Whitney Espich: Hi, I'm Whitney Espich, the CEO of the MIT Alumni Association and I hope you enjoy this digital production created for alumni and friends like you. Good morning. It's a great pleasure to be with so many of you today.
I would like to bring a perspective from economics, not technology, but rather financial engineering and capital markets, to discuss some of the issues around longevity and the challenges that we face, in particular associated with retirement saving and retirement security. And I'd like to focus on two themes with you this morning. One is changes in mortality rates and how that's affected the length of retirement spans. Second is changes in financial markets and how that has raised new challenges for retirement security. And I hope, along the way, to be able to show you a little bit about the experience of the MIT cohort, at least with respect to longevity and how that might matter for thinking about some of these issues. So let me just start with a very simple structure.
I'm going to focus on, really, not the population aging, which you'll hear more about, I think, later, but rather at the individual level. If we think about a household or single person, what's going to determine retirement security for them? Well, length of the retirement period, life expectancy at the point when they retire, as well as the resources they've accumulated, the purview of economics and finance, and the rate of return that they've been able to earn before and after they reach the retirement period. Now, I have to warn you that explaining this is the determinants of retirement security, and this is what economists and finance professors study. One of my PhD students' fathers, when he was-- when that student was graduating from MIT, I was describing the work of the late institute professor, Franco Modigliani, who received the Nobel Prize for the life cycle hypothesis of savings. And the media reported that the prize was essentially for the idea that you needed to save while you were working so that you'd have money when you retired.
And my students' father said, so they give Nobel prizes in economics for that, eh? [LAUGHTER] There was a little more to the story. But in some sense, that's the framework that you need for today. All right, so I'm going to start only with an MIT crowd, what I decide we're going to do a little conditional probability before lunch on a Saturday morning. But I want to give you a little bit of data on the remarkable improvement in life expectancy in the US over the last century and particularly what it implies about those who might be at retirement age. So I'm looking at this, and I hope I'll give you a little sense on-- there are many different numbers you will see on life expectancy and which ones matter and which don't if you're trying to think about retirement security. OK, so I'm looking here at the birth cohorts, individuals who were born in 1906 and 1955 in the US.
This is data coming from the Social Security Administration. And the top line just shows you life expectancy at birth, the number you would see if you looked at comparative international tables. In the US, for men in 1905, life expectancy was 54 years. And it increased by nearly 20 years over the subsequent 50 years, really an incredible historical achievement.
Much of that was a reduction in early life mortality rates. Some of it was an improvement in late life mortality. For women, the experience is nearly as substantial in terms of the improvement. And what I've also shown you is, for those same birth cohorts, the second row shows you, for people who were born in 1905 or 1955 who lived to age 20, what was their remaining life expectancy at that point? You're going to suddenly say, wait a minute. The 1955 birth cohort probably includes some people here.
They haven't finished their life expectancy yet. That's true. These are Social Security Administration forecasts of what this is likely to be going forward.
The 1905 cohort, we have a pretty good sense of how this all played out. So what you could see is that 1905 cohort, they're 20 years old in 1925. They had a remaining life expectancy of about 48 years.
The 1955 men had increased by almost 10 years relative to that, in terms of their adult life expectancy. At age 65, for the men the numbers were about 14 years and 19 years, so a five year improvement in expectancy of life at age 50 at age 65, around retirement age, and somewhat smaller for the women, who had higher life expectancies to start. OK.
The bottom row gives you some sense of the chance that you'd live to 90. So I have a 25-year retirement if you retired at 65. And this is population data. This is the whole US population.
That number rose from about 10% to over 25% for the men, and from 25% to about 37% for women. But I'm going to ask you to look for just a second at that second-to-last row. This is I'm conditioning on people who live to be age 20 and then asking what was the chance that they would live to be age 90.
In the 1909 five men cohort, it was about 6 and 1/2%. It rose to about 20% for 1955. And then for women it's higher, about 19%, and then 32%.
