The Retirement Crisis

by

Scott Thorpe

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Published by ARCHMEDIA LLC at Smashwords

© Copyright 2011 by Arch Media LLC

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Forward

This is not a warning of dire consequences unless we take action. The financial mismanagement of the United States has been so bad for so long that wrenching changes are unavoidable. However, this is also an optimistic book. Because just as bad decisions created the retirement crisis, good decisions will solve it.

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The Retirement Crisis

As the United States recovers from the financial crisis caused by the housing bubble, it faces a larger and more serious threat. Millions of American baby boomers will be retiring, and few of them have made any significant financial preparations for the event. They may own their homes, but typically have meager savings and lots of debt. As a result, they will be dependent on Social Security. Others are more fortunate. They have very generous state and local government pensions. However these pension benefits are unfunded or severely underfunded. As a result, the United States is facing a vast increase in payments and care costs for retirees even as its fiscal condition deteriorates.

How Bad is It?

Over the next twenty years, ten thousand boomers will retire every day. The retiree population will grow dramatically, from 40 million in 2010 to over seventy million in 2030ⁱ. The increase in public expenditures for retirees will be equally large. Paying for the boomers retirement will cost an additional 10% of GDP, the equivalent our current spending on the military, public education, and all colleges and universities.

This puts an enormous new strain on government budgets. Social Security, Medicare, and Medicaid payments already consume most of the Federal budget, while Medicaid which frequently pays for long-term care for seniors, is also a huge component of state budgets.

It only looks worse if the increasing cost of servicing the national debt is added in, as shown in the chart below. Of course, this projection is unrealistic in one sense – if debt continues to increase at current rates, no one will lend to the United States.

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Retiring baby boomers haven’t saved enough to support themselves. Even before the financial meltdown decimated IRAs and 401(k)s, Americans in general had saved little towards retirementⁱⁱ. Most American retirees could not survive long without government support.

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The Challenge

Paying for retirement for baby boomers will eventually cost an additional 10% of GDP from government coffers. Combined with payments on the national debt and increased pension payments for government employees, the total is more than even the United States government can tax and borrow.

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What Can be Done

Americans have a number of options for dealing with the retirement crisis. They are unpalatable, but that is not surprising when one must come up with trillions of dollars in cost savings and/or revenue. Here are some of the more likely ways we will deal with the retirement crisis.

Inflation

Governments do not declare bankruptcy. Instead they cause inflation. The United States is already well down the road to using inflation to significantly reduce its debts. The Federal Reserve has bought as much as 70% of Treasury bonds in recent sales. This level of intervention suggests that the United States would be unable to raise enough money to keep government going at current interest rate targets without printing money, which is exactly what is happening when the Federal Reserve buys Treasury bonds.

Inflation is an economic disaster, but it has a silver lining for big debtors like the Federal Government. Inflation slashes debt. Just a few years of double digit inflation could cut the real size of the outstanding national debt in half. Inflation could also be used to sharply reduce the retirement and medical benefits that the government owes if those benefits don’t keep pace with inflation.

However, the cost of inflation is enormous. Economic growth is slowed, savings evaporate, and prices soar far faster than salaries. In addition, inflation makes it difficult to borrow at low interest rates, making the debt problem worse in the future.

What would the government and the Federal Reserve need to do to cause double digit inflation? The answer is nothing. The Fed has already massively increased the money supplyⁱⁱⁱ.

Inflation has remained low despite the increase in money supply because the increase shored up the balance sheets of banks, who then hung on to that cash. However, unless the liquidity created by the Federal Reserve is reduced, all that money will eventually reach consumers and businesses, making raging inflation is unavoidable.

Inflation will be painful, but it will also likely shave 2% of GDP off of government interest payments. So we will credit inflation with 2% of the 10% of GDP in savings we need.

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Control Health Care Spending

It has been said that the Federal Government is an insurance company with an army, and that is quite accurate. Social insurance and military spending consume all but 18% of the Federal budget. Any meaningful savings must come from these areas.

The retirement crisis cannot be resolved unless health care costs are controlled. Americans spent over 16% of GDP on health care, a much higher percentage than other industrialized countries, including those countries that already have a much higher percentage of senior citizens than the United States. Health care costs are also growing rapidly. The graph below shows total expenditures on healthcare in 2008 as a percentage of GDP^iv.

