Who can manage their own lifetime risk – return of the $6 million dollar man?

If the German retirement system had added as many years to the retirement age as we added to the overall life expectancy over the past century, the official retirement age would stand at around 95 years rather than 65 years.

– Patrick M. Liedtke on Bismarck’s pension trap ¹⁾Patrick M. Liedtke, “From Bismarck’s Pension Trap to the New Silver Workers of Tomorrow: Reflections on the German Pension Problem,” European Papers on the New Welfare, February 2006, German Pension Problem.

In the book, Perfume, the protagonist has an extraordinary sense of smell. Abandoned as a newborn, he ends up in a filthy state-supported orphanage, surviving only because he can smell where the head of the orphanage hides the money she is given by the state. This woman, Madame Gaillard, has a single ambition in life – to save enough from the orphanage to have a comfortable old age and proper burial. To accomplish this, she is quite happy to divert resources meant for her wards. Unfortunately, as with most things in life, this does not turn out as planned. She certainly diverts what she thinks will be enough, but between the inflation of the Napoleonic era (roughly, November 1799 to June 1815) and her unusual longevity (for that time) all comes to naught and the one thing she doesn’t want – to die in a pauper’s hospital and end up in in a pauper’s grave – comes to pass.

We need to account for realities about people if we are going to construct a better economy that fosters flourishing.

Here are two very important realities:

• We live in a world that changes more rapidly than we could have imagined.

• We live, on average, much longer than ever.

We believe that these facts lead to an important conclusion: in this environment, it is essentially impossible for the average individual to be able to manage their lifetime personal financial risk in any coherent manner. Earnings, prices, and longevity are simply too uncertain.

This conclusion has critical ramifications for how we need to think about pensions and the economy, ramifications that are at odds with the current orthodoxy.

The ugly truth that it is not possible for the vast majority of people to manage their lifetime risk was concealed by a seeming golden era when defined benefit pensions were possible, the ratio of retired people to active workers was very small, and we had not figured out how long people would live. As novelist and screenwriter, Deborah Moggach, aptly describes in an interview with Caroline Davies, 1948 was the best year to be born a woman… you got sexual liberation, drugs, and a good pension. Life doesn’t get better than this: “We wanted sex? Suddenly there was the pill! We wanted to rebel, take lots of drugs and do things our parents never did? Blow me down, along came flower power,” she says. “It’s as if we had ordered such things from a celestial menu.”²⁾Deborah Moggach, quoted by Caroline Davies, “Sex, Drugs, Music and a Pension: Why 1948 was the Luckiest Year to be Born,” The Guardian, November 6, 2009, Accessed on November 03, 2013. Sex, Drugs, Music and a Pension]. Accessed October 5, 2020.

To make this concrete, imagine someone at 30 who aims to retire at 60. She starts with USD100K and can save USD10K per year from her income. What kind of retirement will this provide? She doesn’t know if her assets will earn 2%, 5%, 8%.³⁾Indeed, there is a raging debate about what returns pension plans can assume. If, as CALPERS does, you assume 7.75% annual return, all is fine. If it’s 5%, then disaster.  She doesn’t know what inflation will be. She doesn’t know if she will live to 45, 75 or 90 (or 105). She doesn’t know what her health will be at each stage, or what the cost might be for health care or assistance if she is in some way incapacitated.

For a 60-year-old who lives to 100 and earns a real return of 2% to receive $182,00 per month (a lot of money, but not stratospheric in today’s telephone-number-hedge-fund-salary world) would require $6,000,000… hence the title of this article. Of course, with the medical advances projected over the next decades, you might even get a bionic arm thrown in.

All these calculations assume you know how long you will live. But you don’t.

Ok, you say, let’s give the problem to the pension provider. The purpose of the pension provider is to pool risks – particularly around longevity – so the individual can manage their uncertainty. But this just pushes the problem back one level, as the pension provider faces huge challenges of its own:

• As the pension may be for 50 years (or longer), riskier investments (equities) are needed and the returns are highly uncertain.

• Medical advances will occur that may extend life and these are very hard to predict, particularly when we may be on the cusp of game-changing technologies such as individual gene therapy that have the potential to provide dramatic changes in lifespan.

• Future inflation is difficult to predict and hence offering any type of inflation-protected product is risky.

• The insurance company faces important regulatory constraints that require them to remain solvent; as a result, they need to make extremely conservative assumptions that mean the monthly payout will be low.

