Savings and its Impact on a Whole Society

So how do savings rates of different members of a population impact society as a whole?  It's an important question that is rarely if ever discussed by modern economists.  We can explore this question by comparing modern day America to the island nation of Terra discussed in an earlier post.

Like the population of Terra, the population of America as a whole has no ability to save (assuming that there is a neutral balance of trade with other nations which at the moment there is not, but that will be the subject of another post).  This concept will be difficult for someone to wrap his or her head around at first, but if thought about long enough and hard enough one will conclude that this is true.  All of the goods that workers produce are either consumed right away, or after production go into a period of long steady decay.  Even buildings require constant maintenance to prevent them from becoming worthless over a couple of decades, and even then a certain percentage are destroyed every year from natural disasters.  Thus, we must come to accept that at all times production and consumption are held roughly in balance.  Without the production of goods it is impossible for the population as a whole to consume.  Without the consumption of goods, there is no reason to produce them, for excess production will lead to waste and eventual decay to worthlessness.

This of course does not imply that there is no savings for certain segments of the population.  On Terra there were many children and elderly who could not work, but they did consume for to do otherwise would mean death.  In order to provide for their consumption the active workers needed to produce more than they as a group could consume.  Why would they WANT to do this?  In an altruistic society the reason would be to prevent widespread misery and starvation; however, altruistic societies don't really exist.  The main motivation is to work off obligations owed to the elderly and to become creditors to the younger members of the society.  These credits represent future food and shelter, and anyone who can see into the future farther than the next payday will recognize the importance of having the means to eat even when the ability to work has passed.  The credits less the obligations we can call the "savings" of the workers.

So what about America?  Let's perform a very crude mental experiment.  Currently in our country 13% of the population is over 65 and 27% is under 20.  If we assume that these age groups generally don't actively work then this means that at least 40% of the population is consuming goods and services but not producing them.  If we assume that each and every member of the population between the ages of 20 and 65 is actively working (a generous assumption) then 60% of the population is producing the goods that all 100% of the population is consuming.  If we further assume that each individual in America consumes the same amount (some consume WAY more than others, but to keep the math simple we will assume an average consumption level).  The consequence?  Each worker must produce 1.67 times his/her basic needs to keep society as a whole sheltered, clothed, fed, and entertained.  And if he/she doesn't?  Well, it means that the goods available for consumption simply will not be available.

If each worker is producing 1.67 times his or her basic needs this means that his or her savings must be 40%!  It is no coincidence that this is the same percentage as the number of people in the population who are not working!  The excess production or "savings" of the working population must equal the percentage of the population who are not working in order for society to prosper.

And the personal savings rate in the U.S. currently?  It is less than 5%.  In fact, the highest it has ever been since 1960 was 12%.  How is it America's children and elderly are not starving?  It has a lot to do with the purchase of inexpensive goods produced by cheap labor outside of our borders as well as the build up of debt owed to foreigners.  As long as we can count on the kindness of strangers we can maintain our current ways without experiencing much pain; however, if the world changes, as it often does, to correct imbalances then we will be facing a major problem.  There will only be two solutions that will work on a societal level:  1) Our working population increases their savings rate from 5% to 40% (consume 1/3 less than present levels, or 2) We ask our underage and elderly populations to enter the labor force.  I wonder, what will this look like?

Directing the Surplus

The 1990's were an interesting time for American workers.  Public companies were making the transition away from traditional pensions in favor of defined benefit contribution plans.  The responsibility to save for retirement was now placed on the worker rather than on the employer.  Baby boomers were in their peak earning years and the stock market seemed destined to return 15% or more per year annually.  Financial firms were promoting the notion that not being invested in the stock market was a risky notion (never-mind the conflict of interest associated with this message, which will be the topic of a later post).  Because of the expectations of high returns built into the American psyche, workers assumed that they could invest a relatively small percentage of their wages into the stock market, wait for the market to do its magic, and then retire comfortably at age 65 without any change to their standard of living.  There were two very important questions that few seemed to ask:  1) Is this a reasonable and realistic at the individual level?  and 2) Is this workable and socially just for society as a whole?  This will be a two part post that will explore each of these questions separately.

Let's consider the question of whether or not saving a relatively small fraction of a person's income in the stock market over the span of a career and retiring comfortably on the proceeds first.  The thought exercise will produce some numbers that will be useful in the examination of the overall social impact of every employee following the same policy.