All right, focusing on that number for just a second, the chance of getting to 90 given that your age 20. I'd like to ask you to think for just a second, and I'll do a little over-under on this about how those numbers might compare. I've asked the alumni association to do some calculations for us of the chance that people who attended MIT and graduated and were born in 1922, '32, '42, and '52 lived to various later ages. So you've got two numbers here to interpolate between-- so the 1905 cohort, the 1955 for men-- 6 and 1/2%, 20%. Chance that if you were 20-- I'm going to call that old enough to graduate from MIT-- you got to 90.
OK, I'm going to ask you for some overs and unders here on what you think that number might be for the 1922 birth cohort for MIT graduates. Those are people who would, today, be 100. I'm asking the question, what is the chance that they got to 90? We can do the same thing for the 1932 cohort. Anyone want to give me an over-under on whether it's going to be over 25%? Higher? Over 35%? Anyone want to go for over 45%? All right. The numbers are actually for the 1932 cohort.
This is what you'd get if you looked at the Social Security Administration data to see what it should be for the population. You see that for men, 1932 cohort would be about 15%, women about 27%. For the MIT cohort, it's 49.4% for the men and 66% for the women.
Woo! OK. So I think you all need to plan for a longer retirement than you were expecting. [LAUGHS] And the crucial thing I hope you will take away is that you need to do two different things when you think about longevity and something like retirement planning. One is, you need to recognize that to get to retirement you have to have lived to an age like 65. And that changes the calculations around the mortality and longevity.
That's just the conditional probability point. The other thing you have to recognize is those numbers I showed you for the US on the improvements on longevity have not been equally distributed, far from. They are very, very heavily concentrated amongst those in the upper half of the income distribution. So if I jump back for a second, this chart from the Social Security Administration shows us the change in life expectancy at age 65 for men who were born in various cohorts in the early part of the 20th century. And the Black dots along the bottom are the lower half of the income distribution on lifetime earnings.
The white dots on the top are the higher end. You look at the 1912 birth cohort for men, and you can see that the upper and the lower half of the income distribution had almost about the same life expectancy at age 65. They're both around 15 years, give or take a little bit. You go forward by 30 years, and the life expectancy for the bottom half of the distribution had risen by less than a year. The expectancy for the top part of the distribution has risen by almost seven years.
OK? And the happy news for the MIT Alumni Association is that most of our graduates are well into that top half of the income distribution. And the result is that, as we think about the longevity issues around retirement, we have to recognize that for those who have been fortunate to live with relatively high incomes, with high education, and there's lots of social science research and medical research trying to tease apart the causes here. It's better access to medical care. It's better lifestyle. It may be the longer, longer horizons to make more investments.
It's exercise. It's less stressful and less physically demanding jobs. There are many different things that contribute to this. But the key is that there are these large differences at this point and they matter when we're talking about something like retirement planning. And the MIT group looks like it's doing very, very well on this dimension. So I hope you'll regard that as good news.
Only an economist could come to you and tell you that life expectancy is long, but you have to recognize that there is another side to this picture. And that, of course, is that you're trying to finance it with the accumulation from your retirement savings. And I now want to spend the rest of my time just talking a bit about the challenges of retirement saving, not just from the longevity side, but also from the capital market side, because some of the big trends we've seen in the economy in the last couple of decades actually complicate the task of planning for retirement and securing an adequate retirement income. And I should condition this in saying, you know, I'm not going to speak to the, let's say the bottom third of the income distribution, where much of their retirement income will come from Social Security. I'm not going to speak to the top-- I'm not sure how many percent.
Maybe It's 10, maybe it's 15, where the accumulation that they've done is such that they're really mostly looking about bequests and it's how much the kids are going to get and not whether they're going to run out of money. But it's some group in between, where the actual accumulation that they have done is material for figuring out how much they will be able to live on as they work through their retirement years and I'm noting here that retirees of 20 years ago, in most cases, in most cases in that upper part of the distribution, had worked under a world with a traditional defined benefit pension plan that provided them with an annuity so that they weren't going to outlive the income. We're now in a world that's different. Except for the public sector, defined benefit pension plans are relatively rare. So people are increasingly relying on their 401(k)s their own accumulation, and one thing that happens when you're drawing down your own assets, if you have not annuitized the money, is that you do run a greater risk of drawing down the assets and living longer than they can supply.
