(The start of this article is an excerpt from Chapter Three of "Contracts With Our Children", which is the first book of The Great Retirement Experiment series. This article is also available in audio form.)
Consider a fresh, hot pie. Let's call it an apple pie, though it could be blueberry or cherry pie if you prefer. That pie smells delicious, you are hungry, and you want a big, fat slice of that pie. The problem is, so do a lot of other people. How big of piece can you eat? That depends on three things: how big the pie is, how many people want a piece, and whether some people are allowed bigger pieces than others.
Let's call that pie the national economy. The United States economy is what we will be talking about here, but this applies to pies of other nations as well.
Now the marvelous thing about economic pies is that in a growing economy they just keep getting bigger, year after year. Getting a big piece of that pie in the future for ourselves is the motivation for investing of course. We all want the fattest slices of that growing pie we can get, and fortunately there are plenty of people willing to sell us future pieces of that pie or tell us how to get a bigger slice.
How big is that succulent pie going to be? Various reasonable long-term rates of return for our investments are suggested depending on the source and investment type, but a nice one is 10%. The 10% could be a good number, not just because it is nice and round, but it represents roughly what a particular type of calculation tells us is the long-term rate of return in the stock market. We take $1,000 today, invest it for 30 years with annual compounding (reinvestment of our earnings as we get them), and that $1,000 sitting in a tax-deferred account becomes worth $17,449! That is the stuff which financial planning is made of!
The Economic Pie
Another way is to look at the economic fundamentals of our pie. Buying investments does essentially mean that we are buying an ownership interest in the economy. When we buy shares of stock, we become owners of the corporation. The economy is primarily made up of corporations. By collectively owning those shares of stock, we as all the investors effectively own the private economy.
Over the long term (1950-2000), the United States economy has been growing at about 3.5% per year, after removing the effects of inflation (source: Bureau of Economic Analysis). Of that about 1.2% a year can be accounted for by population growth (source: Census Bureau). So we have real growth - per person -- in the economy after inflation of about 2.2% a year. Now, take that same $1,000, and grow it for 30 years at a 2.2% rate, it becomes worth... $1,921.
Hmmm... seems like there might be a problem there. We buy investments expecting to earn a 1,645% profit over 30 years, from our ownership interests in the economy. But the overall per capita economic pie has only grown 92%, after accounting for inflation and population growth. So our expectations for growth in investment wealth are eighteen times larger than the growth in the real economy.
I think you can see our pie problem. Which is the difference between looking at pies, and actually eating pies. Around fifty million Baby Boomers are planning on eating nice slices of a really big investment pie at some point down the road. Not just all the people who buy stocks and other investments directly, but all those who buy through their retirement accounts, and indeed, anyone who is planning on getting a pension as part of their retirement.
The problem is that when we add up all the different expectations for our future pieces of Investment Pie, and compare them to what the total Economic Pie is likely to be - there just isn't enough pie to go around. An individual can certainly earn a particularly fat slice of the pie, so long as they follow an investment strategy that works out very well indeed. As many investors have in the past. However, how can everybody who follows the conventional investment strategies all earn those big slices simultaneously? How can one sixth of the entire population simultaneously have their real worth increase 18 times faster (1,645/92) than the real per capita worth of the nation itself?
It looks like we have a problem. The amount of real wealth in terms of resources, is growing far, far slower than people's perceptions of their current and future wealth, as valued by their investment portfolios. We have a huge group of people planning on actually selling those investment portfolios to get real resources, at the same time, year after year. How do we make it all add up?
The simple answer is: they can earn that wealth on paper, but when it comes to real resources, they can't cash it out. A pie, or an economy, is made up of the sum of its slices. When most of the people are all expecting their own slices to grow far faster than we know the overall pie is growing - an awful lot of people are likely to be very disappointed.
Historical Returns & Hypothetical Behavior
As long as we are asking questions, this is probably a good place to ask another: if a 10% investment return rate and 2.2% per capita economic growth rate are both based on long term history - what's the problem? Obviously they can coexist, so why worry?
