Is Social Security a Ponzi Scheme?

The name calling involved is a distraction from the real problem – the problem of how to keep our entire economic system working with the massive shifting of people into the non-productive retirement ages. Besides the imbalances in pay as you go programs like social security and medicare, there is the problem of who is going to buy the securities that the retirees will need to sell to pay for living expenses? What usually happens when the market knows that someone MUST sell something? What percentage of the stock market’s total holdings MUST be sold over the next 30 years?

Everyone keeps pretending that this is some sort of marginal change situation.  It is definitely not.

What happens if the Boomers sell off causes the market to drop by another 25 – 30%?

Sounds crazy?  But the charts below from the San Fran FRB tells a story…

The solid line represents the ratio of middle aged people (40 – 49) to Old Agers (60 – 69).

This picture shows a 30% drop in PE.  If earnings are also challenged by the low or negative population growth during the same time period, the massive drop is stock prices is quite possible.

So even the people who did save for retirement may be woefully surprised that their money does not save them.

The stock market is but a large and often somewhated distorted mirror of the economy.  If the stock market is challenged by the low growth of the population and the shift from production to consumption of the large retiree population, then that is a reflection that the economy could be challenged in just the same manner.

That is the REALLY BIG problem that needs to be solved.

The Social Security problem is not at all difficult to solve.  According to the most recent actuarial report to the trustees, the shortfall in Social Security is 14% of projected benefits or 17% of projected revenues.  So anyone who can do arithmetic can work out some combination of increases to taxes and decreases to benefits that would bring the program into balance over the 75 year projection period.  Split it down the middle and decrease benefits by 7% and increase social security taxes by 8.5% and it is solved.  But the fact of the matter is that there is no serious consideration being given to any solution, let alone a straightforward solution like the above that anyone could understand.

Hedging Longevity Risk might be the least of our worries

From a mechanical perspective, finding something to “hedge” against longevity risk, i.e. the risk that pension payouts will increase due to improving mortality, is not particularly difficult.  It is necessary to determine investment possibilities that will benefit from increased life expectancy.

Businesses that serve the aged such as nursing homes and medical products companies will be some of the sorts of things that will prosper in an increasingly aged economy.

Clever quants will be able to show that while the hedge is far from perfectly effective, it can be used to reduce the capital requirements of pensions and annuity exposures.

But there is a much larger question that is not likely to be addressed in looking at capital requirements for insurers and pension plans.

That is the issue of whether the economy will be able to sustain the aggregate effects of the aging of the populations in Japan, the US, Europe and China.  Those investments in elderservice providers and elderproduct firms will provide a relative hedge.  Those firms may do relatively better than the rest of the economy.

But on the whole, the economy might well be in the dumps, making the potential to earn the returns on investment needed to support the base level of pensions extremely difficult.  We may well find out that it is not viable for an economy to both maintain its base promises to elders AND maintain a healthy economy at the same time.

Robert Schiller has described this problem well in a NYT Op Ed piece last spring.  He describes an autonomous family farm where they must decide how to treat the family elders who are no longer able to work.  If the farm has a bad year and harvest is poor, do they continue to feed the elders the same as in the good years and therefore starve the working members of the family?  Or would that create a spiral that brought the entire family to ruin?

It would be good if we knew what happens to an economy that doubles the amount of total resources that are directed towards its non-productive elders.  If there is a point where an economy would stop being viable, then the concerns about minor increases to pension benefits due to longevity increases are immaterial.  The ruined economy sill simply not be able to pay the basic benefits.

It seems highly likely that the systems that were imagined in the last 100 years will not stand up to the pressures of the aging Baby Boomers.  The discussion that at least in the US is not happening about funding for retiree medical and income needs may well be the wrong discussion.  The discussion that is needed is to ask how the economy will survive the strain of the very large pool of elders.

Schiller’s family farm example leads to an immediate suggestion.  One that many people are coming to privately, even if there is little public discussion.  That suggestion is a complete rethinking of retirement and employment for elders.  An honest evaluation of the real economic impact of the exploding numbers of elders is very likely to reveal that it is just not practical for an economy to provide for 20 – 25 years of leisure to a large fraction of its population.

This is a situation where our simple extrapolatory approach to assessing risk is inadequate.  The future will most certainly be different from an extrapolation of the past.

Did you accept your data due to Confirmation Bias?

