the big boom

social_securityAnother great piece of well-deserved fear-mongering from the keyboard of a financial doomsayer, who also happens to be one of my favourite investment commentators. With this effort, as usual, he contextualizes simple and unavoidable shifts in biotechnology and boomer demographics and explores the implications of the resulting squeeze on modern social security and society at large

The Boomers Break the Deal
by John Mauldin

My grandfather’s generation made a deal with my children’s generation. It goes like this. If you will pay into Social Security and pensions so we can retire now, we agree to die on time, or at least in a predictable manner. The Boomer generation is going to break the deal. We are going to live longer, and maybe a lot longer. And that is going to cause problems in pension plans and government retirement programs all over the world.

Medicine as practiced today is still of the hammer and nails approach of the past 100 years. Our tools are better today, but the approach is the same. We wait for something to get bad and then we try and fix it. We get regular check-ups to try and diagnose any problems, and our ability to diagnose is getting better, but we still miss a lot. We work at doing what we can to prevent sickness, but our tools are not as good as we would like – basically, diet and exercise and a few medicines that try to prevent disease.

That is getting ready to change.

Image scanners are becoming ever more fine-grained. Just a few years ago it was 32 lines per inch. Then it went to 64, 128, and now 256. 512 is only a few years away. Recognize that pattern? It is going the same way as chips and storage media. Within 5 years we will see a new generation of scanners that will make today’s obsolete. Within 10-12 years we will be doing scans that will allow for much more detail in full three-dimensional color. They will be seeing the early formation of plaque and tumors and have the therapies to deal with them before they become a matter of life and death.

They are building chips which can diagnose all manner of disease by simply putting a drop of blood on the chip. Today, the chips can only diagnose a few diseases, but within 15-20 years it will be a thousand or more. Chips will be cheap and you will be able to get yourself checked often. Hopefully they will allow them to be hooked into your home computer and notify your health care provider if there is an issue. It will be a hypochondriac’s heaven.

There are almost a dozen new technologies for dealing with Alzheimer’s, most of which are already in human trials. Sometime in the next decade, Alzheimer’s and dementia may be a thing of the past, assuming you take charge.

New genetic therapies are cropping up on almost a daily basis. Mice have 99% of the human genome, so we experiment on them a lot. There are mice that cannot get fat, no matter how much they eat. Mice that do not lose muscle mass. Couch potatoes of the world, unite! Mice that live 30% longer with the addition of just one hormone, the same hormone that is in our bodies. They are growing new liver cells from adult stem cells. The list goes on and on.

Of course, these are not yet in human trials, and skeptics suggest it will be a long time before they do go into human trials. I am not so sure. They are using adult stem cells in Brazil on patients with a certain type of very nasty disease caused by a bug bite, which creates problems in the heart that show up later in life. It is 100% fatal once it starts. For some reason, Brazilian doctors decided to inject adult stem cells into their patients. Taking adult stem cells seems to slow or halt the effect on the heart. They don’t know why it works, but the point is they are doing it. Ad hoc human clinical trials. What will be the next thing tried? And where?

We may not see a lot of the human trials in the US with some of the more intriguing therapies, but it is my bet that we will see them elsewhere. Living 30% longer? No fat? No muscle loss? Someone, somewhere, is going to start the testing. I am not arguing the pros and cons of making humans guinea pigs (and I am not volunteering), just noting that I think it will happen.

In short, we are going to start diagnosing and fixing things before they go wrong. Let’s say for the sake of argument that by the end of the next decade it is likely that the average person will live 5 years longer and by 2025 will be living 10 years longer, numbers that Dr. Michael Roizen (YOU: The Owner’s Manual) says are reasonable guesses. You can make a real case for those numbers. Some would say they are conservative. We are not talking immortality. Just that the diseases that kill people today will be dealt with. More people will live long enough to die of simple old age.

Living longer is a very good thing, so why should I worry about that? Because I see the potential for black swans. Today, if you make it to 60, the odds are that you will live at least another 20 years and the last surviving spouse will live for 30 years. What if that goes to 25 and 40 years?

My friend Ed Easterling at Crestmont Research did some very interesting analysis a few months ago. You have saved and invested, and now you want to retire. You decide to take out 5% of your total portfolio to live each year and increase the amount for inflation, so that you can maintain your lifestyle (a number which a surprising number of investment advisors would say is ok). Let’s say you are an aggressive older couple and decide to stay in the stock market because that is where you are told that you can get the best returns over time. And you know that you have the probability of living 30 years. On average you are going to get 7-8% or more, right?

