Terminal Accounts of Wealth Dispersion, Life Expectancy and Individual Retirement

Terminal dispersion of wealth is the technical term that describes the variability of the future value of investment portfolios. This unavoidable variability means that no one knows what your investment portfolio will be worth when you reach retirement age or at any time during your retirement. And the uncertainty of life expectancies of individuals aggravates this problem.

Hedging against the risks associated with these two factors places an onerous burden on individuals. Although this coverage could result in a very comfortable retirement, if one can afford the coverage and the timing is right, the potential downside risk is so great that many people may find it unacceptable. So one has to ask, “Do people really prefer to give up a secure but modest retirement income and gamble with their retirement savings in hopes of doing very well in retirement?”

With individual accounts, people lose the benefit of risk pooling. The two risks that force people to save too much are investment risk and the risk of living beyond the average life expectancy. In both cases, the results, terminal wealth and life span, are highly variable. When risks are pooled for large numbers of people over many overlapping lifetimes, the average outcomes are highly predictable, which is why traditional pension plans work so well.

Traditional pension plans exist, for all intents and purposes, in perpetuity. This being the case, they are able to build reserves during good times in the financial markets and weather bad times, allowing them to make consistent payments to retirees, regardless of when they retire. Unfortunately, people don’t get to choose their tenure periods or retirement years and must take what comes, and what comes can be good or bad. Therefore, individuals should set savings goals that are high enough to protect against the risk that the average return on an investment portfolio over its holding period will be much lower than would be expected in the very long term.

The relatively short length of individuals’ holding periods makes them highly susceptible to the effects of market cycles, which are notoriously unpredictable in amplitude and frequency. Being widely diversified mitigates this risk but does not eliminate it, as a global bear market is quite possible during the holding period. Then, at the end of the holding period for wealth accumulation, a second holding period begins, which will be the retirement term, and this second holding period carries the same risks as the first, but at a time in life when which there is no source. of income to compensate for the poor performance of the portfolio.

The other component of risk that people must cover is the risk represented by the uncertainty of the length of life, which means that people must aim even higher when setting their savings goals. Administrators of large pension plans can rely on retirees living on average only the average life expectancy of employees who reach retirement age. The average life expectancy for someone reaching age 66 is currently 82, and 66 is currently the age workers are eligible for full Social Security benefits, making it a baseline reasonable. Based on these assumptions, the average term of retirement would be 18 years and pension plans should only be funded to the extent necessary to cover the cost of this average term of retirement.

However, people don’t know how long they’re going to live, so they need to oversave to make sure they don’t run out of money before their time runs out. This need to oversave is independent of the first need, so the need to oversave is compounded, that is, an individual needs to save enough to cover the cost of living well beyond the average life expectancy and the amount of savings target at retirement age should be large enough to ensure with a reasonably high level of certainty that the actual amount available at retirement is at least the minimum necessary for survival.

A popular estimate of the retirement term that people should plan for is 30 years. Saving enough to cover the cost of a 30-year retirement is a much bigger burden than saving for an 18-year retirement, but planning for a shorter retirement exposes people to tremendous risk. It also exposes taxpayers to tremendous risk, as people who outlive their savings will no doubt require some form of public assistance to make ends meet and are likely to become wards of the state when they become physically unable to care. of themselves.

A person who bases their retirement savings on living to age 96, but only lives to age 82, will have given up many pleasures in life, such as travel, good food, and better vehicles, that they might otherwise have enjoyed. But many people simply do not have the level of income required to support the savings rate needed to accumulate the wealth required to hedge against the downside of terminal wealth dispersion and the possibility of living well beyond the average life expectancy. For them it is not a question of wasted consumption, it is a question of going through life with the knowledge that they are likely to spend their golden years living in abject poverty and that this will be their reward for 40 or 50 years of hard work. . And it gets worse!

Some economists now believe that 15 years or so from now, given the current rate of health care inflation, 100% of Social Security benefits will be spent on medical expenses: Medicare Parts B and D premiums, copays, expenses. uncovered and medigap insurance premiums. If that becomes the case, anyone without substantial savings or a defined benefit pension will seek public assistance the day after they retire. Although this is probably a worst case scenario, there is a general consensus that people retiring today will need to set aside approximately $180,000 for medical expenses not covered by basic Medicare.

With the situation already in this state, adding private Social Security accounts to the mix would be like pouring gasoline on a fire, since individual Social Security accounts carry the same risks as other individual retirement accounts. Those who have tried to kill off Social Security since its inception find private accounts very appealing. But, not coincidentally, most of them seem to be in the enviable position of not needing Social Security to support their retirement. More recently, younger workers have also come to oppose Social Security, but not for the same reason as traditional opponents. Young workers may be crushed by the growing burden of Social Security and may never receive any benefits from the system. Those who oppose Social Security simply because it is a social program should devote their efforts to reforming it rather than ending it.

If Social Security had been run like a pension plan instead of the illogical system that it is, with today’s workers paying for the retirement of yesterday’s workers, its current situation would not be so dire. In fact, it could very well be a fully funded working system. CalPERS and other large public employee retirement plans have operated successfully for decades, with success defined as being able to meet obligations, not having an adverse effect on financial markets, not having scandalous events attributable to employee misconduct plan sponsors and be free from influence by elected officials. There’s no reason Social Security couldn’t be run that way. It would literally take an Act of Congress to do this, but the hardest part for Congress would be letting the system work without them interfering with its operation.

Shifting the burden of retirement to individuals was a big deal for corporations, but it’s a very poor deal for most people, and extending individual accounts to include the Social Security system would only make the bad situation worse. Not a bad deal for everyone individuals because there will be some who can afford to save a substantial part of their income and whose holding periods will coincide with bull markets, thus putting their wealth in the upper range of their terminal wealth dispersion, and who will also live long and healthy lives. They will be the ones who benefit from excessive savings and living beyond the average life expectancy, but may end up losing a portion of their wealth in the form of taxes to support the less fortunate. I don’t think that’s what the public expects from a well-conceived system.

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