The Coming Generational Storm: What You Need to Know about America's Economic Future

by Stephen McConnel

Review

The Coming Generational Storm is a book which should be read by anyone interested in the welfare of our country and its future generations. It presents a rather bleak view, but also provides some suggestions for solving the problems presented. Informed voters will then have the opportunity to influence politicians into taking the steps necessary to deal with the issues presented.

The authors are not lightweights. Dr. Kotlikoff is a Professor and Chairman of the Department of Economics at Boston University. His accomplishments include multiple articles and books as well as involvement in a company which provides financial planning software for individuals and financial planners. Scott Burns is an experienced journalist, currently on the staff of the Dallas Morning News as a personal financial columnist.

The essential message here is that the demographic bulge caused by the aging of the baby boomers will create much more severe conditions than our politicians are willing to admit and deal with. The authors believe that we are not being told the full extent of the liabilities which face the country in the form of future Social Security and Medicare obligations.

This book delivers a demographic and fiscal reality check…what you'll read in the first two-thirds of the book will scare you, make you angry, and send you running for cover. But keep reading. Help arrives in the last part of the book in the form of new government policy proposals and personal financial moves that can save our nation and protect you from the worst case scenario….Our deepest motivation is very simple: we're fathers. We love our children and worry for their sake and for the sake of all of America 's children about the future.

The authors introduce the concepts of generational accounting and generational balance. They point out that, based on the government's own figures (originally included but later deleted from the President's Fiscal 2004 Budget) it would take an immediate 69% increase in taxes to equalize the taxes paid by this generation and future generations to fund the liabilities that have already been imposed on future generations by the present generation.

Significantly increased longevity combined with declining fertility is yielding a big increase in the average age of the populations of the developed countries, including the U.S. More elderly citizens demand services, many of which; care and feeding, for example, are not “productive” in the sense that our economy is not producing more; it is consuming more. Our older citizens are not saving and investing; they are living off their savings and consuming. Worse yet, because Social Security and Medicare are “pay as you go” systems, they are putting more demands for funds on fewer workers. If one thinks in terms of the demands on our society for those who need care (obviously, that includes children) it is noteworthy that the call on Federal coffers for children under 18 in 1995 was $1,693; it was $15,636 for those over 65.

The concept of generational accounting is critical to the authors' arguments. This involves adding up all of the income that one can expect over time and balancing it against all of the fiscal obligations that exist. But the government has an infinite life and without any modification, both the sum of the income and the obligations would also be infinite.

The authors create the modification by introducing the concept of present value. Ignoring inflation for a moment, how much would you pay me today if I promised to give you a dollar today? Of course, the answer is a dollar. Now, how much would you pay me today if I promised to pay you a dollar in a year? Probably about 95 cents. That would give you an interest rate of approximately 5%. If you extend this analysis out over time, you see that the present value of a dollar is less and less depending on when it must be paid back. One hundred dollars payable in 50 years, assuming a 5% interest rate (referred to as a discount rate) is 4 cents. If the income of the government is present valued, the income due very far out into the future approaches zero, so now the sum of the income over time becomes a measurable figure. The same thing applies to the obligations.

Therefore, the obligations of the government can be estimated and present valued based on when they come due, and the expected income flow in the form of taxes can be similarly estimated. The balance between the two reflects the net obligations of the government on a generational basis. Right now, the deficit approximates $72 TRILLION. As a point of comparison, our officially recognized federal government debt is between $4 and $5 trillion.

The authors go on to show that we currently are taxed (net of the benefits we will receive) at a relatively high marginal tax rate—approximately 50%. They contend that it will be politically difficult for future Congresses to raise that rate very much to fund future benefits. In 2002 a study was done to measure the fiscal gap—“the difference, in present value, between the government's future receipts and future expenditures assuming future generations faced the same net tax rates as current generations.” This worked out to $45 trillion. To correct this gap would take one of the following immediate and permanent changes in our current policies; increase federal income taxes by 69%, increase payroll taxes by 95%, cut federal purchases by over 100% or cut Social Security and Medicare by 45%.

Ahh, but there are several things that could change this bleak picture; technological progress, sale of government assets, wealth transfer from older generations to younger ones, etc. Unfortunately, none of them are sufficiently powerful to take care of the problem. The most suggested way of dealing with the problem, economic growth, won't solve it because our social security computations already take that into account; benefits rise as productivity rises. Therefore, the future obligation is rising in lockstep with economic growth.

Unfortunately, sophisticated economic models also show that the impact of the increased taxes needed to fund these transfer payments on the economy as a whole will reduce people's ability to save and therefore, the economy will suffer a capital reduction. What is needed is a capital increase, in order to purchase equipment to support increases in productivity, resulting in higher real wages and higher taxes.

