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Can the Baby Boomers Ever Retire?

(April 30, 2009)

Dear Subscribers and Readers,

As we discussed in many of our commentaries over the last five years (such as our August 29, 2004 commentary “Economic Survival in the 21st Century,” our August 11, 2005 commentary “Demographics do Matter,” and our December 14, 2008 commentary “Demography is Destiny”) one of the most important secular trends in the world over the next two decades has to do with shifting demographics – specifically the general aging of the global population, and more immediately, the aging of the baby boomers.  With the relative size of the workforce projected to shrink in the coming years (in some economies, such as Japan, the absolute size of the workforce will also shrink), the ability to support retirees under the current retirement system will be severely tested.  More specifically, we concluded that either retirees will need to take dramatic cuts in their retirement payments (or else the younger population will have to pay higher taxes), or that the baby boomers will have to work longer.  The more popular choice (at least in the US) seems to be the latter, as the advent of the knowledge economy has made educated baby boomers much more employable in their old age, especially when compared to an “industrial society” that involved back-breaking labor.  But then, the question becomes: How much longer do baby boomers have to work to ensure a stable retirement (which will allow them to maintain a similar standard of living, with up to 80% of their current income), assuming the current social security regime going forward?  Also, how much has the baby boomers already saved? 

The most recent (June 2008) McKinsey report on baby boomers provides a pretty clear picture of what baby boomers will need to do in order to lead a relatively stable retirement over the next couple of decades.  For those who are interested in the topic (and I think most of our subscribers would), I highly recommend reading the report in full in your spare time.  For the purpose of this commentary, we will focus on the most important points – with brief commentaries in between. 

The first baby boomer started receiving her social security payments last year at age 62.  With the oldest baby boomer now at age 63, there is no time to lose from both a personal savings and a public policy standpoint.  This urgency is further compounded by the fact that baby boomers will have to play catch up since they have consumed more and saved less than the previous generation (the “Silent Generation,” or those born between 1925 and 1945), as shown by the following chart (on the left) courtesy of McKinsey:

1) Savings rate among different ages 2) Disposable annual income per household among different ages

In general, households tend to save at an accelerating rate – with savings peaking during their prime earning years (sometime during their late 40s and early 50s).  However, as shown on the above chart, this has not been the case for baby boomers (this is particularly noticeable for the “late baby boomers”).  On the contrary, baby boomers have been mainly responsible for the collapse in the US savings rate – from more than 10% in the mid 1980s to around 0% immediately before the current financial crisis hit with full force.

Assuming that baby boomers will need 80% of their peak pre-retirement savings to sustain their retirement, McKinsey concluded that about two-thirds of all baby boomers are unprepared for retirement, taking into account personal/retirement savings and socials security benefits, net of credit card balances, car loans, and other non-mortgage debt.  Based on this measure, McKinsey estimated that about 69% of baby boomers are not prepared for retirement.  Including the amount of home equity (which baby boomers can draw on when they retire), McKinsey estimated that this ratio was slightly better – at around 62% (note, however, that McKinsey only assumed a peak-to-trough decline of 6.2% in the median US housing price, which I will discuss later in this commentary).

While baby boomers can certainly fund their retirements by saving more, McKinsey concluded that the best solution is for baby boomers to work longer.  This would not only allow the US economy to continue to grow at a decent rate, but would also allow baby boomers to save more, given a higher rate of total economic output.  Quoting McKinsey:

If the Boomers stay on their current savings path, we project that Early Boomers [those aged 54 to 63 today] will begin drawing down their savings at an average of 65.  But they could choose another path.  They could postpone retirement, keep working, and use the additional income to increase their assets.  By working longer, the Early Boomers would begin drawing down their assets later, at an average age of 70 instead of 65.

Such an additional accumulation of savings would have a significant impact on the shares of prepared and unprepared households.  If Early Boomers were to draw down only their net financial assets, the share of prepared households almost doubles from 31 to 60 percent; if households also tap their home equity, the share of prepared households rise even more, from 38 to 69 percent.

Prolonging saving has a dramatic impact on the number of boomers who can maintain their living standards

Of course, McKinsey's forecasts come with a strong caveat – that is, McKinsey's study was done in late 2007/early 2008, before the severity of the current financial crisis (and the subsequent crash in asset prices) became evident.  As mentioned previously, McKinsey forecasted a US median housing price peak-to-trough decline of only 6.2%.  Thus far, the US median housing price has already declined by more than 20% from the peak!  In addition, McKinsey's study was done based on the amount of assets held by baby boomers as of year-end 2006.  Since that time, the value of baby boomers' assets have declined by anywhere from 15% to 20%.  The following exhibit shows McKinsey's assumptions regarding household asset appreciation from the end of 2006 and onwards:

Assets will appreciate at historical average rates while liabilities track inflaction

Given the state of the US housing sector, it probably makes more sense to focus on the “net financial assets only” portion of the study.  That is, if baby boomers choose not to tap their home equity, what percentage of them could expect to retire if they work (on average) for five more years?  Using the value of baby boomers' assets at the end of 2006 (and projecting them forward with the above assumptions), McKinsey projects that more than 60% (or about double if they choose to retire at an average age of 65) of baby boomers could realistically retire.  Note that this takes into account higher savings, an average of five more years of asset appreciation, and a shorter retirement time period as baby boomers work longer. 

But Henry, what about the latest destruction of baby boomers' balance sheets?  Won't this impede baby boomers from drawing their assets and retiring?

Certainly, but things are not as bleak as one might think.  The financial crisis will only have a lasting adverse impact on baby boomers' balance sheets if we do not use this opportunity to tackle the long-standing structural problems within our economy.  So far, both the US population and the new administration have vowed to tackle these problems – including our aging infrastructure, the issue of energy independence, healthcare reforms, and most importantly, an increased focus on science, technology, and education.  Moreover, to the extent that baby boomers work longer as a reaction to the current financial crisis, this will result in higher productivity and a greater-than-expected increase in wealth going forward – thus helping to rebuild baby boomers' balance sheets.

From peak to trough, I estimate that baby boomers lost about 30% of their total assets.  Since both equities and investment-grade bonds were grossly undervalued at the early March bottom, I believe financial assets in general will trade higher going forward.  Assuming financial assets retrace half of the value lost during the last 18 months (which is very reasonable), and assuming McKinsey's projections hold true going forward, baby boomers would only need to work an extra two years on average (on top of the extra five years proposed by McKinsey) in order to meet McKinsey's projections.  Specifically, baby boomers could save an additional 10% of their assets by shrinking their retirement period by two years, while gaining an additional 5% of asset appreciation by working an extra two years – resulting in a total gain of 15%.  While this will increase the baby boomers' average age of retirement from 65 to 72, this is also one of the least painful ways of resolving the retirement funding gap.

Going forward, public policy makers will need to focus on the remaining 40% of baby boomers that have no ability or hope to retire.  Most distressingly, many baby boomers in this “40% category” also do not have the necessary skill sets to compete in the 21st century, or may be engaged in occupations that can be physically demanding. As a result, many baby boomers in the remaining 40% category will also not be able to work much longer past 65.  With baby boomers making up 79 million of our 306 million strong population, the impending aging of the baby boomers (and the inability of nearly 32 million baby boomers to fund their retirements) will present one of the greatest challenges to US society over the next decade.

Nearly half of boomers work in occupations that can be physically demanding

Signing off,

Henry To, CFA

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