Welcome, dear readers, to a continuation of your humble author's discussion on retirement in our two economies world.
Last week (see here), we took a sobering look at the state of personal savings in most developed countries, as well as the uncertainty surrounding the solvency of defined benefit pension plans, both public and private. The topic is a sobering one. But that was last week.
Today, we will examine some of the compelling arguments which suggest that retirement Armageddon is not just around the corner. The dismal savings numbers do not tell the whole retirement story, and even those potentially facing reduced benefits from their pension plans have cause for some hope. There are, as we shall see, extenuating factors which may make the seemingly dire implications less severe.
Specifically, there is much talk these days about the "great wealth transfer", which promises to provide future retirees with inheritances passed down from the Baby Boomer generation. There are also financial products out there that allow retirees to tap into existing assets not included in their savings, reverse mortgages being the most popular. Finally, there is the matter of spending patterns and lifestyle in old age. Most seniors over the age of 75 do not spend nearly as much on consumption as people in their working years, nor do they spend as much as seniors under 75 years of age.
Of course, these arguments have problems, too, which I will examine as well. However, taken together, they at least imply that talk of a retirement crisis may be somewhat overblown, but we citizens of developed countries are not out of the woods yet.
The So-called "Great Wealth Transfer"
There is, of course, the role that inheritances will play in funding many people's retirements. Indeed, one oft-repeated meme is that the Baby Boomers will initiate "the greatest wealth transfer in history" when they bequeath their staggering collective wealth to later generations. There is some truth to this. Those analysts who point exclusively to low savings rates are not accounting for the role that inheritances will play in providing retirement.
The Baby Boomers currently have the distinction of being the wealthiest generation in history, largely a result of being the generational first heirs of the post-World War II "golden age", about which I have written extensively (see here).
It is estimated that, as they pass away, American Baby Boomers alone will bequeath $68.4 trillion to both the Generation Xers and the Millennials. This is an incomprehensibly huge amount of money, but statistics confirm that the Boomer generation really does control over 70% of disposable income in the US (see here).
So clearly, these statistics would indicate that the impending "retirement crisis" is nothing more than media-hype. Gen-Xers and Millennials can seemingly look forward to a retirement bailout courtesy of the richest generation of all time. But not so fast. As promised, I warned that there are both problems and distortions with the inheritance story.
After all, what of that aforementioned 45% of Baby Boomers who have nothing saved for retirement? It would seem that some of those Boomers cannot themselves retire let alone bequeath a comfortable retirement to their offspring!
Well, we mustn't forget we live in a two economies world now. While, to be sure, wealth disparity has been an aspect of every civilization in human history, what we are seeing now is the slow demise of a spectacularly broad middle-class that emerged (especially in North America) after the Second World War (see here).
At present, inheritances come in all shapes and sizes. When commentators declare that "Millennials stand to inherit $30 trillion", for example, they are using the broadest of generalizations.
Expectations for an inheritance's size have to be realistic. According to Federal Reserve research conducted in 2013, the average inheritance for the wealthiest 5 percent of U.S. households was $1.1 million, while the bottom 50 percent received just $68,000 and the middle 45 percent received $183,000. - Source: MassMutual
As income and wealth disparity continues to grow, then presumably so too will discrepancies in the size of inheritances left to later generations. Indeed, the most recent poll (see here) finds that 70% of Millennials expect to receive an inheritance, but only 40% of their parents can or will leave one. Similarly, in Canada Millennials polled expect an average future inheritance of $300,000, but their parents expect on average to leave them only $50,000 (see here).
There are other mitigating factors that may also influence the size of the inheritances the Boomers' children can expect. Boomers tend to spend more on consumer goods and travel than other generations; they appear to have retained much of their "live for today" mindset even in their older years and, perhaps surprisingly, are also more likely to give large sums to charity (see here).
The uncomfortable conclusion then is that the inheritance bailout Gen-Xers and Millennials may be hoping for may be mostly available for those who populate the upper-tier economy. For those of the bottom-tier economy, an inheritance may not be forthcoming, and for those lucky enough to receive an inheritance, it may not be enough to retire on, given current savings rates.