And I should notice an important conflict of interest disclaimer here that amongst my other hats I wear, I'm a trustee at TIAA-CREF, the retirement income supplier. We do sell annuities, but I'm not here to sell you an annuity this morning. But I do want to note that. And anyone who has a problem with your TIAA-CREF account, I'll be happy to hear your concerns later on.
[LAUGHTER] But let me now just turn to the capital markets for a second and focus in on the challenge that has emerged as a result of falling rates of return, particularly in the bond market, as we look at the last few decades. This is a chart that just shows you the US Treasury yield, the nominal Treasury yield over time. Numbers that were 8% in the early '90s are now down in the range of 2%.
This is the 10-year bond. Shorter-term bonds are lower still. So interest rates have fallen. Now, those of you who took 1402 when you were here at the Institute, and I hope we have a few of you represent this morning, will remember that it's not the nominal interest rate we should focus on in a time of inflation. And many of us are old enough to remember that before just the last year. In inflationary times, we need to focus on the real net of inflation return that is being delivered by an investment, because it doesn't really do you much good to earn 8% if inflation is 12% and you're actually losing ground.
So if we look at the real interest rate by subtracting the inflation rate from nominal rates, this is a chart that shows you the one-year interest rate, which is the green line-- the brownish line in the middle, the inflation rate, which you can see picking up significantly in the last year or so. And the blue line that's below the horizontal axis is the real net of inflation rate that people have been earning. And what you can see is that you go back to the early '90s, this number was positive in a couple of percentage points.
Move to around 0, at the beginning of this Millennium, and then has been negative and in some cases quite significantly negative for the last few years. So negative interest rates are not something that we really taught in the textbooks in economics until relatively recently. You see the same thing, by the way, if you look at the Treasury Inflation-Protected bond market, where this is showing you the bond that is protected against inflation, that pays off in 2028. That's a six-year bond as well as a 30-year bond.
The six-year bond is actually still earning a negative rate of return. And the 30 year bond has just been hovering around 0 in the last couple of years, and is now just slightly positive. You go back to the year 2000, the interest rate that was on a Treasury Inflation Index bond was on the order of 3 and 1/2%. OK? So the challenge here is that, for someone who is trying to save-- and these are all relatively safe investments, right-- someone who is trying to save in these relatively riskless ways is facing lower return opportunities today than they were before.
The US is actually, on these kind of instruments, these government bonds, the US is actually high by comparison to the rest of the world. In the UK today, if you're buying a one-year inflation index bond, the yield is almost minus 5%. You're giving up 5% of the value to do that.
Even if you're holding it for 30 years, it's minus 1 and 1/4. In Germany the numbers are a little bit higher, but not much. So the US looks like the high place in terms of what we're facing for real interest rates.
Now you'll say for a second, and you're right, but I don't hold only riskless bonds. I own stocks, that's part of my expected return. It is much harder to figure out what the likely return on stocks is going forward as we can know from experience. This is a survey of professional forecasters of what they expect on the average real inflation adjusted return on stocks for the next 10 years.
In the early 1990s, that number was on the range of 5% to 6%. Recently it's been as low as 3%, jumping up a little bit at the beginning of this year. The survey data from the 2022, which is the last observation drawn in this graph, was taken in January of 2022, so it was before the outbreak of the hostilities in the Ukraine. So exactly hard to know exactly how to calibrate.
But these numbers have generally trended down, suggesting that, perhaps, even in the capital market for stocks, the returns may be somewhat lower going forward. And by the way, it's not at all inconsistent to say stocks have performed well recently, say until the beginning of this current calendar year, while expected future returns are going down. Those actually do fit together. One of the things that can drive stocks up is the notion that the required return on stocks has come down. And you'll see the valuation in the short run.
It's good to have owned them. It's a challenge to get the return going forward. By comparison, if you look at the returns that were earned by investors who, say, finishing at the end of 2020, were invested in Treasury bonds or invested in the S&P 500. What you see is that, say, for the 40-year period beginning in 1981, the average return on Treasury bonds was about 3 and 1/2% net of inflation.
The average return on the S&P 500 was about 8 and 1/2%. So what that just suggests is that the history that we have lived through may not be the best guide to what the future is, given what the capital market signals are looking like today. So what that raises is the challenge of, depending on where you are in your accumulation profile, thinking about how do you build assets going forward. If you are at the retirement point, how do you draw down the assets you have and think about the rate of return you have going forward? And then, is there anything you can do to adjust on these various margins? Let me emphasize the drawdown part for just a second.
