No one likes to play Grinch during a time of celebration and gift-giving. But I'll take on the role -- momentarily -- to talk about saving for retirement. Our retirement income comes from three main sources: pensions, Social Security, and personal savings. The outlook for the first two is cautious. To maintain their standard of living during their golden years, workers will need to boost their personal savings by spending less.
ILLUSORY RETURNS. In the 1990s, workers hoped that double-digit equity returns in 401(k) accounts and similar pension plans would fund a comfortable old age. People were told that $1,000 invested in stocks over the past half-century was now worth $212,000. That stunning average annual return of 11.3% -- through 1999 -- left the other main investment choices, such as bonds and cash, far behind in the performance sweepstakes. Since then, the nearly three-year bear market has decimated retirement funds -- and the dream of easy money.
Yet the savings problem runs far deeper than the market's manic moods. Take that 11.3% average annual return. In the real world, long-term investors don't pocket anywhere near the sums generated by the market's performance. John Bogle, the outspoken founder of mutual-fund giant Vanguard Group, pointed out in a recent speech that inflation averaged 4.2% over the same period. After taking this into account, he calculates that the impressive $212,000 shrinks in value to a real $31,000.
Worse still, savings are further reduced by 4% in annual investment expenses and taxes. Taken altogether, that $212,000 shrivels to a real $4,300. "Some 98% of what we thought we would have has vanished into thin air," says Bogle. "Will you earn the market's return? Don't count on it" (see "Don't Count On It! The Perils of Numeracy").
SOCIAL INSECURITY. What's more, it's likely that stocks won't record anywhere near an 11.3% gain for at least another decade. Economist John Maynard Keynes argued that market returns come from three sources: the initial dividend on stock, subsequent earnings growth, and the speculative mood of investors.
Bogle tapped into Keynes' perspective to dissect the 17% average annual gains of the '80s and '90s bull market. About 4% came from dividend yields, 6% from earnings growth, and 7% from speculative enthusiasm (measured by the 7% average annual increase in the price-earnings ratio). Using Bogle's framework, a reasonable forecast for real returns over the coming decade is somewhere between 4% and 8%. Dividends are running about 1.5% a year. Corporate earnings growth has averaged 5.6% annually since 1929. Speculative enthusiasm is being washed out of the market. And the 4% to 8% return range doesn't take into account the impact of inflation, expenses, and taxes.
Social Security will be less generous, too. The scare stories about it crumbling from the weight of an aging baby-boom generation are false. But the system is under financial pressure as the population ages. The combination of lower birth rates and longer life spans will push the share of the population 65 and older from its 12% now to 20% by 2030.
FRUGAL FESTIVITIES. Put somewhat differently, the ratio of working-age Americans -- those who support the elderly -- to older Americans is 5:1. By 2030, that ratio will be 3:1. Strong productivity growth and older workers staying employed will make shoring up Social Security easier. Still, the pressure will remain to cut benefits, raise taxes, or devote other tax revenues to Social Security.
"But while faster growth may ease the pressures on government and workers, it will not eliminate the difficulties of providing for an aging population," say economists Erica L. Groshen and Thomas Klitgaard in a recent Federal Reserve Bank of New York paper, Live Long and Prosper: Challenges Ahead for an Aging Population.
Personal savings will have to take up the slack. Savings through residential real estate are on the rise, with a record two-thirds of American households owning their own homes. But there is no gainsaying: Individuals and households need to set aside more money every year than they do now. And that means budgeting to spend less and save more. So, enjoy the holidays, but be frugal. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online