That answers to that question are what the rest of Chapter Three explores, and unfortunately there isn't room in this article to fully address those questions. However, a short answer is that the issue is not whether can stocks can earn a 10% nominal yield while the economy is growing 2% on a real per-capita basis. Because that can work just fine, and has many years in the past. The issue is all the clever people who looked at that 10% yield, and said: "hey, we just found a magic money machine! All we have to do is assume 100% reinvestment of our investment earnings, through our pensions, investment funds, IRAs and Keoghs, and all of society together can become fantastically wealthy! And we can run models using hypothetical investor behavior to prove it historically!"
Now, the problem with that approach, which underlies most long term investment planning today, is that the 18 to 1 figure isn't so much based on historical earnings as it is the hypothetical compounding. All we've really done is demonstrate that exponential compounding is a powerful mathematical concept. If we take an equation with high growth rate - let it run wild with no constraints - then the math proves that we all become wealthy. Keep going in time, and the same math necessarily also proves that our wealth will grow until it is larger than the universe itself. Uh oh. See, that's the usual problem with running exponential equations without outside constraints, and the reason these equations are used with great caution in fields other than finance, or subjects other than our collective life savings.
Unfortunately, there are constraints, and cashing out real goods and services requires a real economic pie. Real financial history is that that never before have we had so many people planning on actually eating such nice big slices of pie, over such long retirements. People generally didn't live that long in the past, and the ownership of securities was concentrated in a much smaller segment of the population. We've made three big changes with our hypothetical investment models, which actually didn't happen in history. Number one, never before have we had so many people investing in the markets, with such a large percentage of the population as investors. Number two, long term exponential compounding of our wealth was not the objective - or the majority behavior. Number three, and this is the most important part, never has such a large segment of society attempted to simultaneously convert such high compounded wealth expectations into real resources, for year after year, over a period of decades. We have never seen anything like this three way combination, and the ability of the markets to withstand this unprecedented test while delivering high rates of return is unproven theory.
The Markets Save Duluth
Another way of illustrating this is to look at one example, and we will use the example of Duluth, Minnesota, a city of 87,000 in Northern Minnesota, located on a hillside above Lake Superior. In 1983, Duluth had a problem with city unions wanting more money than was available in the budget, and voters who didn't want a tax increase. So the mayor just promised the city workers (and their spouses and minor children) free health care for life, instead of spending a couple hundred thousand to give the employees the raise they wanted. Free money as far as the mayor was concerned, because there was no need to account for such promises under governmental accounting standards, and the real expenses were still a generation away, which means they didn't exist politically speaking. Fast forward to 2005 and with rapidly building retiree health care benefits, the city finally gets around to calculating the expected cost of that health care promise - and per the official city study, it turns out to be $280 million. Whoops.
For a while, things were looking pretty bleak around the small city of Duluth, with its already strained budget and massive unfunded but legally binding retirement obligations. It looked like it might need to be a choice between staggering tax increases, or else ultimately file for municipal bankruptcy, as the only way to legally renege on promises made to city retirees. But not to worry, for it appears that a solution has been found. The city will make really good investments. Not just ordinary investments, but the really good kind. You take that good, high rate of return assumption, unleash the full power of exponential compounding, and the wealth multiplies until the investment markets pay for the problem.
What a relief for the good people of Duluth! As it turns out, the historically proven magic of the markets will bail them out of their politicians having promised more than the citizens can pay. Via the mechanism of the markets, vast sums of money and resources will flow into the city from the outside economy, and allow the retirees to enjoy their promised benefits in full without the citizens having to actually pay for those benefits. What a sweet deal, and the even better news is that Duluth is not unique!
The Markets Save Everyone
This same kind of magic is going on with almost every state and local government across the country. The dollar amount per citizen just for health care in Duluth is a bit extreme, but almost every government in the US that has full time employees has entered into promises for future benefits that the government anticipates being unable to pay for from ongoing revenues. Some of these promises are unfunded, others are fully "funded" (meaning adequate current portfolios given the investment return assumptions), but the solution all comes down to the same thing. Via the mechanism of the markets, vast sums of money and resources will flow from the outside economy into the local economies for all the states and cities, and pay for legally binding promises that would otherwise be unaffordable from current revenues.