One of the standard rules that financial planners offer is that you can consume 4% of your assets every year in retirement. So say you start at age 65 with $1 million, and you're earning 4% real every year, and you're drawing down 4% of your balance. That means that you're going to reach age 85 with $1 million because you've been consuming just the income flow essentially every year. Make that 4% rate of return 2%. OK. Some of you can quickly in your heads do either the minus 0.02 times 20.
It's around 0.6. So you're going to end up basically with around $650,000 left in real purchasing power at age 85, if the rate of return you're earning on the portfolio is 2% and you're drawing down 4%. So that's the sense in which this makes it-- you're going to draw down faster in retirement. The same problem emerges if you're trying to save for retirement because it's just harder to build the assets as you go forward.
And I'll show you that in just with one example of what this would look like. If you ask the question, how much would you have to save every year. If you were in investing in a world where you knew what the rate of return was and it was either 5% or 3% or 1%, and you were trying to replace 50% of your salary when you got to retirement with the income you could earn on a portfolio.
The machinery I've built behind this calculation assumes that what you do when you get to retirement is you buy an annuity. And the annuity just combines the mortality rate in the population and the rate of return the insurance company can earn. And you're saving for different numbers of years. I think the 30-year horizon is not an implausible one to anchor this with, to think of someone who begins saving for retirement around 35, plans to retire around 65. When the rate of return is 5%, if you save 9% of your salary a year, OK, this assumes your salary rises 1% a year. You'll be able to pay for 50% of your last year's salary with an annuity when you get to retirement.
The rate of return is only 3%. You're going to have to save 16%. The rate of return's only 1%, you're going to have to have saved 30% of your salary. Now the US is not a high-saving country, but 9% is a number you can imagine. 30% of salary saving is something that I think is really outside the realm of possibility for what we can imagine today. You know, longer horizons will help you.
Saving for 40 years is going to take all those savings rates down. But in a group like this, it's the power of compound interest that really helps in terms of what's happening here. So anyone who's trying to save in a shorter period of time in a lower return environment really faces a significant uphill battle if they're trying to accumulate these resources as they go forward. So where does that all leave us? Well, what are the adaptation strategies for this low-return environment? One, of course, is to raise savings rates. A second is to work longer.
And working longer is a very powerful tool for addressing the concerns here because actually it works double duty. By working longer, you both earn for longer and save for longer, and you shorten the retirement period. So the working longer, I suspect, is a very important component of this. Investors can reach for yield by trying to hold riskier assets and hoping they'll do well. As my Nobel laureate colleague Bob Merton often reminds me, hoping it works out well is not a good strategy for retirement saving.
[LAUGHTER] And any time I'm in a conversation with Bob and the subject turns to equities outperform bonds over the long term, Bob says, you just better hope you don't get the Japan 1989 experience, where the Japanese stock market lost value and did not recover for several decades afterwards. Because if those several decades are when you're retired, that long horizon equity return doesn't do much to help you. And the final thing that I will close with is, there's also the issue, the possibility of doing something that I'll call intergenerational risk sharing. And that's basically the notion that if you have an economy in which the government can do borrowing or can change Social Security rules and transfer resources across generations-- borrowing from our children or similar transactions-- those become opportunities that we can consider in an environment like this. Now it depends critically on whether you think that the low rate of return environment that we might experience going forward is something closer to an aberration of history, like fighting a war, where you would say, well, the generation that bore that cost deserves a little bit of makeup from other generations, or whether it's just a new world that we're in. In which case, it's a rather different setting.
So on that note, I hope that this gives you at least some food for thought about the challenges that are posed by longevity and capital markets. It is really a very exciting prospect, that the opportunities for long and pretty healthy lives has improved so much. But given the developments in capital markets, it does actually raise some challenging issues around the economics and finance of retirement as we look forward to the future. Thank you very much. [APPLAUSE] Whitney Espich: Thanks for joining us and for more information on how to connect with the MIT Alumni Association please visit our website.
2022-06-23