Yet for all that lavish expenditure, Americans receive a lower level of care than in most other industrialized countries. The graph below shows annual doctor consultations, doctors, and hospital beds per 1,000 people in 2008^v, with levels of health care services being higher in countries that pay much less for health care than the United States.

For example, Japan has an excellent healthcare system. Patients visit their doctors three times as often as Americans do. Japanese patients typically do not even bother to make appointments to see their physician. They show up and are usually seen within a few minutes. In addition, Japanese patients have more access to diagnostic and treatment options. MRI exams are more common in Japan then x-rays are in the United States. But despite this high level of healthcare services and a much older population, Japan only pays 8% of its GDP for healthcare services – half the rate of US expenditure for more service and better outcomes. In addition, the Japanese health care system is not socialized medicine. Instead private insurers pay private hospitals and doctors who compete fiercely for patients.

The reason the residents of other countries get more care for less money is simple, they regulate the prices of medical services. Market forces don’t do a good job of controlling health care prices because when one is sick, cost doesn’t matter, particularly if someone else is paying. By controlling prices, other industrialized countries with much older populations have kept health care costs under control.

In addition, in the United States 25% of each health care dollar goes for administrative expenses. That will not surprise anyone who has received a blizzard of bills from multiple providers for a single procedure. Other industrialized countries spend much less on overhead – 2.5% in France or Taiwan. In those countries, controlling prices has provided an incentive to increase efficiency, and the cost difference is huge.

As a result, there are significant savings that can be realized from our healthcare system without reducing the quality of care. Those savings can be used to pay for increased retirement costs. We could follow the Japanese model of health care services, which has private insurance companies paying private hospitals and doctors, but controls the cost of care.

Another way to reduce health care costs for retirees is to control government payments. Under this strategy, senior citizens would be covered by private insurers, with a fixed amount of the insurance premiums paid for by the government. If health care premiums go up, retirees would have to pay more out of pocket or settle for reduced coverage. Such a plan would save the government money, but would only provide good health care at a lower cost if market forces keep prices down. If health care prices continue to soar, retirees would be left with steadily diminishing coverage.

I personally prefer free market approaches, but I am skeptical that market forces can control health care costs. There is a huge imbalance of power between health care providers and health care consumers. 85% of health care expenditures for seniors are incurred during their last year of life. Controlling costs is not a priority for sick or dying people and their families, making market forces ineffective for most health care decisions. Even large corporations and insurance companies have been largely powerless to control health care costs, so it is unreasonable to believe that individuals will be any more successful. The exception is for elective procedures such as laser eye surgery, where prices do seem to respond to market forces. However, most areas of the American health care system simply aren’t designed for price competition.

Regardless of how, there is at least 5% GDP of potential cost savings in the US health care system that could be applied to retirement costs. This includes budgeted increases that if controlled, won’t happen.

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Reductions in Social Security

Since the retirement crisis is largely the result of sharply increasing numbers of retirees, reducing social security benefits would seem like possible solution. Congress has already raised the retirement age for receiving full Social Security benefits to 67 for people born after 1959. Additional reductions including increased taxation of social security benefits are likely.

However, because most retirees depend so heavily on far from generous social security payments, significant savings are unlikely, particularly since retirees are politically active. In addition, 75% of retirees are already electing to start receiving social security at age 62 because financially they can’t wait, even though waiting would greatly increase their benefits. The financial health of retiring Americans simply won’t support significant cuts in Social Security.

I estimate that additional savings from social security will at best only offset unforeseen and un-forecast increases. So the total available savings from social security is 0% of GDP.

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Medicaid

Medicaid pays for long-term care for older Americans, and with more older Americans, the total cost will go up. Medicaid costs would benefit from overall reductions in health care costs, but the elderly without resources will still need to be cared for. However, some modest savings can be achieved by delaying poverty, particularly voluntary poverty where parents give money to children in order to qualify for Medicaid, and by supporting cost-effective alternative care options.

Long-term care costs can be reducing the amount of wealth that patients can give away before qualifying for Medicaid. Many patients voluntarily become poor by giving away wealth to children so that they can qualify for medical benefits. Making it hard to quality after gifting wealth may moderate medical costs.