With 45% of Boomers having nothing saved for retirement, it's extremely unwise from a macro standpoint to embrace the "great wealth transfer" as the white knight riding over the hill to prevent an impending crisis.
Fortunately, inheritances represent just one potential reprieve in our tale.
Flipping A Coin On Reverse Mortgages
Another factor in play arises in the form of alternative financial instruments that allow retirees to access monies over and above their savings. Reverse mortgage loans allow homeowners to borrow against the value of their residences, typically to initiate an equity flow, and have become more common in the last couple decades.
This isn't an article about the ins and outs of reverse mortgages, so suffice it to say these instruments allow seniors to access a specified amount of equity from the assessed value of their homes, while allowing them to remain in those homes until they pass on, or until they move into alternate housing.
The amount of equity available from a reverse mortgage depends not just on the value of the home, but on the age of the borrower. This is because even though there are no monthly interest payments to make on reverse mortgages, interest nevertheless accrues until such time as the mortgage is repaid. Upon sale of the house, the borrower (or his estate) is responsible for both the principal owing and any accrued interest. The younger you are when you take out your reverse mortgage, the more interest you will presumably owe when the bill comes due.
Presently, reverse mortgages have not taken off in the US as much as might be expected. However, recent regulatory changes may be responsible for recent dips in popularity. Debt-burdened Canadians, on the other hand, appear more eager to utilize this product, with total reverse mortgage debt now doubling every three years (see here). In Australia, meanwhile, the government has gone so far as to briefly debate making easier access to reverse mortgages a permanent component of its so-called "aging-in-place" policy.
The potential of reverse mortgages to ease the pain of any future "retirement crisis" is obvious. Just as high home costs have crushed many Millennials, they have also enriched a great many Boomers and Xers. Your age and the value of your property will determine the extent to which your home equity may help you achieve your retirement dreams.
Someone 65 years of age who owns his home valued at, say, $400,000 should be able to turn that into a roughly $200,000 loan which can be taken as a lump sum or in installments. Obviously for those who have little or nothing saved for retirement, but who at least own their homes, this could be a life-saver.
There are obvious downsides, of course. When the homeowner sells, he must pay back the outstanding loan plus whatever interest has accrued over the years. Depending on the length of the loan, this could mean that the owner has very little left after selling his home and repaying the reverse mortgage loan. If the owner passes away while living in his home, the loan and interest will still have to be repaid by the estate, which could conceivably eat up the entire value of the home.
Another obvious concern is that any seniors depending on reverse mortgages to fund retirement will likely have nothing to leave to their children. This impacts the aforementioned inheritance component of our previous discussion: namely, many Xers and most Millennials and Zers are about to discover yet another factor eating away at their future inheritances.
Another problem arises from our two economies world. As Teresa Ghilarducci of Forbes notes, the majority of Americans overestimate the value of their homes by an average of almost 20%! This is exacerbated by owners in poorer neighborhoods where property values have not risen at the national average. Turns out, according to Ms. Ghilarducci's calculations, reverse mortgages may well provide an effective retirement income, but primarily for higher income households (see here).
Even among those for whom reverse mortgages are effective, there is much psychological resistance. For example, many in the middle-class are reluctant to remortgage their homes after having just spent decades paying them off. Such factors explain, at least in part, why reverse mortgages are not more popular in the US.
What emerges is a picture where products like reverse mortgages may offer a reprieve to Baby Boomers and Generation Xers. Those who have failed to prepare for retirement - but have at least paid off their homes - can bail themselves out, so to speak, by tapping into the value of their primary residences. Whether this equity will be sufficient to satisfactorily supplement government pension plans will likely be determined by which of the two economies a potential retiree belongs to.
For younger generations the picture gets dicey. Millennials and Generation Zers will likely not receive much, if anything, by way of inheritances. Worst of all, with home ownership rates starting to trend down, especially among the youngest demographics (see here and here), the home equity option will be available to a smaller portion of the population into the future. If there's a bright side, it's that this group at least has a long time to prepare, if it can navigate the pitfalls of wage stagnation and runaway real estate and education costs.
