Book Excerpt: How You Got Screwed

Author’s note: Some of you may remember a booklet called “How You Got Screwed” that Jim shared here about a year and a half ago. After seeing it online, a publisher contacted me and asked if I would flesh it out so they could release it as a full book. It just came out a few days ago (you can find it here), and Jim suggested I share a few chapters through TBP. This is the first of three to be shared; I’ll release the next two over the next few weeks. Thanks to Jim for all his support!

Note also: Footnotes/sources not included here but are in the book itself.

Chapter 4: How you’re getting screwed by…Retirement Promises

The Point: Most people have an expectation that they’ll be taken care of later in life thanks to government programs like Social Security and Medicare, private or public pensions, or through their own efforts to build up their net worth. In reality, it was never possible for governments and corporations to fulfill the promises they made to you, and those assets you saved may not be worth what you think they will be, when it’s time to cash them in.

There is a predictable pattern to life: We start out as dependent children; grow to be independent adults; and, inevitably, become dependent again as we move into old age. We know this is coming; not a single person in history has avoided it. So it’s important for us to plan for that while we’re in our prime.

Unfortunately, the vast majority of Americans are completely unprepared for the 100 percent certainty of old age. There are many reasons for this:

• Because we live in a debt- and credit-driven society, we have come to think only of our immediate needs and wants. There’s no need to save for the things we want to buy: We just borrow the money and promise to pay for it later. This mindset not only means that we’re hard-wired against saving, it also means we’re probably going to grow old with a pile of debt—all those things we said we’d pay back in the future. We have some assets—notably our home equity—but all that debt keeps our net worth low.
• We’re about to deal with a huge demographic bubble—the aging of the huge Baby Boomer population—which will result in a selling frenzy of the assets they accumulated in better times. Asset prices will crash due to little demand and huge supply of those assets.
• The government has promised to take care of us in our old age thanks to programs like Social Security and Medicare, while many big businesses, along with the government, have similarly promised to take care of their employees through pensions. These promises—which are actually false promises, in that they cannot be met—have allowed us to forgo our own efforts to prepare for the future.

In short, even though we know for a fact that we each need to prepare for our old age, we’ve been taught not to worry about it and robbed of the ability to do it. It’s guaranteed that this will not end well for the majority of people in this country.

Are Americans Ready to Retire?

Americans are awash in debt, with credit cards, mortgages, and auto loans among the primary contributors. According to NerdWallet, with additional color added by Fool.com, 69 percent of U.S. households have one or more kinds of debt, and the average level of debt carried in those households was $130,922 at the end of 2015. Levels of household debt in the U.S., along with the numbers and percentages of households that carry that kind of debt, are as follows:

“Surely,” you must think, “those numbers aren’t the same for people across age groups. Young people must take on a lot of debt, while people near retirement have paid theirs off.” While that’s true to an extent, a lot of people enter retirement age with a lot of debt. In fact, according to the U.S. Census, in the year 2011, 60.4 percent of people in the age 65–69 bracket carried debt, and the average amount of that debt was $109,973. And the debt levels of people nearing retirement age have grown over the past several years: According to data from the New York Fed, the average debt levels of people ages 55–64 have grown an average of 66 percent between 2003 and 2015.

And what about the other side of the coin—savings? Those debt levels wouldn’t be bad if savings were much higher. However, according to the U.S. Census, in 2011 only 21 percent of households entering retirement age (55–64) had a net worth (in other words, after debt is subtracted out) of $500,000 or more, while 43 percent have less than $100,000 in assets. And for most, more than half of their net worth comes from the equity in their homes, meaning they would need to sell their houses in order to live off those funds. In fact, as The Fool website reports, “According to the U.S. Census Bureau’s data, the typical American’s net worth at age 65 is $194,226. However, removing the benefit from home equity results in that figure plummeting to just $43,921.

The Demographic Bubble

From post-war 1946 to 1964, the United States produced an epic wave of children. This generation, known as the Baby Boomers, remains the single largest generational group in the country, and as they moved through their lives from birth to seniorhood, they have had a profound impact on American society.

But their greatest impact may still be to come: The first of those Baby Boomers began to hit retirement age in 2011, and as a result the number of retirees in this country is projected to go from 40.3 million in 2010 to 82.3 million in 2040. In terms of percentages, thanks to the Boomers, retirees will go from 13 percent of the population to 21.7 percent during that time.

This is a huge population shift in a very short amount of time, and it’s going to hit our country like an earthquake. That’s 42 million additional people drawing Social Security. Forty-two million receiving Medicare. Forty-two million needing all kinds of specialized products and services, such as elder care facilities and transportation services. And most important, 42 million who are no longer contributing to the tax base, but instead beginning to draw from it. We’ll explore some of the implications in the next few sections.

Personal Assets

Let’s consider the market theory of supply and demand:

• Suppose you go to a farmer’s market and see a handful of vendors selling bananas, and hundreds of people lining up to buy them. What do you think will happen to the price of bananas?
• Suppose you go to a farmer’s market and see hundreds of vendors selling bananas, and only a handful of people interested in buying them. What do you think will happen to the price of bananas?