According to the Bureau of Labor Statistics, as of the 4th quarter 2011, the average worker aged 20-24 earns $467/week or $24,284 per year.  The average worker aged 55-64 earns $885/week or $46,020 per year.  Thus, over a 45 year working life a person can realistically expect their salary to double.  Side note:  this is a doubling in real, inflation adjusted terms.  To make the following thought exercise simple, all figures will be in real terms.  So, your "average Joe" can expect to start work earning $24,284 per year and expect a real salary increase of 1.4% per year.  The following graph illustrates "Joe's" salary over his working life.

Now Joe's employer, fully aware that the burden of preparing for retirement is now squarely on Joe's shoulders, offers Joe the use of a "magic piggy bank" on his first day of work.  The employer clearly spells out the features of the magic piggy bank for Joe as follows:

1. The piggy bank will accept up to 15% of the employee's salary
2. For every $1 the employee puts in this piggy bank, up to 5% of the employee's salary, the employer will match dollar for dollar.
3. The employer and the employer's financial advisers believe, but cannot guarantee, that the money in the piggy bank will increase by 7% per year, in real inflation adjusted terms.  Side note:  This is the market rate of return that was commonly accepted in the late 90's (and still accepted by many today).  It was an assumption promoted in Jeremy Siegel's book "Stocks for the Long Run".
4. There is also a possibility that the money in the piggy bank will only increase by 3.6% per year, in real inflation adjusted terms (of course, Joe had to read through the small print to even see that this was a possibility).  Side note:  The historical change in the price level of the US Stock Market from 1900-2010 was 1.6%, adjusted for inflation.  To this we add the current dividend yield of 2% to arrive at an expected 3.6% real rate of return from the market going forward.
5. At age 65 the employee can retire and start accessing this money; however, there will be a one time coin flip that will adjust the employee's total balance.  If heads comes up the balance will be adjusted upward by 20%.  If tails comes up the balance will be adjusted downward by 20%.

Joe, being atypical of the average American worker in that he doesn't mind doing a little math before committing his money, works out some scenarios to figure out if this is a good deal.  Ever the optimist, he focused on the most generous assumptions of a 7% rate of return with a 20% one time upward adjustment at the very end.  Joe assumed that he would work for 45 years, retire at age 65, live to age 85, and need $46,000 per year (his projected final salary) to enjoy retirement fully.  Quickly doing the math, he realized that twenty years in retirement multiplied by the funds he needed every year implied that he would need at least $920,000 in the piggy bank when he reached age 65.  It seemed like a large amount of money given his meager $24,000/year starting salary but after sitting through a few highly persuasive investing seminars he thought this goal might not be out of reach.

Armed with an Excel Worksheet he went to work projecting the growth of the money he planned to invest in the magic piggy bank.  After a few minutes he was very pleasantly surprised to find that saving only 5% of his salary will do the trick.  Below is one of the graphs he made to illustrate the "power of compounding" within the magic piggy bank.

In addition to a curve showing the projected balance in the piggy bank as a function of his age he also included a curve showing the total amount of fresh money he and his employer would contribute over the years.  Joe observed that if he contributed 5% of his salary to the piggy bank and was matched dollar for dollar by his employer that the total of contributions over 45 years would be a meager $152,000.  On the other hand, he predicted that by the time he retired the amount of money in the piggy bank would be nearly $1,000,000.  He will retire a millionaire!  All he would need to do is to save $76,000 of his own money, the employer would contribute $76,000, and the power of compounding would add $847,000!  Truly this WAS A MAGIC PIGGY BANK!!!  Saving for retirement should not be a problem at all!

Joe was so excited that when he went home this was the first thing that he showed his wife, Jane.  Jane, having been raised by a banker, was always a little wary when it came to finances.  She was always skeptical when something looked too good to be true.  To Joe's dismay, Jane immediately started questioning his assumptions.  "How can this possibly be true?  I recently read an article about this guy named Sated who was the leader of an island nation.  The story made a good point that working aged people would need to forego 25% of the fruits of their labor in order to sustain the inhabitants of the island.  Doesn't the same logic have to hold true for a country?  If everyone were to forego the consumption of only 5% of the fruits of their labor there wouldn't be enough surplus goods and services to satisfy the needs of the population as a whole."

