One must save to retire, because savings transfer purchasing power from the present to the future and in order to stop working one must have claims on future goods. That much is obvious (if not, read this post). Since such claims are dollar denominated, the purchasing power is set by the supply and demand of dollars vs the supply and demand of goods. That should be obvious too.
A person’s ability to retire will thus be determined by his relative wealth(*). In other words, how much money does the person have relative to other people, and how much money does the person spend relative to other people.
(*) Wealth is here defined by having sufficient purchasing power to pay current bills.
These days a wildly popular solution to retirement can be summarized with the following list of words: “15%, (ROTH) IRA or (ROTH) 401k, index fund, and compound interest”.
The reason for the popularity is that the simplifying assumptions behind the concept are easy to understand, which has made it possible for Nobel Prize winners to write academic papers on the subject; investing requires very little effort; and it has given Wall Street a new product to sell to Main Street. Who me, cynic?
Thus a lot of people have been led to believe that they can get superior returns by practically no effort at all other than hypnotically chanting “magic of compound interest” while waving their hands and perhaps showing what-if scenarios based on historical results.
Well, those results are history. And this particular history just might not repeat itself.
In the 19th century 4% returns used to be pretty awesome deal. In the 20th century we came to expect 10%. This was accomplished through a massive wealth transfer from the biosphere to the human realm. In other words humanity has been encroaching on the biosphere and in the process turned it into furniture, pavement, clothes, stadiums, etc. It is estimated that the combined mass of humanity (humans and all their stuff) now weighs ten times more than the sum of all other life on the planet. Ouch! This means that there is less “other life” left to consume and turn into precious GDP or precious stock market growth.
Still, GDP grows by only about 4% a year, so in order to have reached returns of 8-12% several factors had to come into play. The US enjoys a natural edge in previously being inhabited by neolithic people who enjoy a much smaller population density. Colonizing Europeans could thus access a lot of land for free as it was not already inhabited by somebody’s children. Still today, the population density of the US is less than half that of Europe’s but thanks to the “magic” of having more than two children, population densities will reach parity within 1-2 doubling periods. At this point it will be rare for an American to see a wild squirrel. (I grew up in Europe and I was 18 before I came across a squirrel in the local forrest for the first time).
The final edge is that the magic of compound interest is especially magical when it benefits the few in such a way that it transfers wealth from consumers to capitalists. If everybody becomes a capitalist this wouldn’t work. For instance, when demand for bonds increase, the interest rate drops because the price goes up. Thus if everybody bought bonds, the interest rate would drop and returns would be less. Similarly, if everybody bought stocks, the price level would increase and reduce further appreciation potential. Blindly buying index funds only ensures that stocks are mispriced in the aggregate — although their will be internally diversified, diversification does NOT eliminate systemic risk, which is exactly the kind of risk that the index fund investing is currently creating (see here for more).
In addition, if everybody could get the magic 8-12% (pick your level of optimism), a general increase in price level would ensue. This would be caused by demand pull inflation from a large amount of paper assets chasing a decreasing number of real goods
Systemically, if everybody started saving more (a fake effect can be produced by borrowing money from outside the economy or more nefarious, getting the government to do it) we would have tremendous productivity growth. Sooner or later, this would cause a bubble in some sector of the economy, like laying down too many fiber optic cables in the late 1990s or building too many houses that people couldn’t afford to live in 5 years later.
So how do we fix this problem?
In my opinion industrialism is close to death. If Earth is a room, we have now painted ourself into a corner by taking up 75% of our potential to expand. There is simply no way of continuing down the present path as the world is not big enough to expand the industrial footprint of the western world (1 billion people) to the rest of the world (the “other” 5.5 billion).
Continuing regardless would turn human interaction into a zero-sum game where wealth is generally transferred from the have-nots to the haves (a general rule in complex sociostructures). We have already seen the first attempts to secure resources through military and economic means.
If the vote (what people do, not what they say) is to continue down the present path, the best way of ensuring happiness is to have more than everybody else. He with the most retirement funds wins. Currently this is easily accomplished by taking larger than popularly recommended [baby] steps towards financial independence, and preferably doing it before everybody else finds out. The world can satisfy 6 billion people with a standard of living corresponding to the average Mexican if wealth is equalized, and that is not bad although it is somewhat less than what readers of this blog might be used to. However, wealth is most likely not going to be equalized, so better beat the average.
Alternative, humanity might choose to pull their combined head out of the sand. This will be very hard. First, developing countries would like to have their shot a industrialization even though it’s physically impossible. Second, the entire west has to transition from a more is better mentality to a enough is enough mentality.
If this is accomplished, traditional retirement as we know it, will no longer be an option since there is no hyper-productive/hyper-consumerist society to piggy-back on. Hence the idea of saving a million dollars and living the good life in retirement will be void. The reason is that there won’t be a million dollars worth of stuff to buy with that million dollars. Stuff will be more expensive. The good news is though that people will have more time for everything else. For instance, there is no limit on information(*).
A solution to both problems is to accumulate more than average (given that the average is so low, this is not too hard) and learn to live well one a small footprint.
(*) I hope this doesn’t mean that everybody will suddenly go into a twitter frenzy though 😉
Originally posted 2008-06-04 07:37:25.