Now substitute bananas for stocks, bonds, or homes, and think about what happens when the millions of Baby Boomers need to sell their assets into a market of people who are barely making ends meet. What’s going to happen to prices for stocks, bonds, or homes?

In truth, it’s not clear how much of an impact this will have on the stock market: While Boomers own 47 percent of equities, most of those are concentrated in the hands of the wealthiest 10 percent and will not be sold for living expenses. But it will certainly provide a headwind, particularly as Central Banks put so much effort on boosting the prices of assets in order to create a “wealth effect” and assure people that all is well.

The greatest danger lies in the housing market. If Boomers have not saved enough to survive in retirement, and their homes represent 77 percent of their net wealth, simple logic tells us that those homes will have to be sold in order to cover their expenses (at least for a few more years). And the generations coming up behind them, including Generation X and the Millennials, have less wealth, making it that much more difficult to absorb that housing surplus. The future is not bright for those who hope to sell assets at current price levels.

Social Security

Many people look at Social Security as their retirement plan, and as a guaranteed right. The government does not. In the landmark Flemming vs. Nestor case of 1960, the Supreme Court ruled that paying into the system does not mean you have the right to receive benefits. As the Social Security Administration itself admits, “In its ruling, the Court rejected this argument [that people who pay into the system are guaranteed to receive benefits] and established the principle that entitlement to Social Security benefits is not contractual right.”

The Act itself states that Congress has the authority to alter, amend, or repeal any element or rule that they want. They can raise the age for eligibility to eighty, they can limit the program to people living below the poverty line, and they can cut benefits in half if they so choose. As the Cato Institute notes, “Social Security is not an insurance program at all. It is simply a payroll tax on one side and a welfare program on the other. Your Social Security benefits are always subject to the whim of 535 politicians in Washington.”

At its core, Social Security is a Ponzi scheme, designed so that a large group of people would pay into a system that provided benefits for a few. It worked at the time it was designed, but the variables have changed over the years to turn it into a disaster in the making. Dr. Ken Dychtwald provides the following analysis:

The problem is that current government entitlements and pensions were masterfully designed in an era when there were dozens of workers supporting each recipient, people died relatively young, most workers were diligent savers, and the government and employers were widely trusted. We now live in an era, where there are very few workers to support each retiree, most people die very old, savings rates have plummeted, and the government as well as employers’ promises are not generally trusted. The ratio of 40 productive workers to each retiree that existed when Social Security was launched, has steadily shrunk, from 16 to 1 in 1950 to only 3.3 to 1 today. By 2040, it is projected that there will only be 2 workers, and perhaps as few as 1.6, to support each boomer retiree, who could be living as many as 20 to 40 years in retirement. And, between 2010 and 2030, the size of the 65+ population will grow by more than 75 percent, while the population paying payroll taxes will rise less than 5 percent.

Perhaps the most confusing and controversial element of the Social Security story is its “trust fund.” The Social Security Administration will tell you that they have a trust fund of $2.8 trillion, and that those reserves will cover the system through 2034. What they don’t like to tell you is that those reserves aren’t actually sitting around in a bank, in actual cash form: The government spent that money as soon as it came in and left an IOU in its place in the form of “special issue securities.” These securities are special in the sense that they cannot be sold on the open market: They can only be redeemed by the U.S. government, and since we’re already running a large deficit from year to year, they’ll have to raise new money to redeem those bonds, either by further increasing the deficit (i.e., even more Treasury bonds), raising taxes, or reducing spending elsewhere.

If you’re still comforted by the illusion of a $2.8 trillion trust fund, it may be worth considering what happened when the government bumped up against its debt limit in 2011. When asked what would happen to Social Security checks if the government failed to raise the debt limit, President Obama said, “I cannot guarantee that those checks [he included veterans and the disabled, in addition to Social Security] go out on August 3rd if we haven’t resolved this issue.  Because there may simply not be the money in the coffers to do it,” a statement later confirmed by Treasury Secretary Tim Geithner. With nearly $3 trillion in reserves, wouldn’t the Social Security Administration just redeem some of those securities to ensure that payments were made? Or does this make it clear that these reserves are a convenient fiction?

Considering that 36 percent of current workers expect Social Security to be a major source of income when they retire—10 percentage points more than a decade ago—it’s critically important that people realize just how unreliable this program may be in the future, and what the implications of that would be both personally and to the country as a whole.

Medicare

Building on the foundation of social welfare established by Social Security in 1935, President Lyndon B. Johnson signed the bill that led to the establishment of Medicare (for those 65 and older, regardless of financial status) and Medicaid (for low-income citizens) in 1965. Now, just over fifty years later, Medicare serves around fifty-five million seniors and people with disabilities, and accounted for 15 percent of federal spending, $632 billion, in 2015. The program is currently funded through general funds (40 percent), payroll taxes (38 percent), and other sources.

