The economics of aging.

• Author: Wise, David A.
• Position: Program Report

Next year, the leading edge of the baby boom generation turns 62 and becomes eligible to receive Social Security benefits. Projecting forward, the U.S. population aged 62 and older will increase from 45 million to nearly 80 million over a period of just 20 years. Compounding the impact of the aging baby boomers are trends in longevity. At age 62, life expectancy is about 20 years for men and 23 years for women, and it is getting longer all the time. Whether this growing population of older Americans works or retires; how much they will have saved for their retirement; what health care they will need, and how much it will cost--are all critical questions. Also important are the policy questions: How will demographic trends affect the public and private retirement support programs that have traditionally been extended to retirees in the United States and around the world? Are these policies financially sustainable? Are they flexibly structured to accommodate a different population demographic, and how might they evolve in response to demographic trends? These questions motivate our research agenda in the Economics of Aging Program. Our aim is to understand more fully the relationships between age demographics, retirement and health care policy, economic behavior, and the health and economic circumstances of people as they age.

Begun in 1986, the NBER's 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. NIA has also supported our efforts to engage new investigators in studying issues in aging, to develop new research directions through pilot projects, and to bring together research teams to collaborate jointly in studying more complex issues and questions relating to aging. Thus the Aging Program has operated in an unusually interactive, coordinated, prospective and collaborative way. The Program has also benefited more recently from a Center grant from the Social Security Administration, which has enabled us to study in greater depth the challenges facing Social Security, its financial sustainability in the face of an older population, its economic structure, and the implications of various approaches to Social Security reform.

More than 100 papers are completed annually by participants in the NBER Aging Program. Some of these appear in a series of books published by the University of Chicago Press, the eleventh of which is forthcoming later this year. (1)

Retirement Saving

One of the most important aging-related trends in the United States is the growth of targeted retirement saving. Over the past 25 years, personal retirement accounts have replaced defined benefit pension plans as the primary means of retirement saving and contributions to 401(k)-type plans have expanded dramatically. A series of studies by James M. Poterba, Steven F. Venti, and me has quantified this transition and considered its implications for the economic circumstances of future retirees (11974, 12834, 13081, 13091). Because 401(k) plans have not existed for the full careers of currently retiring workers, their impact is moderate now, but is becoming more significant with each wave of new retirees. The typical 401(k) participant retiring in 2000, for example, contributed only for about seven years. As time passes, many more new retirees will have participated in 401 (k) plans; they will have contributed for a larger portion of their working careers; and their contributions will have compounded over longer periods of time. We project that if equity returns between 2006 and 2040 are comparable to those observed historically, then by 2040 average projected 401(k) assets of all persons age 65 will be over six times larger than the maximum level ever achieved by traditional defined-benefit pension plans. If equity returns average 300 basis points below their historical value, we project average 401(k) assets that are 3.7 times as large as the peak value of DB benefits. Looking at individual households, we project that the average value of 401(k) assets of families at retirement will grow from about $44,000 in 2000 to $575,000 in 2040 assuming historical rates of return, or to $348,000 assuming historical returns less 300 basis points. This represents a fundamental transition in the composition of post-retirement financial support in the United States.

Some of our recent analysis of 401(k) plans has considered how this growth could be affected by the asset allocation decisions of account holders. For example, recent research by Poterba, Joshua Rauh, Venti, and me compares several asset allocation strategies, including rules that allocate a constant portfolio fraction to various assets at all ages, and "lifecycle" rules that vary the mix of portfolio assets as the worker ages (11974, 12597). The results are sensitive to four features of markets and households: the return on corporate stock, the worker's relative risk aversion, the amount of wealth held in other ways (outside of personal retirement accounts), and the investment expense ratios. At modest levels of risk aversion, or in the presence of substantial resources outside of personal retirement accounts, historical returns imply a higher expected utility from an equity-based allocation, rather than more conservative investment strategies. Also, when asset allocation is near the level that generates the highest expected utility, variation in expense ratios becomes more important than variation in asset allocation. Interestingly, expense ratios appear to be largely ignored in the asset allocation decisions of many investors, as shown in studies by Jeffrey Brown, Nellie Liang, and Scott Weisbenner (13169) and by James J. Choi, David Laibson, and Brigitte Madrian (12261).

Another piece of our research has explored how the design of 401(k) plans affects worker participation, saving rates, and the allocation of savings across investment options. In one line of research, John Beshears, Choi, Laibson, Madrian, and Andrew Metrick analyze the important impact of the default provisions of 401(k) plans (11074, 12009). They find that more people participate when there is automatic enrollment. Participants are also influenced strongly by the default contribution rate, the default allocation among investment options, and the default approach to withdrawing funds. A related set of papers--also by Beshears, Choi, Laibson, and Madrian--looks at how a simplification of the decision process at enrollment can increase participation in the same way that automatic enrollment increases participation (11979, 12659). The most recent study by this research team looks at the extent to which employer contributions to 401(k) plans may crowd-out employee contributions. (2) They consider in particular what happened when a firm replaced its matching program with employer contributions that were not contingent on employee contributions, and find that employee participation and contribution rates did decline modestly after the plan change.

Related to the research on 401(k) plans are several analyses of the possibilities and complications of establishing an individual accounts component in the Social Security system. One concern with such a system is that workers might bear a greater risk from the uncertainties of investment returns. In one study on this topic, John B. Shoven and Sita Slavov illustrate that there is substantial "political risk" to participants in Social Security already, as the structure of taxes and benefits is frequently changed in response to economic and political pressures (12135). They find that "political risk" can be compared quantitatively to the "market risk" in a personal accounts retirement scheme. Thus the debate over personal accounts, they suggest, is not one of "safe" versus "risky" benefits, but one of portfolio choice.

Other studies have looked at ways to moderate the investment risks of investment-based Social Security reform, including a study by Martin Feldstein that considers various trade-offs between a guaranteed minimum return and a probability distribution of possible higher returns (11084), a study by Andrew Biggs, Clark Burdick, and Kent Smetters on the pricing of minimum benefit guarantees, (3) a study by Andrew Samwick on how changes in the progressivity of the Social Security benefit formula could be used to reduce the risks of investment-based Social Security reform (13059), and a study by John Geanakoplos and Stephen P. Zeldes on how one could convert Social Security into a system of personal accounts while preserving the progressivity of the current system. (4) As an alternative to funding an investment-based Social Security system, Alan J. Auerbach and Ronald Lee have analyzed policies known as "Notional Defined Contribution" (NDC) plans, which mimic the characteristics of fully funded defined contribution plans, while retaining pay-as-you-go financing (12805). Using different versions of the system recently adopted in Sweden, calibrated to U.S. demographic and economic parameters, their study evaluates the possibilities of the NDC approach in improving fiscal stability.

Jeffrey Brown and Scott Weisbenner consider how people perceive savings-based, defined contribution retirement plans (DC plans) relative to traditional defined-benefit (DB) pension plans, when offered a choice between them (12842). They are analyzing an actual employment situation in which newly hired workers can make a one-time, irrevocable choice between a traditional DB pension plan, a portable DB plan, and an entirely self-managed DC plan. Interestingly, the results show that a majority of participants fail to make an active decision among these...