Consumption Declines With Age
There is one more potentially hopeful factor to consider. Most of the dire warnings about insufficient retirement incomes assume that retirees are trying to, at a minimum, maintain the standards of living they enjoyed during their working years. This is not a nefarious assumption, as no one wishes to retire just to be poor. However, the assumption doesn't necessarily jive with the behavior of most seniors.
It turns out, while seniors may spend at a similar or even faster rate compared to their working years, this is only true from ages 65 to 75, roughly. At around 75 years of age, seniors typically reduce their spending on things like consumer goods and travel.
Healthcare, of course, is another matter. I won't touch on this here partly for reasons of brevity and partly because there is such a dramatic difference in how various developed countries fund and deliver healthcare.
Studies from Germany, the USA, and Canada show retirees indeed drawing down assets and saving less in early retirement, but once they reach their 70s, the drawdown typically slows or even reverses, and in some cases, savings rates even increase, producing a rise in wealth (see here).
The important takeaway is that this post-70 year old reduction in spending seems to just be a natural part of life, not something done out of necessity or due to financial distress. In other words, we all may be overestimating our true income needs.
We should not assume all generations will behave identically. Currently, the above cited patterns of seniors' consumption largely reflect pre-Baby Boomer generations. There are extremely troubling signs that their frugal behavior may not be getting mirrored by their progeny.
The World War II generation is famous for its frugality and high savings rates. This is great news for Baby Boomers who are in the process of inheriting or preparing to inherit those hard-won savings.
As the Boomers enter retirement age, it's becoming clear something is changing. In the US, seniors have actually begun piling up debt at a rapid pace, with their debt burdens increasing by roughly 20% just between 2010 and 2016 (see here)! In Canada, seniors are now racking up debt (and struggling with insolvency) faster than the regular population (see here). Australia is also dealing with a spike of seniors struggling with debt loads and bankruptcy (see here).
Perhaps the "live for today" mentality of the Baby Boomers is finally catching to them (and the rest of society). Perhaps the heightened expectations and lowered prospects of Millennials are draining the savings of their concerned elders. Perhaps the burden of managing defined contribution pension plans has overwhelmed and broadsided a great many more.
In all likelihood, all these factors and many more are simultaneously at play. Suffice it to say, the prospect of lower living costs in our senior years is encouraging, but is not something we should just assume will happen, especially for those hoping to receive an inheritance from the Baby Boomers or from Generation X.
Retirement: The Ultimate Luxury Good
In my last article, I argued that in a two economies world, retirement was becoming a luxury good: affordable for some, but unaffordable for a growing majority.
A dark picture is painted when one looks only at savings rates and the state of pension plans. However, as this article shows, there are at least bright spots.
Inheritances are forthcoming for tens of millions in the developed world. The problem that arises is that the numbers bandied about in the media are merely averages or aggregates. They fail to appreciate the two economies world we live in.
Those in the lower-tier economy will receive by comparison far fewer inheritances and the ones they will receive will likely be modest. Moreover, by relying on those inheritances, low earners pretty much ensure that there will be little family wealth left for their own children to inherit.
As for reverse mortgages, a similar tale unfolds. The top-tier earners are both more likely to own their residences (and thereby take advantage of reverse mortgages) and more likely to live in residences holding enough equity to partially fund a retirement.
For those of the bottom-tier economy, the picture is less certain. A modest home yielding less than, say, $200 000 in reverse mortgage income may be the difference between retirement and no retirement, but such a sum will not be sufficient to finance the middle-class lifestyle they're likely accustomed to. And, tapping into home equity will likely ensure that there is little or nothing left over to bequeath to their own children.
Join your humble author next week when he does his best to digest these facts. There are some sobering conclusions to be made about what the retirement situation says about the shrinking middle class, the future of developed economies, and the macro picture we as citizens and investors need to be aware of.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.