Simply put, Medicare is a bomb with a fast-burning fuse. We have a rapidly-growing population of seniors (see the information on demographics above) about to enter a system that has seen regular increases in spending: According to the Kaiser Family Foundation, Medicare spending increased at an annual average rate of 9 percent from 2000 to 2010, and then at 4.4 percent from 2010–2015. Going forward, the Foundation expects average annual growth in total Medicare spending to be 7.1 percent between 2015 and 2025, resulting in a program costing well over $1 trillion per year. Beyond that, as healthcare costs continue to increase and the bulk of the Boomer generation moves into retirement territory, it’s anyone’s guess as to where those numbers could go, or how the program could continue to be fully funded. For an explanation of why prices keep going up, see chapter 12, “The Healthcare System.”

Pensions

For those of you with a pension from your corporate or government employer, there’s bad news: It is extremely unlikely that you’ll see all of the payments and benefits promised to you. In fact, depending on when you retire and the state of your employer, it’s very possible that you won’t see anything at all.

The problem with pensions—especially “defined benefit” pensions, which guarantee a certain payment regardless of the performance of the pension fund’s investments—is that they were popularized at a time when the world was very different. Like Social Security, they were introduced when people didn’t live much past retirement, and they were designed by corporate and government leaders who wanted the immediate benefits without having to stick around to see the end game, so it was easy to make promises that future generations would have to fulfill. As a wave of retirees hit the eligibility mark, and the expected returns on pension funds’ investments fail to materialize, we’re seeing the end game for these retirement promises.

Private Pensions

Private pensions are more than a century old—the first was offered in 1875—and are an artifact from an era when people would hold a job with a single employer for an extended time, often for their entire careers. While they are in decline (only 18 percent of corporate workers have them today, compared with 35 percent in the early 1990s) because of the changing nature of the job market and because employers now have more retirement plan options available to them such as 401k programs, the fact remains that a large number of Americans receive, or expect to receive, support from these defined-benefit programs.

And they have some reason to expect that their pension plans will deliver on their promises: After some pension programs went bust in the 1960s due to a failure of employers to contribute as promised (the most notable case being the Studebaker auto plant), Congress passed a law in 1974 that set rules mandating that employers fund these programs, and established an insurance program through a new Pension Benefit Guaranty Corporation (PBGC) that takes over for failed pension programs.

However, rules or no rules, corporations have had a hard time staying in business with the burden of these plans, and can shed them through bankruptcy or other restructurings. That’s when the PBGC takes over. As of 2014, the organization has taken over 4,640 pensions covering more than 2.2 million retirees, with some of the biggest coming from the airline (Delta, Pan Am, United) and steel (Bethlehem, LTV, National) industries. As a result of its obligations, the PBGC was $61 billion in the red at the end of 2014.

So, while the organization is currently able (despite its running deficit) to make the majority of people whole, or close to it, the future is less certain. Based on reports from private pension funds to the PBGC, they have seen the levels of funding among still-operating pensions drop from 84 percent in 2008 to 75 percent in 2014, putting the PBGC at risk of covering an additional $550 billion in obligations in a worst case scenario. Private pensions are clearly struggling, and the PBGC may soon be making some hard decisions on how to leverage its limited resources.

Government Pensions

Pensions for civil servants became popular at the same time as private pensions, when it was seen as a way to compensate government workers who received average to low pay.

And those pension plans are entering a crisis phase: Depending on who you ask, public pensions are underfunded by as little as $1.5 Trillion (according to the Pew Charitable Trusts) up to more than $5 Trillion (according to a Pension Task Force established by the Actuarial Standards Board). No matter which estimate you accept, the deficit in what pensions have versus what they have to pay out is staggering, and it’s happened for three reasons:

• Outsized promises. Pension details vary widely by state, but as a rule pensions pay out much more than they take in from participants. Some are far more generous than others; California offers retirees a pension at 87 percent of what they were making as employees, with lifetime benefits approaching $1.3 million, while Mississippi offers retirees 54 percent of their former salaries, leading to average lifetime benefits of just $307,000. And this is typically after thirty years of employment, resulting in people retiring in their fifties and living for thirty years or more.
• Underfunded systems. Politicians are typically very good at making promises, but very bad at following through. And as required payments to state pension systems become greater and greater, squeezing out other government priorities, many politicians have opted to delay or skip making those required payments, which will just compound funding problems in the future.
• Unrealistic assumptions. In order to maintain the illusion that they’ll be able to meet future obligations, most pension funds assume that they’ll consistently make a fantastic return on their investments: Of 150 public pension funds surveyed, 97 percent assume that they’ll make annual returns of between 7 and 8 percent. Since low-risk investments don’t provide anything like that (the 10-year Treasury bond is close to 2.5 percent as of this writing), many funds pursue risky investments in order to attempt to clear this bar.

While problems for public pensions were always considered to be in the future, there have been some recent developments indicating that the future is becoming today. Some towns, such as Stockton and San Bernadino in California, have been forced into bankruptcy due to their pension obligations. And some pension funds, such as the Central States Pension Fund and the Dallas Police and Fire Pension System, have either started talking about reducing benefits and halting lump-sum buyouts.

Whether you’re relying on Social Security, pensions, or your own investments, the reality is that the stories you’ve been told about preparing for retirement have been just that: Stories. It’s time to think about other ways to protect yourself in the future.

To order the complete book, go here.