"Oh honey", Joe said, "you would have to speak with the financial counselors who spoke to me to understand.  It has to do with the power of compounding.  If we get started right away then the money our savings generates will generate more and more money with each and every passing year.  Just take a look at the curves!  The math isn't hard to understand.  Here, take a look at the pamphlet the company gave me..."

Jane read through the pamphlet.  It was filled with many colorful pictures such as the curves the Joe showed her.  It also had numerous pictures of elderly people lounging on islands, golfing, water skiing, riding horses, etc.  They all appeared to be having a great time.  Every one of them had a big smile on their face.  Something didn't seem right.

"What's this footnote here about a possible 3.6% return and a potential 20% loss at the very end?", asked Jane.

"Oh, that's just a disclaimer.  The financial adviser told us that this possibility was so remote that it wasn't worth considering.", said Joe.

"Could you please humor me and put these numbers in your spreadsheet and see what happens?  How much money could we end up with if we only save 5%?", asked Jane.

Joe hesitated for a moment, but seeing how uncomfortable his wife was he agreed to do the calculations.  What he found was a little disturbing.  Below is a copy of his revised graph.

He brought the chart to Jane.  After a moment Jane said, "That makes more sense to me.  I've seen this work at my father's bank.  Combined, you and your employer are contributing $152,000.  Others who need this money will use it and return it to you with interest.  In the end, you'll have $271,000, which is $119,000 more than you put in.  Still, if you plan to be retired for 20 years and had to make this money last we'll only be able to afford to spend $13,500 per year.  This is only 30% of what you said we will need to have a happy retirement.  What would we need to do in order to meet the goal?"

Joe went back to his home office to start seeing what would happen if they saved a greater percentage of his income.  He started by increasing the percentage to 6%.  That didn't seem to have much of an effect, probably because the employer match had already been exhausted.  He increased it to 7%, then 8%, then 9%.  None of these savings rates got him close to the $920,000 end balance he felt they would need.  Finally he changed his savings assumption to 15%, the maximum amount his employer would allow him to contribute to the magic piggy bank.  The graph he brought to Jane is shown below.

"Jane, we have a problem.  Even if we save 15% of my pay we'll still fall short of the goal.  We'll only be able to count on having $542,000 when I retire.  I'm a little depressed now, but we need to discuss what to do about this."

"Well, look on the bright side", said Jane.  "If we hadn't discussed this we could have spent the next 30 years saving only 5% of your income.  If that had happened we wouldn't have any options.  We could have found ourselves in a situation where you were within 15 years of retirement with only $150,000 in the magic piggy bank.  That would have been a disaster.  At least being aware of this early enough gives us some options."

"And those are?", asked Joe.

"We can always save more.  The magic piggy bank only allows you to save 15% of your salary, but there are other places we can put our money, provided we're willing to sacrifice more now in return for some security later.  There are some other options as well.  For example, you can plan to work longer.  Working an extra few years gives you more opportunity to save, and the final balance will not need to last for as many years.  We can also plan to downsize in retirement.  If we can find a way to be content with less when we retire then maybe we won't have to sacrifice as much in the near term future."

"I don't like any of those options", said Joe.

"Of course not honey.  That's why that brochure they gave you at work is so inviting at first glance.  It wouldn't have been nearly as compelling if they provided you a glimpse of reality.  Let's discuss why that 7% real rate of return is just not reasonable..."

(to be continued in part II)

The Social Pact

In a far away and yet undiscovered corner of the world is an isolated island nation that is named "Terra" by its inhabitants.  The people of Terra are not unlike you and me.  They have professions.  They have day to day worries.  They celebrate when good fortune smiles upon them and struggle through their share of misfortune and bad times.  On the whole, they live their lives enjoying simple contentment.  All of their needs are met in large part due to the wise leadership their steward, a man who was given the name "Sated" by his parents.

Sated had always been observant, and he learned long ago that the people would tend to prosper in proportion to what they were able to produce.  In years when the people were feeling inspired to work hard everyone had enough to eat, had dry huts, and plenty of firewood to keep them warm throughout the year.  Some years, after a season or two where the inhabitants worked less, the following winters would feel longer due to the need to ration food and wood.  It was never possible to work less in a given year and still enjoy a full stomach, even if the people of the island had worked extra hard the year before.  Food, and other products of the people's industry, never seemed to last long enough in storage to get them past a single winter.  As a consequence, the people lived year to year.