However, because the number of Americans over 85 will increase dramatically, it is doubtful that Medicaid costs can be significantly reduced, even with reforms. Medicaid savings will probably contribute little if anything to paying for the retirement crisis.

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Military Spending

The United States spends more on defense than any other country in the world. As a result, we have a military force without equal.

We also devote a greater share of GDP to our armed forces.

In 1999 the United States supported an overwhelmingly dominate military with 3% of GDP. After 9/11, military spending grew by 81% in real dollars to well over 4% of GDP. However, military spending can be reduced at least back to 2000 levels without compromising national security, if we stop fighting insurgents and engaging in nation building.

Most of the increase in defense spending in this century has gone towards fighting insurgents and providing security for nation building activities in Iraq and Afghanistan. As the British learned during the American Revolution, fighting locals is expensive and difficult. Even when outgunned, the locals have time on their side. They know that foreign soldiers will eventual go home.

However, new tactics and weapons have made fighting insurgents even more difficult. Improvised Explosive Devices (IEDs), cellular telephones, and powerful mobile weapons allow lightly-armed insurgents to inflict damage on even heavily-armed, mechanized soldiers with air support. After America’s experience in Iraq and Afghanistan, it is unlikely to rush into another insurgent conflict.

Conventional wars in general are also becoming less likely. Many of the nations with which the United States would likely engage in hostilities have or soon will have nuclear weapons. And most of the other regional powers in the world either already have nuclear weapons or have the capability to acquire them in a matter of months. This makes a conventional conflict much more dangerous. Just as NATO and the Warsaw Pact avoided war because of potential nuclear consequences, conventional wars among an ever expanding group of nuclear nations will avoided out of fear of escalation to nuclear war. This does not mean military power will be less necessary; it will just be used more judiciously.

Finally, the United States can afford to reduce military spending because its largest potential competitors including Russia and China are struggling to grow their economies and provide for their own rapidly growing population of retirees. The expenditure numbers show that no one wants an arms race.

As a result, we could cut 2% of GDP from military budgets and still fund a preeminent military at the funding levels of 2000, or a little less than 3% of GDP.

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Higher Taxes

Higher taxes are always an option when governments need more money, but in the United States, taxes are looked on as a last, if ever, resort. Still, higher taxes are not out of the question. Even Ronald Reagan raised taxes. He did so in 1982 and 1984 by closing loop holes and broadening the tax base.

The United States could raise more revenue to pay for baby boomer retirement and other government functions by broadening its tax base. And there are a number of massive loop holes that could be closed. Until the Bush tax cuts, tax collections averaged at least 18% of GDP. Currently they are 16%. They could be as high as 20% of GDP through effective broadening. Here are several broadening opportunities.

Corporate Taxes

Many corporations pay little or no taxes, although they are highly profitable. They simply use financial and legal strategies to move their profits to low-tax, offshore jurisdictions. As a result, corporate tax revenue as a percentage of GDP has been steadily dropping.

Governments have been helping corporations to cut their tax bills too. Most manufacturing and office functions can be done anywhere in the world. Low taxes are commonly used to attract and retain jobs, so countries, states, and even cities compete with one another to offer lower taxes to attract business and broaden their tax base. It is unlikely that any government will raise taxes on jobs.

The solution is to tax the sale rather than the job. Jobs will always favor low-tax jurisdictions, so taxes on jobs - factories, offices, and labs, should be zero. However, businesses will also always sell wherever they can make money, even if the sale is taxed. The United States could raise significant additional revenue by imposing an excise tax on commerce while eliminated taxes on corporate profits and jobs.

Estate Taxes

Estate taxes are often demonized as death taxes, although personally that is when I would prefer to be taxed. Only a small percentage of estates are subject to estate taxes, but those that are belong to powerful, politically savvy families. Many of these families have spent and lobbied much to reduce or eliminate estate taxes.

However, baby boomers will inherit over $9 Trillion^vi from their parents and grandparents. It would be poetic justice if the generation that is largely responsible for being unprepared personally and as a nation for retirement had its inheritance heavily taxed.

Payroll Taxes

If corporations and baby boomers don’t pay more in taxes, then the increased tax burden of the retirement crisis will likely fall on the least powerful and affluent members of society through increased payroll taxes. There is strong precedent for this - payroll taxes have been the only taxes to rise significantly in the last 30 years.

