Barry's Pickings:Demographic Partings

Let's talk really macro policy for a bit. 401(k) plans and DB plans are (private) vehicles for financing retirement income. Social Security is a public vehicle for the same purpose. So, in fact, is Medicare. As people age, medical costs make up a greater and greater share of the cost of living. For many, in the end, medical costs are all you spend money on. So, one pretty useful way to think about Medicare is as another (public) vehicle for financing retirement.

What exactly does it mean to finance retirement? You're providing a system for paying people who, by definition, aren't producing anything. There are (at least) a couple of ways you can do this. Private systems, like our 401(k) and DB systems, pre-fund this obligation. In public systems, on the other hand, retirement income is financed on a pay-as-you-go basis. Public retirement programs are, more or less, systems of generational transfer payments. That is, a younger generation pays, out of its wages, for the retirement of the older generation.

Either a pre-funded or a PAYGO system should work fine in a generic, stable economy, with a generic, stable population. That is not the current situation. The most significant retirement policy fact is that, over the next 40 years, the old-age dependency ratio—the ratio of retirees to workers—will increase dramatically. In Europe, the old-age dependency ratio will go from around 25% currently to 50% in 2050. Japan is at the extreme, with old-age dependency going to more than 70% by 2050. In the United States, the problem is less severe, with old-age dependency projected to rise but to remain below 40% in 2050.

In the context of increasing old-age dependency, poverty (or at least a dramatic decrease in living standards) can be avoided only if you increase productivity, so that fewer workers can produce more goods and services. That happens, or at least is understood to happen, naturally where you pre-fund retirement. Saved wages are invested in capital and capital goods, which increase productivity. Not so in PAYGO systems; the deferred wages of the younger generation are not saved but are paid to and consumed by the older generation. So, they are not invested in a way that will make the necessary productivity gains likely. It's still possible that a generation or a country or the planet will hit the jackpot, discover the internal combustion engine or something like that, and be able, outside the ordinary course, to finance a large older generation out of the superproductivity of a smaller, younger generation but, under a PAYGO system, it's at least less likely.

I raise all of these issues because of a remark a friend made to me recently—that not just our health system (which, remember, is largely a retirement financing system to begin with), but also our retirement system itself will go the same way as Europe's, with private pre-funding being replaced by public "finance."

I'm not sure how that's going to work in real life, as opposed to in the realm of think tanks and focus group-tested rhetoric. Abandoning a system in which each generation at least partly pays for itself for one where each generation rides the back of the succeeding one doesn't make a lot of sense to me, and doesn't seem to be working out that well in Europe. For that matter, while Social Security may weather the current storm, Medicare is widely viewed as a financial car crash, with no solution in sight.

Michael Barry  is President of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has had 30 years' experience in the benefits field, in law and consulting firms.

Mike Barry
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