Confirmation bias (also called confirmatory bias or myside bias) is a tendency for people to favor information that confirms their preconceptions or hypotheses regardless of whether the information is true. As a result, people gather evidence and recall information from memory selectively, and interpret it in a biased way. The biases appear in particular for emotionally significant issues and for established beliefs. For example, in reading about gun control, people usually prefer sources that affirm their existing attitudes. They also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and/or recall have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a stronger weighting for data encountered early in an arbitrary series) and illusory correlation (in which people falsely perceive an association between two events or situations).

From wikipedia

Today’s New York Times tells a story of Japanese longevity data.  Japan has long thought itself to be the home of a large fraction of the world’s oldest people.  The myth of self was that the Japanese lifestyle was healthier than that of any other people and the longevity was a result.

A google search on “The secret of Japanese Longevity” turns up 400,000 web pages that extol the virtues of Japanese diet and lifestyle.  But the news story says that as many as 281 of these extremely old Japanese folks cannot be found.  The efforts to find them revealed numerous cases of fraud and neglect.  This investigation started after they found that the man who had been on their records as the longest lived male had actually been dead for over 20 years!  Someone had been cashing his pension checks for those years and neglecting to report the death.

The secret of Japanese Longevity may well be just bad data.

But the bad data was accepted because it confirmed the going in belief – the belief that Japanese lifestyle was healthier.

The same sort of bad data fed the Sub Prime crisis.  Housing prices were believed to never go down.  So data that confirmed that belief was readily accepted.  Defaults on Sub Prime mortgages were thought to fall within a manageable range and data that confirmed that belief was accepted.

Data that started to appear in late 2006 that indicated that those trends were not going to be permanent and in fact that they were reversing was widely ignored.  One of the most common aspects of confirmation bias is to consider non-confirming data as unusable in some way.

We try to filter out noise and work only with signal.  But sometimes, the noise is a signal all its own.  And a very important signal to risk managers.

2040 – America Becomes the Land of the Very Poor Old Baby Boomers

By 2040, the oldest of the infamous Baby Boom generation will turn 95.  The youngest, born almost 20 years later will be 75.  Unless there is a drastic change in course for the way that we generally prepare for retirement living, amost all of the Baby Boomers who survive until then, and many of us will, will be living entirely off of Social Security.

For more than half of the retirees, that will mean a big drop in the standard of living that we have grown accustomed to.  Five factors will feed into that trend:

• Unless there is a sub prime like boom in lending, the part of Baby Boomers standard of living that is supported by debt, will lose that support.  Lenders are quite likely to develop a lack of ability to understand that people with low fixed income and declining assets are not good credit risks, but I would not plan the future of the generation on that presumption.
• Real estate will NOT be the unbeatable asset that is has been most of the lives of the Baby Boomers.  There will just not be enough demand from the smaller generations coming after the Baby Boomers to keep real estate appreciation at levels comparable to inflation.
• Inflation will be higher into the future.  That is because there are two ways that future generations can afford to pay off the promises that have been made to Baby Boomers for retirement:  Inflation and a Miracle.  With inflation, wages can grow enough to fund the retirement and medical benefits if there are small differences in the ways that the inflation impacts on Social Security and Medical expenses and how inflation impacts wages and taxes.  The Clinton administration started this trend by changing the definition of inflation, lowering it by 1%.   Future changes will be needed to allow for balance without large tax increases.  Medical costs inflation must be controlled to something lower than wage inflation, or health care will simply bankrupt the economy.
• It is well known that Baby Boomers are not saving enough for retirement.  And the Boomers who started late were all putting much of their savings into stocks to roll the dice to hope that they picked up 30% per year returns to make up for 30 years of zero savings.
• Very few Boomers will have a significant part of their retirement income in lifetime guaranteed annuities.  The most common approach to dealing with longevity risk is for retirees to plan to spend their retirement income over their life expectancy.  That thinking is the same as planning to run across the street knowing that you have a 50% chance of being struck by a car.  Half of all people live beyond the life expectancy.  Life expectancy is another one of those very bad terms that totally misleads people, in this case will help for them to plan for a very poor old age.

This could be thought of as a Black Swan scenario, except that it is highly likely.  It is probably much too late for anything different to happen.  There are just not enough future working years for the Boomers to make a major change in their own future and there is doubtless little will for the rest of the world to sacrifice to focus yet one more period in history on our generation.

But this scenario needs to be seriously understood by both the individuals who will be a part of this and by the firms who are in the businesses that will be most impacted.