Ed calculates what you would get for 78 different 30-year periods since 1900. Let’s say you start with a million dollars. On average, this has been a good bet. You could maintain your lifestyle and end up with $3.6 million. You’ve been pretty conservative, right?

Wrong. Because the returns you get over the next 30 years are highly dependent on the P/E ratios at the beginning of those 30 years. Let’s break up those 30-year periods into four quartiles of beginning valuation. If you start in a period when P/E ratios are in the highest quartile, you find that over 50% of the time you end up penniless, on average within 22 years. Here’s that data from Ed:

P/E performance table

Where are we on valuations today? You go to S&P’s web site and you find that core P/E’s are 17.4, at the upper end of the second highest quartile. Notice that even when starting with the lowest-quartile valuations that 5% of the time you ran out of money within 23 years. Want to take a lifestyle bet that you have a 1 in 20 chance of losing? As Ed points out, it will not be fun to have to go to work as a WalMart greeter at 80.

Now, let’s throw my assertion that one of the surviving spouses is going to live on average 10 years longer. The failure ratio, meaning that you run out of money, gets a lot higher. And it gets worse if you use a traditional mix of stocks and bonds, because bonds lower the overall return.

The point is that retirement planning is going to get a lot more difficult. And we are going to have a generation who will be in their ’70s when they realize the good news is that they will live longer but the bad news is that they can’t afford it. And the bad news is that they are going to want the government to step in and help. And by that I mean they are going to need more tax dollars.

Let’s think of some of the implications. First, we already know that the large majority of US citizens have not saved enough for retirement. But for those that think they have, they may be budgeting for a future that is going to be a lot longer than they plan.

Second, this is going to cause a massive problem with pensions and annuities. Defined-benefit pension funds and annuities are based on current mortality tables. If you add 10 years to their future budgets in 2025, they become massively underfunded at some point in the latter part of the next decade. This is especially worrisome for smaller annuity firms, as they have no source of new infusions. They were funded on the basis of an initial cash input.

Third, public pension funds at the state and local levels will be in real trouble. They are already underfunded by perhaps as much as $1 trillion. In 40 states it is illegal to cut or change pension guarantees. Many cities are already battling with underfunded fire and police pensions, as politicians made deals with unions that future generations will have to pay for.

In both Europe and the US, where governments have promised pension benefits, their costs are going to go up. Social Security in the US will start to be more painful in just 15 years than the pain we have already projected today. Don’t even get me started on Medicare. Yes, we will be less sick, but those new treatments and therapies will not be cheap. And since the largest part of medical expenses occur in the last year of life, we will just be postponing the costs, not getting rid of them.

For most of the people in this room, living longer is not going to be a financial issue. But it is sobering to think about the societal issues with which we will be dealing.

Let’s look at some of the consequences. Because of the ever-increasing costs of public pensions, you can look for substantially higher local taxes in cities where they have old legacy pension programs. That will mean that newer cities which did not make the pension fund promises will have a relative advantage. As we will see from the next trend, moving to and working from lower tax venues is going to be easier than ever.

You can count on higher income taxes in the US, and a shift in where funds are spent in Europe. Most agricultural subsidies will be history by the middle of the decade in both the US and Europe. Ethanol subsidies will go by the end of the next decade.

You can make book that Social Security and their equivalents in Europe will be means tested and taxes raised. Pension payouts from private funds will have to be scaled back. All this will cause a lot of angst among voters, and politicians will put off any meaningful reform until there is a true crisis.

But there are a few opportunities. Life insurance companies are going to benefit, as their payout schedules will lengthen due to longer-lived policy holders. Major new health-care and drug companies will be created. We will need more housing, as longer-living Boomers will need to live somewhere. I think there will be a real opportunity in real estate in certain countries where it is cheaper to retire. (My friends at International Living write about living outside the US, and often write about locations with great climates and low costs. You can read more here).

Quickly, there are some things that should be done to mitigate the problems, but they are unlikely to be done in the current political environment. We should raise the retirement age more quickly. When Social Security was started, the average lifespan was 65. We have only added a few years to the age when you can first receive benefits.

We should go ahead and put Boomers on notice that means testing will gradually be introduced. We should make the growth of the payments less in the early years. We should encourage more immigration so as to have more people paying into the system.

The likelihood of any of these happening in the next six years is slim to none, and Slim left town, as my Dad would say.