There is no guarantee that the U.S. will continue to attract foreign capital, either. Foreign capital (and U.S. capital, too) can flow freely across borders. Unless the U.S. provides greater returns for capital than other countries, we won't have a net inflow of capital. Furthermore, most of the capital in the world is already in the U.S., Europe and Japan. All three economies have similar problems with aging, high social pension costs and reduction in workforce and so it is unlikely that there will be capital inflows to the U.S.

In addition, the wealth transfer that boomers are expecting will be less than expected because there are a lot more boomers than there are parents or grandparents, so the wealth transfer per capita will be about what it has traditionally been. Further, traditional pension plans are being replaced by other, less secure (and less richly funded) plans. Even the traditional pension plans are less secure; look at what has happened to the United Airlines pensioners, for example.

Immigration has become significantly more difficult, so immigrants will not solve the problem. Illegal immigration simply adds people to the underground economy where they don't pay taxes, so that doesn't help much, either.

Economies can turn bad in an amazingly short period of time. If a country appears to be in economic trouble, the interest rates on its debt will go up because lenders need a higher rate of return to accept the increasing risk associated with that country's debt. This action slows the economy down and people spend less, slowing the economy down further. Governments can attempt to defeat this process by printing money. The result is inflationary, and the value of assets and government pensions go down: a disguised tax.

We are currently seeing the leading edge of media attention to long term Social Security and Medicare funding issues. This attention, combined with increasing discussion at the political level will sink in slowly but could result in a point at which long term bond interest rates begin to go up rapidly as the investing public realizes the long term risks. This could result in economic slowdown and a stock market drop. Consumer demand could then drop, and since America is the only engine currently driving the economies of Asia, combined with the economic problems in Europe and Japan, the whole world economy could tank.

The authors suggest a comprehensive reform of Social Security consisting of eleven proposals. Essentially, the existing system would be frozen with existing benefits payable based on benefits accrued to date. A retail sales tax would be implemented to pay off the existing accrued benefits. An actual trust fund would be established, funded by employees, employers and the government (the latter for disabled and unemployed workers). The trust funds would be invested in a global mix of stocks, bonds and real estate. Each worker's trust fund would be converted to inflation adjusted pensions between age 57 and 67. Remaining balances would be inheritable for those workers dying before age 67.

Medicare creates an even bigger fiscal gap. It would be cured by eliminating the current fee for service system and substituting health insurance vouchers. The vouchers would be specific to the person, taking into account the person's own health. Insurers and HMOs would have constraints requiring basic service and prescription coverage and requiring insuring of all applicants. The value of vouchers would increase based on real wage growth. This system would also cover Medicaid.

The cost savings of these reforms reduces the generational shortfalls mentioned earlier by more than half. Limiting Federal discretionary spending to 6% of GDP (where it was when George W. Bush took office) and eliminating the Bush tax cuts would eliminate the balance. The question is whether there is the political will to make those changes.

So, absent changes in policies at the national level, and with recognition of the probability of increased taxes and the possibility of increased inflation, what can the individual do to protect oneself?

First, people should monitor the investments they make to make sure that they are paying minimum management fees. Consider “low-load” mutual funds, or index funds instead of traditional mutual funds or asset managers. Although the difference in costs is small on a year to year basis, over time such savings add up to significantly larger returns with little or no change in risk.

Also, remember that a house that is free and clear creates, in a sense, invisible income. This income will not be taxed in a high tax, high inflation world and will create some hedge against inflation, as well. In the meantime, they may downsize their home, also creating a savings.

Speaking of savings, people should make sure that they are developing a diversified savings program which includes alternative investments such as foreign stocks and bonds, inflation protected bonds such as U.S. Treasury “TIPs” and perhaps some commodities, including gold. As some assets are hit hard, others will be buoyed up; resulting in a more stable portfolio.

Some people will delay their retirement as they consider the potential impact of the future, or they will change their work habits to continue to earn a significant, but reduced income, delaying the time that they have to reach into their retirement savings.

Younger people should save as much as they possibly can. If they are in a couple's relationship, they should try to live on one income and save the other. In addition, they should consider Roth IRAs instead of traditional IRAs. The difference is that, using a Roth IRA, they will be paying taxes now (at, presumably, a lower rate) and taking their money out tax free at retirement when rates must be higher to fund the retirement and medical benefits for the elderly. A regular IRA would reverse that concept.

Perhaps one's most valuable asset is health, particularly for the young. Productive life will be longer with good health: more can be saved and retirement can be deferred.

All of this implies that active, longer lived seniors will not continue either to work or volunteer—they will become greater burdens on society. Experience to date doesn't seem to support that. As people age, but remain in good health, they may retire from the full time working population, but work on a part time basis. Or, if not working, they remain active by contributing to the community through volunteer work, which adds value to the society without actually generating visible economic activity.

In addition, the only sure thing in today's world is change; often change that we least expect. Therefore, we know that what is postulated in this book won't exactly take place. But this is a wake-up call with a very big alarm clock.