The economics of aging.

• Author: Wise, Dean A.

The U.S. population is growing older and living longer. Yet older people have been leaving the labor force at younger and younger ages. Moreover, most Americans have saved very little. At the same time, the cost of medical care has been increasing. These demographic trends and changes in individual circumstances will contribute to some of the most important economic transitions and policy challenges for the coming decades. Understanding the determinants of retirement, the nature of saving for retirement, and how to more efficiently provide medical care are perhaps the most critical issues that demographic trends have forced on us. These and related issues make up the activities of the NBER's Program on the Economics of Aging.

Begun in 1986, the Aging Program has developed primarily around large, coordinated research projects that simultaneously address several interrelated issues in the economics of aging. Extensive funding for the program has been provided by the National Institute on Aging (NIA), both through multiple research grants and through a Center grant, which provides centralized infrastructure support to the Program effort.

The major research categories in the NBER's Program on the Economics of Aging are: 1) saving and the evolving financial circumstances of older Americans; 2) work and retirement decisions at older ages; 3) health care; and 4) aging around the world. In each of these areas, a major goal of the research is to better understand individual decisions as people age, and how these decisions are affected by individual circumstances and the economic incentive effects of government policies and programs. This article summarizes research in each of these areas.

Much effort also has been directed to attracting young researchers to this field. To that end, our NIA Fellowship Program provides annual fellowships to between five and ten graduate students who are beginning research on the economics of aging. It also provides two or three postdoctoral fellowships each year to recent Ph.D. recipients, enabling them to spend a year at the NBER to do research on issues in the economics of aging and health care. The combination of NIA support for research training and fellowships, new project development, data resource development, and smaller "exploratory" grant support has been instrumental in our efforts to expand the program, and to engage outstanding new scholars in research on aging.

Nearly 100 papers are completed annually on issues in aging by participants in the NBER Program. Some of these appear in a series of books published by the University of Chicago Press.(1)

The Evolving Financial Circumstances of Older Americans

The way Americans provide for financial support in retirement is changing rapidly. All three of the traditional pillars of retirement support - Social Security, employer-provided pensions, and saving - are in transition. Potential changes in Social Security have received the most public attention. The aging of the population has made the continuation of current levels of real benefits from Social Security an uncertain prospect. Employers, too, are reacting to the increasing costs of their retirement benefits, with many of them discontinuing traditional pension benefits and retiree health insurance programs. At the same time, the rapid expansion of 401(k) programs, and the dramatic growth in savings in 401(k) and IRA programs, suggest a transition in personal savings as well. While most households retiring in the past had essentially no financial asset savings, that may not be true in the future. By the mid-1990s, at least one spouse in over half of U.S. families was eligible for a 401(k) plan, and over 70 percent of those who were eligible made contributions. Today, over $100 billion is contributed annually to 401(k) plans.

The Growing Influence of Retirement Savings

A long series of studies by Steven Venti, James Poterba, and me has considered whether IRAs and 401(k) programs have added to personal saving, or whether they have simply replaced saving that would have already taken place in some other form.(2) Using a number of different data sources and analytical approaches, we have consistently demonstrated that the saving taking place in IRA and 401(k) plans is new saving.

Having identified IRA and 401(k) plans as important inducements to saving, we focused more recently on the implications of these savings for the financial status of retirees in the future. A central feature of this work is a detailed summary of eligibility, participation given eligibility, and contribution rates, by earnings decile and age.(3) based on conservative assumptions about future participation and contribution rates, we estimate the 401(k) assets of cohorts who will be age 65 in 2025 and 2035. For all but the lowest earnings decile, the projections suggest that 401(k) saving could represent a very substantial contribution to retirement income. Among those reaching age 65 in 2025, for example, the average level of 401(k) assets is likely to exceed the discounted value of Social Security benefits. Thus their 401(k) plans could contribute more to their retirement support than Social Security. While these large financial asset accumulations are unlikely to be realized by families with the lowest lifetime earnings, 401(k) assets are projected to become a substantial fraction of Social Security wealth for families with lifetime earnings above the two or three lowest deciles.

One widely expressed concern is that employees changing jobs may have the opportunity to remove funds from their pension plans, leaving little for retirement. We studied the incidence and disposition of these lump-sum distributions and found that a substantial number of people with small balances do take money out of these accounts.(4) However, most larger accounts paid out as lump-sum distributions are reinvested in ways that preserve the funds for retirement. Thus the vast majority of funds remain in personal retirement saving plans.

More recently we expanded our projections of the 401(k) accumulations of future cohorts of retirees to account for "leakage" caused by cash-out of 401(k) assets when people change jobs. Although cash-outs have some effect on accumulation, the foregone accumulation at retirement attributable to this leakage is only about 4 or 5 percent of assets that are retained until retirement.(5)

Research by Andrew Samwick and Jonathan Skinner has analyzed a closely related trend: the movement among employers away from defined benefit pension plans and toward defined contribution pension plans and employer-sponsored savings plans.(6) They ask how this trend will affect the financial security of future retirees. Their simulations show that average and median pension benefits are higher under defined contribution plans than under defined benefit plans, and that minimum benefits are comparable. They argue, therefore, that the growth in defined contribution plans may strengthen retirees' financial security.

In related work, John Shoven and I documented the very high tax rates on distributions from retirement saving plans - particularly those for savings distributions passing through an estate.(7) Marginal tax rates on non-estate distributions were as high as 62 percent, while marginal tax rates on distributions passing through an estate were as high as 99 percent. Moreover, with moderate ongoing contributions to a 401(k) plan over a working career, these high tax rates could be faced by savers who did not have extraordinarily high incomes. However, perhaps in part because of these studies, these "success" taxes were eliminated as part of the Taxpayer Relief Act of 1997.

Alternative Theories of Saying

David Laibson's work has focused on nontraditional theories of saving, drawing on behavioral findings in experimental psychology.(8) Laibson suggests that savings decisions are influenced in part by "hyperbolic" discounting - a form of discounting that uses relatively low discount rates to evaluate distant events, and increasingly high discount rates to evaluate more proximate events. The implication is that people want to plan for the future (such as by saving for retirement), but their long-term plans are impeded by temptation in the present. Laibson's work suggests that actual consumption and saving decisions over the course of life are in fact quite consistent with hyperbolic discounting.

Laibson's work also suggests that commitment mechanisms such as payroll deductions and early withdrawal penalties tend to increase saving among people making decisions based on hyperbolic discounting. These mechanisms are part of why 401(k) plans are so successful in promoting saving. Specifically, by using payroll deductions and by imposing a financial penalty on early withdrawals, 401(k) plans tend to be more effective than other approaches in encouraging saving. Simulations suggest that 401(k) plans may raise the national saving rate by at least 89 percent.

The Composition and Annuitization of Retirement Saving

Andrew Samwick has initiated a number of research projects using the rich pension, earnings, and wealth data in the Health and Retirement Survey (HRS). A collaborative analysis by Alan Gustman, Olivia Mitchell, Samwick, and Tom Steinmeier finds that HRS households have a large proportion of their wealth in the form of entitlement benefits, rather than real and financial assets.(9) The combination of pensions, Social Security, and health insurance accounts for half of the wealth held by all households in the HRS, for 60 percent of total wealth of the median HRS household, and for as much as 48 percent of the wealth of households between the 90th and 95th percentiles of the wealth distribution.

Jeff Brown, Mitchell, Poterba, and Mark Warshawsky have explored the role of annuities for older households, focusing initially on how annuities are priced.(10) Using the Social Security Administration's mortality...