Old people are annoying. They sit around, contributing no productivity to the economy and complain about us young people eating too much avocado. Ok boomer.
In all seriousness, retirement is a unique stage in someone’s life. You don’t work (by definition) and, therefore, don’t have an income. But, you are still consuming. It is important to have a financial safety net large enough to last one’s whole retirement. Not just for the retiree, but for society.
What is retirement for?
Retirement is the time where the excess money earned throughout one’s working life can be enjoyed with excess leisure time.
As we age, we also get less physically and mentally agile, so continuing to work often has diminishing returns, in terms of our economic output. This another reason we take our leisure at the end of our life, and not at the start or in the middle. It doesn’t make much sense otherwise. Especially when we’re still able to enjoy travel and leisurely activities just as much as before.
Life cycle model
A simple economic model of one’s financial stages through life is the life cycle model. In youth you are supported by parents and only consume. Once you begin working, you consume some percentage of your wage and (hopefully) save some percentage. These savings are then drawn upon during retirement.
Based on this model we can develop some questions around how one should approach thinking about retirement. The key questions around the life cycle model are around how much one consumes (during working years and retirement) and therefore how much one saves during working years.
The cost of lifetime consumption cannot exceed lifetime earnings. Note: Lifetime “earnings” includes things like winning the lottery. This is known as the lifetime budget constraint.
Government Support
The government supports the old by subsidising health services, which often has the greatest delta in consumption, between working and retirement. An old age pension can also help support the elderly during retirement.
There are a few justifications for supporting the elderly with taxpayer dollars. Firstly, they need it. Often retirees are short sighted and have failed to save enough during their working years. Second is equity. The younger are better off than the elderly (as a society) and so it’s fair that the young now support the old. The old now also used to be young, and they supported their elderly. Thirdly, similar to the first, is less about carelessness and more about risk and probability. There are risks involved with ageing, and it is usually best to distribute this risk by social insurance. Such risks include:
- Longevity risk: the risk that someone will live longer than they expected. i.e. they run out of savings
- Health risk: Someone might die earlier due to a health condition or have increased health costs during retirement
- Retirement risk: Sometimes retirement is involuntary and before the retirement age. A workplace injury might disable someone and rescind their ability to work, which could mean they have had less time to save for their retirement
Private risk pooling
While government risk offsetting may be effective, people are also free to participate in private risk pools. Private risk pools reduce the variation of risk by allowing for the lucky and unlucky people to counterbalance each other. Those who end up with bad luck have their costs offset by those blessed with good luck. Joining a private risk pool is voluntary. They are usually participated in for peace of mind, if one would prefer to maintain a higher standard of living than that provided by just the governmental support during retirement.
Concretely, let’s say there are 10 people who wish to risk pool. The probability that a bad outcome, which will cost $100 to cover, will occur is 10%. Thus, each person will put $10 in the pool. The one person who is struck by the bad outcome can rest assured that the pool will cover the full $100 cost.
There are some incentive related flaws to such schemes. For one, healthy people are less likely to join the schemes since they will be knowingly offsetting the unhealthy people. Unhealthy people are more willing to sign up, so now the pool is likely to run thin, and not be able to cover enough bad outcomes. These people don’t actually have to be healthy or unhealthy, only to perceive themselves in such a way. Due to the egocentric bias, people are more likely to judge themselves healthier than average. Thus, people are less likely to sign up than the equivalent rational actor.
The scheme can have the probabilities recalculated to counter these problems, e.g. the probability of some bad outcome occurring in a group of unhealthy people is now 15% and so they each pay $15. Some consider this unfair. It is only unfair if the input parameters of the equation include genetics and/or other factors outside your control. It’s more than fair to pay a higher premium for bad lifestyle choices like smoking or eating processed meat, because otherwise it’s unfair on the healthy people. This does not completely solve the problem, since within this group of “unhealthy people” there is a spectrum of un-healthiness, leading to the same incentive imbalances as before.
Private risk pooling also fails if people don’t sign up in time. Due to a mixture of optimism and laziness, people tend to postpone signing up to a private retirement scheme. This is stupid, but it is a common enough occurrence that it is worth mentioning.
Preparing for retirement
You should try to have enough savings to let you live a comfortable, financial-anxiety free retirement. Though, depending on your life trajectory you may want to spend more in your youth, so as not to end up with too much money and too little physical well-being to do expensive things like travel world in your geriatric years. These are decisions left for each individual. Though when it comes to retirement, it’s usually best to err on the side of safety. And even better to start young, and exploit the power of compound interest.
