Demographic effects on personal saving in the future.

• Author: Pryor, Frederic L.

1. Introduction

   Analyses of the long-term growth of the U.S. economy generally focus primary attention on the rate of technological change. It is generally assumed that saving to finance the necessary investment will not be a problem. In this essay, I use a simulation model incorporating a lifetime income approach toward saving to argue that this assumption is wrong. More specifically, I show that in the long run, personal saving will decline as a shift in the demographic balance between savers (those in the working ages) and dissavers (retired workers), and, as a result, economic growth will taper off, especially since it seems unlikely that the decline in personal saving will be offset by increases either in business or government saving or in greater capital inflows from abroad.

   The argument proceeds in three steps. The two building blocks of the argument are the behavior of personal saving and the age structure of the population, which are discussed in section 2. In section 3, I present a simulation model to provide some idea about the magnitudes of the changes involved in the saving rate when the age structure of the population shifts. In section 4, I explore several variations of the model and, in section 5, some of the most important implications of the predicted changes in saving.

2. Setting the Stage

   The Saving Rate

   According to the National Income and Product Accounts (NIPA), which measure saving as a flow of resources, the annual rate of personal saving (excluding expenditures for consumer durables) as a percentage of GDP followed an inverted U-shape pattern, rising from 5.2% in the 1950s to 6.7% in the 1980s before falling to 4.6% in the 1990s. (1) Business saving as a percentage of GDP rose about 2 percentage points between the 1950s and the 1970s and subsequently leveled off for the rest of the century so that it did not offset the fall in personal saving in the 1990s. The flow of funds data from the Federal Reserve reveal similar trends from the 1950s through the 1980s and a more dramatic fall in the last decade of the century.

   Such a picture of the saving rate becomes muddied if we measure saving in terms of changes in personal net worth (stock data). By this yardstick, the ratio of saving to the GDP did not change between the 1980s and the 1990s. Such results seem primarily due to a rise in asset prices and the resulting capital gains rather than any activity giving rise to growth in real investment. I return to this phenomenon in section 4.

   For economic growth, the crucial fact is that, as a share of GDP, domestically financed investment remained roughly constant from the 1950s through the 1980s and then fell 2 percentage points in the 1990s, a circumstance giving rise to concern about the fall of domestic saving. As a result, many economists have focused considerable attention on the causes underlying this short-term fall in the saving rate during the 1990s (when saving is defined in terms of flow data) and whether this phenomenon will become more serious in the future.

   VVarious arguments are offered to explain the changes observed in the flow of saving during the 1990s. Some, such as Bosworth, Burtless, and Sabelhaus (1991) and Parker (1999), argue that it can be traced to a fall in the saving rate at all age-groups. (2) Others, such as Gokhale, Kotlikoff, and Sabelhaus (1996), provide contrary evidence that the fall came from a redistribution of income from the young to the old and a decline in the saving rate of the elderly due to a fall in the need for saving both for bequest purposes and for precautionary purposes. (3) Still others stress the fact that since most saving in the United States in recent years has been through unrealized capital gains, much of the lower saving measured in more traditional ways is due to a wealth effect, a hypothesis that is hotly disputed. (4)

   While these various microeconomic effects may be important in the short run, I show in the simulation analysis here that some much more important long-term changes due to shifts in the age structure of the population will take place, and these will prove to have a more lasting impact.

   Demographic Changes

   A major part of the model deals with the changing age structure of the population and the ratio between retired to active workers. For analysis of the age structure, one key concept is the elderly dependency ratio, which is the ratio of the elderly (those over 64) to those in the working ages. Table I presents not just the estimates by the Census Bureau and the Social Security Administration but also some much more sophisticated estimates by Lee and Tuljapurkar (1994; hereafter L-T), who use probabilistic methods to take into account uncertainties about birth and death rates.

   From these three sets of estimates, we can draw two simple conclusions. First, the nation is likely to face a dramatic rise in the elderly dependency ratio in the next half century. Second, the range of these estimated ratios is very large. For instance, the L-T calculations give a 95% probability that in 2050 the dependency ratio will fall somewhere between 30.6% and 51.5%. If uncertainties about the future of immigration policies are taken more adequately into account, the range of these estimates would undoubtedly be larger.

   The next step is to consider the ratio of retired to active workers.

   This ratio depends, of course, not just on the elderly dependency ratio but also on the age of retirement, a phenomenon requiring us to take into account two sets of circumstances:

   (i) Life expectancy is increasing. In 2000, a 65-year-old person could expect to live 15 more years; by 2050, this will be closer to 20 years. Moreover, because of advances in medicine, the young-old (i.e., those between 65 and 75) are healthier than a generation ago.

   (ii) From the mid-1960s to the mid-1980s, the percentage of men from 60 to 69 in the labor force declined (Quinn 1999). Since then, however, this percentage has leveled off. For women in the same age cohort and in the same period, the pattern was more irregular. In general, however, the percentage in the labor force remained roughly the same until the mid-1980s, when it began to increase. In the 1990s, many of those who would have retired were either taking bridge jobs or postponing retirement. A variety of factors underlay these changes, including changing health status, evolving patterns of home ownership and pension availability, and changes in mandatory retirement laws, Social Security payments to the working elderly, and the degree to which inflation eroded savings.

   In looking at the future of saving, these demographic considerations have two important implications. First, it is necessary to take into account both the rising life expectancy and the possible postponement of retirement. Second, if the customary retirement remains the same, future cohorts will have to have a higher annual saving rate to finance the longer retirement period brought about by the longer life span. If, by way of contrast, future cohorts shift their retirement age so that the length of retirement remains the same, then they will need a lower annual saving rate because they will be able to spread accumulation of a given amount of retirement funds over a longer lifetime.

3. The Impact of Aging on Saving

   The analysis focuses on aggregate net saving, that is, the result of gross saving by active workers and gross dissaving by retired workers. I begin the analysis with some highly unrealistic assumptions about the hyperrationality of savers and then relax them after the mechanics of the model are clear.

   The Model

   For individuals, I start by assuming complete foresight and a lifetime income approach toward saving. With full knowledge of how their incomes will change up to their retirement, workers decide on their saving and consumption rate each year to achieve three goals: to maintain a constant level of consumption over their working lifetime, to have enough savings during their retirement to finance some selected fraction of this consumption each year thereafter, and to exhaust their savings in their final year. The future growth and interest rates of the economy are constant, which individuals know when making their saving decisions. (5) All workers are assumed to have the same annual income so that the results of the calculations for one worker can be easily aggregated for the entire working population. (6) The initial model also assumes an equilibrium situation, with the only shocks coming from the changing age structure, the changing life expectancy, and the changing retirement age that are introduced by the sim ulator. This simple approach allows the implications of the basic mechanism to be understood and the results to be presented in a systematic and quantitative fashion before complications are introduced.

   Each year, the L-T population estimates are divided between workers and retirees. Active workers include all those from 25 up to the age of retirement, and retired workers are all those over the preselected retirement age. (7) Of course, in the real world only a fraction of those between 25 and 65 participate in the labor force, and the number of retirees must be multiplied by a similar fraction to determine the number of retired workers. It should, however, be clear (and the simulation results confirm this intuition) that the chosen participation ratio has no impact on the simulation results about changes in the net saving rate. (8)

   Workers are assumed to have labor income increasing at a fixed percentage each year for their working lifetime, which takes into account higher labor productivity due to technical change and capital accumulation. With a full knowledge of how their incomes will change up to their retirement, they save (or dissave) so as to have the same consumption every year of their working lifetime and, after retirement, to have enough savings to allow them a certain fraction of this consumption...