The Economics of Retirement Planning

John R. Brock, Ph.D., Vice President

Last month I attended the American Economic Association’s annual meetings, where several thousand economists gathered to discuss their research.  One of the most interesting sessions I attended was a lecture by James Poterba, a highly-regarded MIT economist with a specialty in the economics of retirement.  His speech, “Retirement Security in an Aging Population,” addressed two critical issues:  the demographics of aging and the importance of saving for retirement.

The life expectancy data he presented is striking.  In 1900, men in the U.S. had a life expectancy at birth of only 51.5 years of age.  By 2000, male life expectancy at birth had risen to 80.0 years of age, a substantial 55% increase.  Women, who have longer life expectancy, experienced a significant increase as well.  Professor Poterba further noted that recent longevity advances have come largely from those over age 65, since infant mortality gains in the U.S. had previously been achieved.  In addition to longer life expectancy, we continue to see increases in the number of disability-free years of retirement.  Over the 14-year period from 1992 through 2005, men over 65 experienced an increase of 1.7 years of disability-free life, rising from 9.2 to 10.9 years.  So, Poterba noted, “you’re getting older but you’re also getting better.”  This is encour­aging news!  However, with advances in life expec­tancy come the additional years of expenditures that need to be supported in retirement.  Poterba further noted that when males born in 2000 reach age 65, demographers estimate they will have a 20% chance of living to 93 (and females to 97).

So what does all of this mean for retirement savings?  For those entering retirement, their nest-egg accumu­lation phase is drawing to a close.  If your nest egg is too small to support your desired lifestyle, then responses to longer lifespans include working longer, investing to increase your nest egg’s rate of return, or reducing spending during retirement.  However, for the younger generations, time is on your side.  You can save more during your working years in order to accumulate a large enough nest egg to support a longer lifespan.  The need for younger workers to save for retirement continues to grow.  Dr. Poterba stressed that the traditional “three-legged stool” of retirement support—social security, private pensions and personal savings—continues to erode, with the ongoing decline of defined-benefit pension plans (currently offered by 30% of medium-large size firms, down from 80% in 1985).  The clear emphasis is now on the individual to increase savings in the other two legs of the stool—defined-contribution plans (e.g., a 401k) and individual retirement accounts.  The challenge going forward, claims Professor Poterba, is to increase the level of financial literacy in the country and to capitalize on the important insights from behavioral economics for promoting saving.  To this end, I encourage those planning for retirement to read my recent commentary on our website, “Getting Rich Slowly:  A Guide for Purchasing Retirement.”  As with last month’s IRA study, extra copies are available for the asking.