Wednesday, June 6, 2012

Future Shock: Boomers & Retirement

Born between 1946 and ’64, baby boomers are the children of the euphoric generation who won the last world war and established American global political supremacy. The first boomers began reaching age 65 in 2011, when the population of those 65 and older reached 41 million. About 75 million more boomers are getting ready to retire today—the largest pre-retirement market ever! In the next 18 years, the over-65 age group will expand to about 120 million.

However, as buyers of retirement products, boomers are woefully underprepared. Since 2008, they have been battered by a cruel economy. Distressed children and parents often have had to move in together. Many boomers have found themselves unable to retire until their early 70s.

Today’s 60-year-old, having worked 30 or more years, has only accumulated about $200,000 in his 401(k) plan, according to the Employee Benefit Research Institute, and his household spends about $40,000 per year.

That’s a problem. And yet another problem that’s less talked about is his health.

Research results from both the West Point Academy and the Citadel Military Academy in Charleston, S.C., show that 18-year-old Americans were extremely fit until 1920, just after World War I ended. According to authors John Komlos and Marek Brabec, the average 18-year-old American weighed a mere 138 pounds in the 1920s and had a body mass index (the height to weight measure) of 19.8, which is in the range for good to excellent health (the median value is 21.7). Even in the ’50s and ’60s 18-year-olds were very fit with weights of about 150 pounds and body mass indexes of 22.5. But that trend exploded later. The 18-year-old of 1980 is now a 50-year-old with an average weight of 168 pounds and a BMI of 28, close to obesity. At obesity, health problems start to accelerate severely.

The increase in weight has clearly registered on the personal consumption expenditure tables compiled by the Bureau of Labor Statistics. The chart below shows how our health-care expenses have changed over the last 25 years for different age bands. Observe the two strong relationships. First, the obvious one. We already require much more health care as we age. Yet that data mostly reflects the health-care consumption of the World War II generation, those already between 65 and 95 who were fitter most of their lives than their boomer children. That means the boomers’ potential body mass index health problems have not yet made their way into the research, and boomer behavior will thus change the data in the future.

The second obvious relationship one sees in the data is the increase in boomers’ expenditures over the last 25 years, which seem to be very similar to their BMI trend line. Other relationships are less noticeable. For example, health-care costs have been inflating at twice the CPI rate in recent years. Medical advances have increased our average life span even as inflation looms, which means greater chances of bankruptcy.

Things Money Just Can’t Buy
Good health care is not cheap, certainly not with Medicare alone. And health care is the only cost that increases with a person’s age. Figure 2 from the Bureau of Labor Statistics shows the cost of living, after taxes, for different age groups from 1990 to 2010.

The spending patterns of boomers during these years show that the buying power of pre-retirees is staggering. The 25-year-olds of 1990 went through their careers adding spouses and families, buying houses, spending for transportation and leisure, buying food, spending on education and paying taxes. By 2010, the boomers had ratcheted down that spending as their children left the nest but started spending more on health care. Considering that two-thirds of the boomer population (following national trends) may face the problems of excess weight in old age, even their most essential health-care costs may also turn up sharply. If push ever came to shove on this most essential need, which of all the other spending would you give up for the sake of your health?

Some good news is that our forced savings—in 401(k) plans, whole life insurance and FICA—have increased over time. The increase in savings is nearly perfectly complemented by the drop in the personal average (not marginal) tax rate.

Besides access to modern medicine, good health care also requires proper nutrition and exercise, cozy shelter, familial warmth, adequate transportation, taxes (of course), etc. If we could strip away the cost of good health from all the other stuff we spend money on, how much would we really need to ensure it till the day we die?

There Must Be A Way Out Of Here
One idea that has piqued the interest of advisors and their risk-averse clients is fixed annuities, which can be used to match health-care expenditures. But to use these instruments in effective ways, advisors must first start stripping out the bare essential holistic health-care costs that clients are likely to pay for the rest of their lives in retirement.

For example, as someone ages from age 65 to 95, health-care costs will change as he consumes more and faces inflation. What will be the all-in costs for the first 10 years (the go-go years)? For the next 10 (the slow-go years)? Or the last 10 (the no-go years)? If we can deduce these costs, then we can start buying fixed annuities to cover our essential health-care needs for, say, any one of these decades.

Fixed annuities work much like Social Security. The monthly checks arrive just in time. They can also offer health-care inflation riders so the annuitant maintains his purchasing power. The only difference is that the instrument is purchased from a private company. You can buy into them anytime before the payout begins. You are usually locked into a term of at least 10 years.

Other varieties of annuity will not do for problems like tackling health-care costs. Not that the large sellers haven’t come up with variations. They often start by building fixed annuities and then add unknown ingredients to the bundle and give it names like “structured notes,” etc. that can turn scary. Just as term life insurance protects clients against the risk of a premature death, fixed annuities protect their beneficiaries and help them match and anticipate future cash-flow needs. If you step out of this realm into variable annuities, indexed products, etc., you are in trouble.

Somnath Basu is a professor of finance at California Lutheran University and the director of its California Institute of Finance. Dr. Basu also serves as a professor of the Helsinki School of Economics’ executive MBA program. He’s involved with financial planning organizations including the National Endowment for Financial Education, the CFP Board of Standards, the International CFP Board and the Financial Planning Association.

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