Governments aren't the only ones using this compounding magic, so are most of the major corporations. Oh, the defined benefit plans are disappearing fast in terms of the ability of workers today to participate, but there are still tens of millions of workers covered, and many trillions of dollars of pension and health care benefits that will have to be paid, by such companies as General Motors and IBM. Future benefits that would destroy corporate profitability, and drive many corporations into bankruptcy. If that is, it weren't for the magic money wealth compounding machine of the investment markets. With that market wealth paying for the money to buy the goods and services for retired employees, that employers would otherwise not be able to pay.
Individuals are not left out of this game, far from it. That's the whole idea of retirement plans, be they IRAs or Keoghs. You can put money in, but you can't take it out before retirement, or at least you are strongly discouraged from doing so via tax penalties. So your money stays in and compounds. As demonstrated in the financial planning models that have been run for many millions of individuals, just take a modest amount of money monthly, let historical rates of return compound forward, and you too can have a quite comfortable retirement. Along with the other 50 million Baby Boomers doing the same thing, as we all cash out together.
This leads to a quite simple question, that I'm sure many of you listeners and readers have already seen coming. If the economy is made up of the corporations, governments and individuals, and the corporations, governments and individuals are all attempting to compound their wealth because they all can't afford to pay for the Baby Boom retirement promises and expectations, then who, precisely is it that cashes them out? If all the components of the economy can't afford to pay for something from current revenues, then how do they all get bailed out? Who is the Santa Clause who steps in and bridges our example 18 to 1 gap between wealth growth expectations and the growth in real wealth?
Who bails out the economy itself? Is it the new generation of investors who will be coming into the markets? That smaller generation of investors behind the Boomers? With the money they have left over after being unable to pay for Social Security and Medicare? Those are questions of capacity, but perhaps the biggest question is one of motivation. Even if they could, would the Boomer's collective children and grandchildren really work night and day for the privilege of voluntarily buying out the Boomer's portfolios at the highest prices in history? Or might they do something else, like trying to hold on to as much of the goods and services they are creating as they possibly can for their own benefit?
We could say that the "who" will be the corporations that will appear and thrive between now and when the bill comes due. All the new Googles and so forth. Except, there aren't really that many Googles, and the one we have is miniscule compared to the size of the problem. The idea behind founding new companies is generally to try keep as much of the money as you possibly can for yourself, instead of passing it along to the passive investors in legacy companies. Can we really count on an entirely new economy appearing, with a growth rate far in excess of historical standards, that will be happy to step forward and bail out the old economy?
Some others might say that the "who" will be the other nations of the world. Their economies will bail us out! Except, well, maybe as a starting point, we should be buying their economies right now, instead of selling them ours, as we are doing with our massive trade and budget deficits. There is also the issue that other nations have their own demographic issues, much of Europe has problems that are worse than those of the US. Which doesn't likely leave much left over to bail out the US. As for the booming economies of Asia - sure it is convenient now for them to support the US economy while they grow their own productive base, but do we really expect them to continue to subsidize our standards of living at the expense of their own for decades to come?
The corporate and government officials making these plans are quite confident, because they do have history on their side. They (or really their financial advisers) can selectively pull out their exponential compounding equation. They can plug that equation into their hypothetical models and say, yes, our magic money machine should have worked this decade, and yes, it should have worked that decade. They can show that it in fact works, by pointing to those years when massive amounts of money were pulled out of the markets and used for real resource consumption, without slowing down the steady rise of the markets, years like, you know... well... um...
That's the problem. There aren't any years like that. Years where extraordinary amounts of money were pulled out of the markets and converted into real goods and services in order to meet widespread societal needs that are so great that they are otherwise unaffordable for corporations and governments. There are no years like that - because we've never actually tried this before, on anything like this scale.
About as close as we can come is a few years where substantially more investors have tried to take money of the markets than putting money in. Nothing like the thirty plus consecutive years that the Baby Boom has in mind for their strategy, just an individual year here and there. 2001 would be the most recent of the years, 1929 is another well known one. You know, it was the strangest thing too, because real goods and services didn't spontaneously arise from the earth to cash out all those millions of investors selling their symbols at the same time. Instead, much or most of the symbolic value of the markets just disappeared in those years instead. "Poof", went away, almost like it was never there at all.