When Sated was made steward of the island he was facing a particularly difficult problem.  There was a feeling of animosity between the islanders who were of working age and the elders.  The elders, having worked for many years making the goods that the whole island consumed felt that they had earned the right to live out their old age without having to work as hard as in the past.  Of course, the very elderly didn't have much of an option.  The working age men and women were resentful that they had to work so hard to produce more than they themselves needed in order to be comfortable.  Sated felt, and he was right, that if he could not find a way to calm the discord that the working age men and women might not work hard enough to get the people through the next winter.  He retreated into his hut to think about the problem and did not emerge for a full three days.

As the flaps of Sated's tent opened the children took notice and ran to their parents and grandparents to bring them the news.  The islanders all gathered around to hear the pronouncements of their steward.

"My people", said the steward, "we have lived together for many generations on this island, and we must make a pact to ensure that future generations are able to live together as we have.  I have thought long and hard about our current situation and have come to some conclusions that I will share with you now.  There are three groups of islanders that must come to an agreement if we are to enjoy continued prosperity."

"Many of you are twenty years old or less and still dependent upon your parents.  You are either too young to work productively, or are spending time learning a trade so that when you do work you can produce items of greater value.  While you are not working now, you must recognize that you have an obligation to those who are supporting you now to make sure that you show your children the same kindness that was shown to you."

"Quite a few of you are over the age of 65, have worked long and hard to produce for the needs of both yourselves and your neighbors.  You have brought us through many winters and we are in debt to you.  Many of you are too old to work.  Some of you are very tired from having worked hard in the past.  You've earned your rest; however, you'll notice that without someone working to produce the food that you will eat or the materials to maintain your hut you will not enjoy a good life, regardless of how deserving you may be."

"That leaves the rest of you, those of you who are working age.  You are the lifeblood of this island and you produce all of our food, our clothing, and our shelter.  Your industry keeps everyone fed, clothed, and sheltered.  You can easily produce enough to satisfy your own needs and then some, but you must observe what has happened to your elders and recognize that a day will come when you no longer have strong backs and agile fingers."

"We have always been a nation that valued freedom of choice.  It has been the backbone of our society and it has enabled us to live lives of dignity.  That said, I am not here to impose a mandate upon you but rather to compel you to make a social pact between generations."

"You who are able to produce more than you need to survive should love your children and provide them with food and shelter until they are old enough to leave your houses and be productive themselves.  You should do this just as your parents did for you.  As the only workers on the island you also have a special obligation to make sure that enough is produced that your elders do not live in discomfort.  Before protesting please consider how it would be possible for you to satisfy your needs when you reach an age where you are too old to work."

"Simple arithmetic dictates that for this arrangement to work you must produce 25% more than is required to satisfy your own needs and the needs of your children.  After all, if you yourself cannot work past the age of 65 or choose not to then you will live 1 year out of every 4 years of your life in retirement.  It is not a coincidence that about one fourth of our island population is over the age of 65.  You must produce this surplus in every year of your working life if we are to have enough to for all inhabitants to consume."

"Because we are a nation of free will and not an island of slaves, each of you will be given a choice of how hard you work, how long you work, and how much you consume.  Making this choice available to all is the only way we can maintain our individual dignity.  But there will be consequences, as there must be, for not participating fully in this pact.  As you treat your elders now, so will the next generation treat you.  We will create a tally system to keep track of the surplus goods you create during your working lives.  We will call this tally system 'money'.  For every surplus good produced you will be given a unit of this 'money'.  When you are an elder you can trade these units of money for surplus goods produced by the workers.  Beware, you must manage these resources wisely for if you run out you will have very little to offer the working class and you will have to rely on their charity."

"I ask you all now to accept this pact.  If we are successful then it will ensure that all future generations will live lives where there is enough food, shelter, and clothing to meet everyone's basic needs.  This will make it possible for multiple generations to live together in harmony."

And so it was that Sated introduced the social pact to the island nation of Terra.  The inhabitants accepted this pact and lived their lives just as Sated predicted.

This blog will explore some ideas in the realm of economics, investing, and social justice.  I introduced the fictional story above as a basis for developing and communicating these ideas in a way (I hope) that individuals from different backgrounds can relate to.  Please join me on this journey.  Your feedback, provided it is polite, will always be appreciated.

Paul