schools, then the job and housing markets. Now, baby boomers are being warned that their sheer numbers could reduce the three main sources of their retirement income: private pensions, individual savings and Social Security.

Their retirement also could negatively affect the capital available for the nation's economic growth.

Forecasts of potential problems with future Social Security benefits have been available for some time, but until recently, no one had attempted to calculate and publish similar estimates for private retirement savings. Stanford University economist John Shoven and Sylvester Schieber of the Wyatt Corp. undertook the task of producing a comparable 75-year-outlook for the private pension system.

They find that the private pension system also faces potential problems when the time comes that there are more baby boomers wanting to cash in their pension assets than younger buyers wanting to purchase them. The selling price for individual investments in assets also would be affected.

"The question that begs to be answered is who is going to be buying the assets that the pension funds [and individual investors] will be selling and at what prices?" Shoven said.

"The answers are not obvious, and probably all one can say is that there is extra uncertainty about asset prices during the baby boom's retirement years. It doesn't seem too much of a stretch to think that something like the housing price run-up of the 1970s will be played out in reverse in the second and third decades of the next century, although this time the assets affected could be stocks, long-term bonds, houses and perhaps even gold."

Shoven, dean of Stanford's School of Humanities and Sciences and the Charles Schwab Professor of Economics, said he is not suggesting that the price of stocks, bonds and other assets will go down in value as we approach the retirement of the baby boom generation, but that "returns will likely not be as high as they have been in the last decade."

A decline in asset earnings might be as high as one-third, he said, which is not a Depression-level drop but similar to the 1970s, when stocks were selling for one-third less than they were worth in terms of the cost of replacing the factories, trucks, computers and so forth that stockholders owned.

The baby boom refers to the large bulge of U.S. citizens born between 1946 and 1964. The largest demographic event for the United States in this century also may turn out to be the largest one for the next century, when the baby boom generation retires, Shoven said.

The impact of the baby boom retirement extends beyond individual baby boomers to the entire economy, he said, because pension fund investments and individual savings for retirement have provided much of the cash available for borrowing by industry and government. Investment capital is necessary for national economic growth.

Under the influence of the baby boom, pension assets have grown from less than 2 percent of national wealth in 1950 to almost 25 percent by the end of 1993.

"In the whole period since World War II, the funded pension systems in the United States have been large net buyers of financial securities such as stocks and bonds," Shoven said. "Pension assets have grown more rapidly than any other form of wealth and now total approximately $4.5 trillion."

To put that number in perspective, he said, "it is of the same order of magnitude as the value of all of the residential real estate in the country."

For the next 15 years or so, the private pension system will continue to be a major source of saving for the U.S. economy, but when the baby boomers begin to retire in large numbers, the pension funds combined may for the first time become net sellers, rather than buyers, of assets. Under the assumptions used in their forecast, Shoven said, the saving generated by the pension system begins to fall precipitously starting about 2010, and the system becomes a net seller by 2024.

Forecast speculative

The forecast is "speculative in the extreme," he warned, because there are factors ranging from earthquakes and hurricanes to tax reform, from a new wave of mergers or immigration to changes in birth and death rates that can affect such a long-range forecast. Some economists also may argue that various asset markets are already taking the retirement factor into account because buyers and sellers have foresight.

"I doubt that markets have 30 years of foresight," Shoven said, "but I wouldn't be surprised to see this as a somewhat dampening factor [on asset prices] to some extent as early as the first decade of the 21st century."

Given all the factors involved, however, Shoven said it will most likely be difficult for future economists to figure out after the fact what role the baby boom retirement actually played. "My bet at this point is that this underlying force will be felt in the economy, but lots of other things will be felt also."

It is, of course, even more difficult to predict who exactly will benefit and who will lose from such an underlying force. Some of the adjustment will likely come in the form of reduced demand for investment capital as well as in the form of inducing people to save by offering assets at reduced prices.

One positive way of looking at a drop in asset prices that reduces baby boomers' retirement income, he said, is that "the generation behind them who will, in all likelihood, face higher tax rates to support the large elderly population, at least will be able to accumulate assets for their own retirement on attractive terms."

"Some of the assets will undoubtedly be purchased by the so-called Generation X members, but they are, of course, less numerous than the baby boomers. Some of the assets may be bought by households in other countries, but most developed countries, particularly in Europe and Japan, will also be experiencing an unprecedentedly large cohort of elderly.