Abstract Theory or Common Sense?
There are two ways of looking at the information presented so far. One perspective is that this is abstract theory, the other is that we are talking common sense about all of our futures. Yes, as a Chartered Financial Analyst and Finance MBA with almost 25 years of professional experience in working with financial mathematics, I'm taking a chance in thinking that anyone besides myself will find topics like the mathematical divergence between economic and investment wealth models to be of interest. Talk about a sleep-inducing topic! If you have been listening to the mp3 version of this file, I hope you weren't operating an automobile or heavy machinery at the time.
However, when we get away from the math and economics jargon, I think that what we've been talking about here is really no more than common sense. Indeed, let me suggest that problem with our current investment approach is that it is so steeped in jargon, that people miss the underlying common sense questions, which are quite readily understandable to the average person.
Questions such as: Can the average person really become wealthier than the average person - or do things need to add up at some point? Can we all eat more pie than there is pie available? Can all of us really be wealthier than the economy through stock investments, and then cash out that wealth independent of the economy? What does happen to the price for symbols when too many people start to cash out symbols and there aren't enough resources to go around? If the collective corporations, governments and individuals can't pay for Baby Boom retirement promises, and we rely on the investment markets to pay instead - then who pays? Precisely that is - who pays? With exactly what do they pay? Even if they could pay - why would they pay? What is their compelling motivation to pay the highest investment prices in history, year after year?
I want to know: who is going to pay me, with what are they going to pay me, and why are they going to pay me? Don't you? To me, that's not abstract theory at all, just common sense.
Did the information above make sense to you? Do the implications worry you? Did you find yourself considering any perspectives that were new to you? Perspectives that sound like common sense to you? Considerations that maybe all of us should be thinking about? If the "unconventional" concepts contained herein sound like common sense to you, then please pass the link on to people you know who might be able to benefit. If there is not to be a devastating financial disaster down the road, then changes will need to be made, which will require asking uncomfortable questions. Given how lucratively profitable the status quo is for the financial industry, there are going to have to be a whole lot of people asking uncomfortable questions before there is any hope for a change in the situation for society.
The other action you can take is to do what you can to protect yourself individually, or perhaps even find ways to profit from the situation. For that, you will need knowledge. A good place to start is to read the rest of Chapter Three, as well as the rest of the book, "Contracts With Our Children". Take a long look at the Boomers investments from the perspective not of the Boomers - but the following generations who will be cashing out those investments. Look at the central issue of supply and demand for investments, and what happens as the ratio of buyers to sellers falls for decades. The thin theoretical reed upon which the current case for stocks rests, is unending exponential growth in consumer spending. Learn what happens to this thin reed when 77 million of the largest generation of consumer spendthrifts in history begin steadily going on a fixed and lower income.
Picture an interconnected world of 77 million Boomers who are demanding tens of trillions of dollars from the generations behind them for Social Security, and more tens of trillions for Medicare - even as the 50 million Boomers who are investors seek still more tens of trillions from the expected sale of their investment portfolios at the highest prices in history. Picture a world of many tens of millions of younger workers, entrepreneurs and investors at the peak of their own careers, using all of their creativity and intelligence to find ways of holding onto the wealth that they are creating, instead of passively and obediently passing it over to retirees. Picture your investments as part of the back and forth struggle between the generations that will determine how the entire Great Retirement Experiment is really going to work (instead of just the promises that the Boomers are making to themselves today). Picture yourself reading the remaining three quarters of Chapter Three, "Pie Slicing & Missing Trillionaires", as well as the rest of the book. Picture yourself going to The-Great-Retirement-Experiment.com and taking advantage of the books, articles, pamphlets, and audios, that together explore what happens when the stratospheric symbolic wealth expectations of the Boomers and their pension plans wrestle with the reality of limited real resources and self-interested investors, in a title bout refereed by Adam Smith...