So, faced with extreme uncertainty of its own, the insurance company cannot offer the client what she really wants: an inflation-protected, reasonable pension based on somewhat predictable projections. So it does the logical thing (from its own perspective) and shifts as much of the risk back to the individual (that is, to a defined contribution pension where the individual is bearing the return risk) and/or offers very low payout rates on annuities to ensure they can meet this threshold, meaning essentially that the individual is paying a high price for the insurance company to bear the risk.

Either case is unsatisfactory for the pensioner.

What can this individual do in these circumstances? If I’m not sure how long I’m going to live and what my later-life care may cost, the rational response is to reduce my spending. I need to husband my resources to make sure I can eat to the end of my life, like Madame Gaillard from Perfume.

Unfortunately, as we push personal responsibility back on the individual, we are actually making the economy worse, as this optimal response of the individual for an uncertain future depresses aggregate demand.

Moreover, reducing your spending between 50 (or 60) and 80 has a severe negative impact on flourishing. Health is very uncertain at this age, and not participating in activities or travel, in order to husband resources for an unknown future, is a huge loss of opportunity. So what is to be done about all this? We think there are three steps.

First, much as a recovering alcoholic, we must admit we have a problem. In the last 20 years, the orthodoxy has been that individuals have to take more and more responsibility for their own retirement planning. We need to push back on this orthodoxy. While it’s wonderful to ask people to take responsibility, we also need to admit not only that individuals can’t solve this problem on their own, but also that it’s counter-productive for the overall economy and for flourishing to ask people to take full responsibility for their pensions.

This is another example where some systemic thinking demonstrates that what is seemingly sensible for the individual, when aggregated, is negative for society. Just as importantly, there’s no empirical evidence showing that increasing individual responsibility for a pension actually improves the economy.

In fact, the drive for an individual to take responsibility for his or her own pension⁴⁾Readers may recall the attempt to privatize Social Security under President George Bush. seems to come primarily from the financial services industry, as a result of the obvious fact that these policies increase fees for the industry. But there is no a priori reason to believe that this will benefit individuals and plenty of emerging evidence that the financial services industry destroys value.⁵⁾Recent academic articles have highlighted, for example, the under-performance of hedge funds as an asset class versus the market. Given that one pays 2 + 20 for the hedge fund and a few basis points for an index fund, this is pretty clearly a case where value is destroyed.⁶⁾Edesess, Michael. “Why Hedge Funds Destroy Investor Wealth.” Hedge Funds Destroy Wealth. Accessed September 5, 2020.

Second: a practical proposal given to Andrew by Professor David Hendry.⁷⁾Professor Hendry is one of the UK’s most distinguished macro-economists, based at Nuffield College, Oxford University. Its genesis is from Bismarck’s original conception of a pension.⁸⁾“Social Security History.” Social Security, Social Security.

The basic state pension should increase dramatically at age 80, essentially guaranteeing economic security for the rest of one’s life. Why does this matter? Well, if an individual knows that they will be secure after 80, it’s much easier to make income and spending decisions in the 50s, 60s, and 70s. These are likely to be hugely welfare and flourishing enhancing, as the person may be relatively healthy in their 70s and so able to take that trip to the Galapagos, take the chance to start a new business, or pursue an interest that lay dormant during working life in middle age. This will be a huge benefit to the economy at relatively modest cost because, as we know, while many people live past 80, not everyone does.

This proposal also recognizes an important reality about people: optimal development outcomes come from the right balance between development pressure and support. We don’t ask beginning skiers to take on black runs (endangering their lives) or Grade 4 students to interpret Nietszche. Instead, we design as well as we can an optimal development plan that applies the right kind of pressure at the right time in the right ways.

Third, and perhaps most importantly, let’s use this challenge to start a discussion on a more fundamental issue: the structure of a working life needs to change. People are often healthy up until 80 or beyond and some want to do some work. Others would like to retire early or change jobs as they age. In only a few professions can people control their own working life. So people may work for a total of 60 years… but how they work should be able to change over a lifetime. This will ensure the benefit to society of immeasurable skills, energy, and experience while guaranteeing the dignity to individuals of choosing their own way.

Like breaking past barriers – gender, race, sexual orientation –  this is going to require some radical thinking and bold experimentation. A couple of the key issues here are:

• As people age, they may desire to work, but how they want to work might change and the workplace needs to cope with this.

• Poorer people live shorter lives than richer people. So any changes to work restructuring needs to take this into account. Specifically, a system that simply extends the retirement age – as we have seen in most developed economies – is a highly regressive tax and not consistent with social justice or the concept of flourishing. Indeed, regard for human dignity requires that we rectify this and foster flourishing by creating a social context within which poor people live as long as rich people. Guaranteed basic income is part of the solution to this problem, as will be discussed in Flourishing In Canada: How to be Capable of Living the Good Life.