Lecture 2: The Changing U.S. Retirement Landscape Monday, August

By the end of this lecture, you should be able to: Explain why retirement income has become major issue in private and public sector Describe current sources of income for the elderly Describe major trends facing retirement landscape in the US Discuss rationale for public concern over pensions Explain why employers might offer pensions out of self-interest

Demographic Shifts Life expectancy (at birth) 1900: male = 51.5, female = : male = 79.6, female = 84.3 Fertility declines Work patterns In 1900, 2/3 of those who reached 65 continued working Today, only 1/8 continue working after 65 Living arrangements Nearly 3 out of 4 retired men in 1900 lived with adult children Today, fewer than 1 in 5 do

Source: Fast Facts & Figures about Social Security, August 2004

Social Security Act of 1935 Social Security as a national retirement system Championed by FDR to offer “some measure of protection to the average citizen and to his family … against poverty ridden old age” Backdrop: high unemployment (25% in 1932) and stock market crash of 1929

Social Security Today In 2005, more than 48 million Americans will receive approx. $518 billion in benefits Approx 40 million of these are retirees, or their dependents and survivors (rest is for DI) More than 9 of every 10 individuals over age 65 receive SS benefits About 2/3 of elderly receive 50% or more of their income from Social Security SS is the only source of income for 22% of elderly

Employer Sponsored Pensions Largely gained popularity in post WWII period – often driven by unionization Savings accumulated in employer plans is growing fast $1.6 trillion in 1985 $5.5 trillion in 2003 Pronounced shift away from defined benefit to defined contribution plans Much more to come on this topic!

Individual Savings Accounts for 15% of all retirement income, but is highly skewed More than half of households report income from assets, but many have none Line between personal saving and pension saving is getting increasingly blurry

Labor Earnings In 1962, 36% of households age 55+ received labor earnings In 2002, only 22% do Choosing retirement date is an important adjustment mechanism for those who have over- or under-saved Ability to contribute to workforce much greater today Better health than elderly of 50 years ago Job skills not as tied to physical prowess

Public Assistance Programs such as SSI (Supplemental Security Income) 5% of elderly households receive some form of public assistance For 25% of recipients, it is sole source of income

What are the Big Trends? 1.Continued aging of the population 2.Shift towards more “self reliance” DB to DC Debate over personal accounts 3.Rising health care costs

Population Aging Ratio of individuals age 20 – 64 to individuals age : >7 1975: : : 3.3 Today, 1 in 8 citizens is age 65+ By 2050, 1 in 5 will be age 65+

DB vs. DC Plans Defined Benefit Defined Contribution

The Shift from DB to DC 1980: 38 million DB participant 20 million DC participants 1999:41 million DB participants 60 million DC participants Source: U.S. DOL Private Pension Plan Bulletin

Health Care U.S. spent 14.1% of GDP on health care in 2001, or about $1.4 trillion Up from 8.8% of GDP in 1980 Likely to reach 16% by 2010 Growth in costs expected to accelerate – some estimates that it will be 38% of GDP in the long-run!!! Disproportionately large fraction of health care expenditures incurred by the elderly

A Model of Individual Retirement Savings Behavior The “Life Cycle Model” Individuals like to smooth consumption over their lifetime But income is not even over lifetime What do you do?

A Simplified Life Cycle Model Age 22 Age 62 death $ Income Consumption borrow save Spend down wealth

A Simplified Life Cycle Model Age 22 Age 62 death $ Income Consumption borrow save Spend down wealth

The “Rational” Case Against Public and Private Pensions If individuals were behaving rationally and with perfect foresight, they should be saving enough today to take care of their retirement Attempts to force savings through public or private pensions will be: At best, redundant and unnecessary At worst, harmful, by making people save too much, etc.

The Case for Public Support of Retirement Pensions Inadequate foresight or planning Uncertainty and imperfect insurance markets How long will I live? What will my expenditure needs be? Income Redistribution

The Value of Pensions to Employers Tax deferral The three Rs Recruiting May help “sort” out type of applicant that you want Retention Vesting rules, back-loaded compensation plans Retirement Influence choice of retirement date Encourage Productivity Discourage collective bargaining