In 1983 pay roll taxes were increased to generate a surplus to pay the benefits of baby boomers and other retirees. All of the revenue raised by this tax increase was immediately spent. The government did put Treasury Bills in the Social Security Trust Fund, but they are as valuable as an I.O.U. to yourself. The trust fund only serves to formalize government’s obligations to retirees.

If I could bet on which taxes will be raised to pay for the retirement crisis, I would put my money on payroll taxes. These taxes go directly for social security, Medicare, and Medicaid payments. More to the point, their burden also falls most heavily on those with the least political power.

Plenty of Tax Opportunities

The United States tax code is well over three million words long. There are countless other opportunities for broadening. I believe that 4% of GDP could be raised through broadening of the tax base so that the Federal government collects 20% of GDP in taxes.

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Government Pensions

State governments have between $1 and $2.5Trillion in unfunded pension obligations, depending on how optimistic one is about future investing gains for state pension plans. The Federal Government has unfunded pension obligations of over $15 trillion. Currently over 40% of Federal employees are eligible to retire. As we have learned from the Postal Service, these high retirement obligations mean that government services can be cut drastically while costs actually increase.

These retirement obligations may be reduced by slightly eliminating double dipping and could be cut sharply by allowing inflation to cut payments. This is unlikely as it would as cut benefits to lawmakers.

However, the retirement crisis could provide the motivation to reform the way government pensions are forded. Most government pension programs are defined benefit pensions with the retiree promised a regular retirement payment based on her working salary. Defined benefit programs are almost universally underfunded. It is simply too easy to pay less now, and suffer later. As a result, most organizations with defined benefit pension plans owe staggering amounts to those plans. Defined benefit plans regularly bankrupt businesses and even whole industries.

Workers prefer defined benefit plans because they are more generous, but they are more generous because organizations can promise much in the future for a small cost now.

Most corporations have moved from defined benefit plans to defined contribution plans. Defined contribution plans can’t be underfunded. The contributions must be made every year. Converting to defined contribution plans would force governments to pay the full cost of promised benefits now, rather than pushing those costs onto future generations. So while government pension reform won’t help resolve the retirement crisis, it could reduce the chances of a future repeat of the problem.

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Government Services

One of the most frequently mentioned targets for cost savings is Federal Services. Federal programs and employment have increased dramatically in the last ten years, primarily for security functions, and caring for veterans.

The increase has actually been much greater than is shown here because of the increased use of contractors. Although a smaller share of the budget than insurance and defense programs, significant savings are possible. Federal programs could be cut to provide 1% of GDP in savings. These savings will come from a diverse set of programs, and will be heavily influenced by politics.

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Give the Foreigners a Haircut

A tempting solution is to give our foreign debt holders a “haircut.” Foreign governments and banking centers hold massive amounts of Treasury debt, so it is tempting to stiff them.

These bond holders will take a big hit, along with everyone else that owns T-bills. In fact, they have been taking a hit as the dollar has depreciated against other currencies.

However, stiffing foreign debt holders isn’t much of a solution. Remember that most of the obligations that have bankrupted our country are not Treasury debt, but instead are obligations owed to Americans in the form of Social Security, Pensions, and Medicare, as well as to government employees in the form of pensions.

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Fairness

The Bush administration largely saved Wall Street from the consequences of a financial meltdown that it created. The Obama administration spared auto workers from losing the unsustainably generous retirement benefits they had won, benefits that were largely responsible for the collapse of their employers.

The pain of the Retirement Crisis will not be spread evenly. Those with more political power will probably find a way to escape the reductions in what they were promised in more naive times.

The politically powerful will argue that their benefits can’t be reduced because there was a contractual arrangement that now precludes changes. This is a ridiculous argument. Everyone, private sector workers, government employees, and congressmen, were promised benefits in exchange for tax contributions or service. No group should be given preferential treatment. However, if the past is any indication, that is unlikely to happen.

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Conclusion

By controlling and reducing the most expensive government costs, health care, military, and program spending, and with some inflation and higher taxes, we can pay to retire the baby boomers with federal expenditures of 20% of GDP and 20% revenue in taxes. It won’t be easy, but it is possible, and essential for the future security and growth of the United States.

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