William Goetzmann has written a masterful book (Money Changes Everything) on the role of finance in world history.  The basic message is that financial development has played an enormous role in the advancement of civilization.  This is in spite of various financial debacles that have come along periodically.  Goetzmann suggests that there are four major functions or purposes of financial markets and financial institutions:  to finance ventures, smooth consumption, reallocate risks, and enable complex transactions.

In his 500+ page book Goetzmann covers a wide range of topics, including the history of money, financial exchanges, development of the corporation and limited liability, present value, accounting, and more.  In this essay, I’d like to focus on just one of the issues that he discussed – retirement planning.

Back in 1795, in his treatise A Sketch for a Historical Picture of the Progress of the Human Spirit the philosopher and mathematician the Marquis de Condorcet identified the tremendous power of innovations in finance and mathematics to enable people to solve major social problems, like retirement.  He envisioned a fund wherein people would utilize their own savings, and the savings of others, to secure old age support “not merely to a few families but to the whole mass of society.”  These innovations included ones already invented at the time, like probability theory and actuarial tables that companies were using to value so-called life annuities (where you receive a steady payment for as long as you live), and ones remaining to be invented like mutual funds, index funds, defined benefit pension plans, and government provided social insurance (e.g., Social Security).

Condorcet was an optimist and believed in the idea of progress generally; and specifically that the development of probability and statistics enabled resolution of the great challenge of universal provision for an uncertain future.  He was opposed by Thomas Malthus who in his epic rejoinder treatise, the 1798 Essay on the Principle of Population argued that any improvement in the standard of living or economic security would only trigger increased population growth such that there would be insufficient economic output to enable everyone to enjoy a comfortable living.  In his own words

“Such calculations may appear very promising upon paper, but when applied to real life they will be found to be absolutely nugatory.  Were every man sure of a comfortable provision for his family, almost every man would have one, and were the rising generation free from the ‘killing frost’ of misery, population must rapidly increase.”

Malthus believed that the bulk of mankind is destined to live forever in poverty.

Of course, just about that time is when the Industrial Revolution started to pick up steam (pardon the pun) enabling massive improvements in the standard of living for most of mankind.  In my opinion, Malthus’ assertion must go down as perhaps the worst forecast ever made by an economist.  And that is saying a lot.  Indeed, what has transpired as people have gotten wealthier is that they have fewer children not more, and global population growth has been decelerating now for the past 40 years, even as the expected life span of the individual person has continued to expand.

Goetzmann points out that Malthus’ worry about things continuing to get better may be well-founded, although for the wrong reasons.  As fertility rates decline and lifetimes increase, the average age of the population goes up, and the ratio of people who are retired to those who are working also goes up.  The question then becomes, do these demographics destroy the economic foundation of retirement plans like Social Security or defined benefit pension plans?

Social Security in the US was designed to provide approximately 40% of pre-retirement income for the median wage earner, and is somewhat progressive (higher wage earners receive less than 40% of pre-retirement income and lower wage earners enjoy more than 40%).  It is a pay-as-you-go system in which payments to retirements are financed by contributions of current workers.  If real wages stagnate and the ratio of retirees to workers continues to increase due to rising life expectancy and declining birth rates, then the plan clearly can become non-viable.  For example, suppose each working person is supporting one retiree.  Absent growth in real wages, the combined employee and employer payroll tax on the working person would be, on average, 40%!  This is aside from taxes to support other government programs.  In this (extreme) scenario, the current Social Security program would require significant modification.

Similar issues face defined benefit pension plans.  Although rapidly disappearing from the private sector, most public sector employees participate in defined benefit plans.  These plans can be much more generous to the retiree than is Social Security, sometimes offering inflation-indexed retirement income of as much as 100% of pre-retirement income.  A positive feature of defined benefit plans is that prior employer and employee contributions have created large asset portfolios that are managed to the benefit of current and future retirees (i.e., these plans are not pay-as-you-go).  While it is certainly possible that the combination of contributions and portfolio earnings can cover retiree benefits, the arithmetic does not look good for many state and municipal plans.  We’ll discuss the problem of public sector defined benefit retirement plans in a future essay.