"Maybe the economies of China and Eastern Europe will be a source of world saving and they will be buying the financial assets that pensions will be offering on the market, but that seems like an unlikely bet."

The federal government could help, he said, by running a surplus, or firms could reduce their need for external financing by retaining more earnings, but those seem unlikely scenarios also.

"What seems most plausible is that the assets that the pension systems will be selling will have to be discounted to clear markets until a sufficient demand is generated from younger Americans."

Baby boom's historical burden

For the baby boomers, however, particularly the younger ones, retirement presents the same sort of uncertainty that their numbers have generated all along, Shoven said. "They tend to disrupt institutions in each phase of their lives."

One of their first impacts was more crowded schools. Primary school enrollments grew by 70 percent between 1951 and 1954 and then remained high for 15 years. The number of students in high schools and colleges and universities also surged when the baby boom generation reached the appropriate ages.

The baby boomers next caused the labor force to grow rapidly in the 1970s - at a rate of almost 2.5 percent per year compared to 0.8 percent in the first four years of the 1990s. "It is almost certainly not coincidental that the growth of real wages was low during the period in which labor markets were asked to absorb so many new entrants," Shoven said.

Some analysts also attribute the increase in the relative price of housing during the 1970s to the baby boomers' reaching the house-buying stage, he said, and in their old age, they can be expected to influence everything from medical care to the price of certain types of homes popular for retirement.

Once again, the younger part of the baby boom may bear the brunt.

"When someone born in 1946 retires, there will still be a 53-year- old baby boomer gearing up for retirement by accumulating assets as fast as he or she can. On the other hand, when the 53-year-old becomes 65 and looks to see if there is a 50-year-old to buy theirs, they've got to look at the baby bust generation." If asset markets begin anticipating the baby boom's retirement, however, older baby boomers also may get lower returns than people who are retiring now.

Planning for uncertainty

Individuals, employers, pension fund managers and public policy makers should begin to take these considerations into account in their planning, Shoven said. To the government, he suggests:

  • Easing regulations that limit pension contributions. "Right now we have a lot of tax rules that try to make sure that people aren't saving too much. I think those are ridiculous."
  • Better informing the public about the advantages of saving through information fliers accompanying Social Security statements.
  • Restructuring Social Security so that it is viable over the long run. The most recent forecast indicates the system faces bankruptcy in 2029 if it is not modified. Adjustments made sooner rather than later mean they will have to be less draconian, Shoven said, and will allow baby boomers sufficient time to adjust their saving accordingly. Revisions could include a further advancing of the age for the collection of full benefits, a lifting of the income levels subject to taxes for Social Security, increases in the tax rates or reduction in the benefit formula.

Employers should take different actions depending on their situation. Those who fund defined benefit plans should examine whether they have put aside enough to cover their commitments. If they cannot cover them, Shoven said, taxpayers "could get caught holding the bag" the way they did in the savings and loan crisis because of government guarantees.

Employers with defined contribution plans should examine the adequacy of their contribution rates and those of their employees. In defined contribution plans, employers and employees contribute to retirement funds that are invested by the individual employees, who are not guaranteed a particular retirement benefit but rather the returns on their investment.

Employers without pension arrangements for their employees should "make available, at least on a voluntary basis, all the tax-deferred saving opportunities that the Treasury Department allows." About half of American workers have no retirement pension at all.

Individual members of the baby boom should:

  • Consider increasing their saving rates because of the uncertainty.
  • Hold their wealth in a diversified manner.
  • Take advantage of all tax-deferred retirement plans available, such as individual retirement accounts.

Some studies have indicated that individuals who manage their own retirement plans are too conservative in their investing. Investing in Treasury bills, guaranteed investment contracts and money market instruments is "probably too conservative for people investing for retirement purposes," Shoven said. "Treasury bonds are not safe when you think of inflation, so I personally would rather see people invest in equities until the government issues inflation-indexed bonds.

"If you really want to diversify, you ought to have some international investments as well as domestic investments, but a diversified portfolio of stocks with some exposure in bonds is what I have in mind for most people."

Finally, he said, he would urge individuals to seek "an hour or two of professional advice" because situations vary greatly and retirement decisions are "frighteningly complex," especially when health care costs are considered.

"Typically in a defined contribution plan, you've got several hundred thousand dollars set aside, but how do you know if that is enough?" he said. "You are financing the rest of your life and this is one area where you don't get a second chance. You've got to get it right the first time."

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