Fiscal Fitness

The Coming Retirement Burden

The baby boomers are about to retire. Megan McArdle explains why it will hurt.

Is the upcoming Social Security transition manageable? Dean Baker argues that it is--and that people who say otherwise are ignoring the much larger transition we've already made, back in the 1960s:

Baker is right that we've already made a substantial demographic transition. But he is still wrong, because from the perspective of the worker, the worst transition is still ahead. As the ratio of workers to beneficiaries has fallen from 42-to-1 in 1945, to 3.3-to-1 in 2007, here's what it has taken at various points to support one worker--and what it will take when the ratio falls to 2-to-1 sometime in the 1930s.

Up at the top, in 1940, each of 42 workers is contributing just an infinitessimal portion of their income, so small you can barely see it. By 1965 it's substantial. By 2030, it's huge.

This is obviously very crude, because we don't support retirees at 100% of their working wages; the point of the graph is just to demonstrate the effect of moving from a lot of retirees to a few.

And what you see here is that the larger the number of retirees, the more each worker is burdened by even a small decline in the ratio. The shift from three workers to two takes a bigger chunk out of each remaining worker's paycheck (25%) than the shift from sixteen workers to four (20%).

But that actually understates the problem, for two reasons. First, the major shift in the 1950s and 1960s took place when social security benefits were comparatively low. During the late 1960s and 1970s, congress made those benefits much more generous. In 1965, despite the precipitous decline in the worker-to-retiree ratio, Social Security paid its bills with a 2.2% payroll tax. By 1990, that had more than tripled.

The bigger problem, however, is that while Baker is looking at total income, that's not how workers experience tax increases. A worker doesn't care how much their total income has fallen; they care how much their paycheck--their after tax income--has fallen.

That means that for workers who are already paying a lot of money to support retirees, any given increase in their burden feels larger than it does for workers who started out without those obligations.

Hmmm, that sounds a bit confusing. Let's run through a little simple math.

Say you take a worker who has no one to support--just himself. Now, someone needs to retire. You require that worker to contribute 30% of their paycheck to the needy retiree.

That's a lot of money, and your worker is probably pretty grumpy, because his disposable income just fell by 30%. But now say you add another retiree, who needs another 30%. You're giving the exact same check to the second retiree as you did to the first. But the worker just saw their paycheck fall by 42% instead of 30%. Add a third retiree, and your worker's paycheck falls by 75%.

In other words, the higher the existing tax burden, the more burdensome a given tax increase becomes. And once you're paying more than 50%, the burden accelerates pretty fast.

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If you take the numbers from the charts above, and you look at the additional burden as a percentage of the worker's previous income after they'd contributed to the support of retirees, you'll see that the shift we're facing is substantially larger than the transition in the 1950s. The graph below shows the burden of new retirement contributions since the previous bar--but as a percentage of the worker's disposable income in the previous period, instead of their total income. I.e. 2007 shows the difference between 2007 and 1965, 1965 shows the difference betweeen 1965 and 1950, and so forth.

Of course, there's a caveat. This is a crudely stylized model to demonstrate broad principles, not a representation of the actual paycheck dynamics: for one thing, social security does not replace 100% of earnings, or anything like it; and for another, incomes aren't static; they rise over time. It's a lot less painful to turn over a rising share of your paycheck to a retiree if that paycheck is growing.

But there are caveats to the caveat. First, in the charts above, social security is the only thing workers have to pay for, while in actual fact, they have a bunch of other taxes coming out of their paycheck. So while social security taxes will never come close to 50% of an actual paycheck, taking even an extra 5% means a larger-than-5%-decline in disposable income.

Second, social security is not the only way that current workers pay for retirements. Whether a retiree's income comes out of a corporate pension, social security, or a 401(k), some current worker has to generate the real goods and services that the retiree will consume. If one-third of the adult population is consuming without working, that is going to place a heavy burden on worker incomes--unless the retirees take sharp cuts to their living standards.

And third, an aging population will almost certainly mean slower growth. During the earlier transition, most of the decline in the ratio of workers to retirees was driven by the fact that the program had only been created in the 1930s, and didn't start paying out benefits until 1940. The changing ratios in the early years were driven not by demographic change, but simply by more people becoming eligible for a new program.

Now, by contrast, the main driver is the aging population, which means big economic change at the same time as our entitlement burden is growing. There will be economic drag from slower workforce growth, but also from a shift in the population's physical stamina, psychology, and incentives. Older people seem to be somewhat more risk averse than younger people, both because of brain changes and because they have less time to either recoup a loss, or enjoy a big win. When you're twenty-five, it makes sense to risk everything on a startup that could make you a billionaire in 20 years. When you're fifty-five, on the other hand . . . well, are you willing to risk eating cat food for a small chance at getting into the best nursing home in the nation? As they age, older workers also lose the sheer physical resources that high-risk, high-reward enterprises demand. Few people can work 100 hours a week at the age of 25, but almost no one can do it 30 years later.

The same remorseless logic applies to retraining; at some point, investments in new education simply don't repay their costs. That point is sometime in the late forties or early fifties, making it harder to redeploy labor from struggling sectors. Which is to say, reducing the flexibility and dynamism of the economy.

Oh, and did I mention that the aging workforce may make it harder to recover from recessions, including the one we're still pulling out of?

All of which is to say that we should probably expect slower paycheck growth in the future. Which will make the burdens of supporting future retirees even worse. Personally, I think that barring some radical technological breakthrough, the economic growth projections used by most government agencies and NGOs are probably too high. And I certainly don't want to count on them to bail us out of the unsustainable obligations we've assumed.