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In the 1950s and ’60s, MIT economist Franco Modigliani published a series of papers on the “life-cycle hypothesis,” proposing that individual consumption and savings patterns follow a predictable lifetime path: During their working years, people spend less than they earn, rationally foreseeing their retirement years, when they “dissave”—spending down assets accumulated during a lifetime of saving.
The idea now seems self-evident, the very foundation of retirement planning, but half a century ago, the life-cycle hypothesis was a revolutionary concept, for which Modigliani later won a Nobel award.
But it’s not the whole story.
While initial estimates by Modigliani and others backed the idea, more sophisticated analyses showed that in the United States and other developed countries, individuals often age (and die) with significant assets, more than simple life-cycle theory would predict.
This so-called retirement savings puzzle has gnawed at the profession for decades. Proffered explanations include bequest motives, uncertainty about various expenses, housing issues, aversion to public long-term care and unknown longevity, but a complete answer has yet to be found. Solutions are a pressing concern, however, in light of aging populations, underfunded pension plans and expensive government insurance for seniors.
Revisiting the riddle
In a recent Opportunity & Inclusive Growth Institute working paper “Medical Expenses and Saving in Retirement: The Case of U.S. and Sweden” (IWP 8, April 2018), visiting scholar Makoto Nakajima, with Irina Telyukova, focuses on the role played by concerns about uncertain health care expenses.
They compare two similar nations with very different medical insurance and pose the hypothetical: What if one nation adopted the other’s health insurance plan? “Unlike in the U.S.,” note the economists, “medical care across Europe tends to be insured by some combination of government-provided and mandatory private insurance. … [I]n Sweden, the tax-based universal health care system … covers all expenses.” Keying on that distinction, the economists tease out the contribution of health care expenses in explaining how seniors spend down accumulated assets.
Nakajima and Telyukova find that out-of-pocket medical and long-term care expense risk explains about a quarter of the difference between U.S. and Swedish net worth profiles. (Another possible explanation, saving for bequests, can generate “at most 16% of the observed differences.”)
If other economic and demographic differences between the nations’ 65-year-olds are accounted for, the model can explain “more than 90% of the observed differences.” In short, their model works well. And, significantly, they find that this risk primarily affects financial assets. Seniors in both nations tend to hold onto their homes—’til death do they part.
Facing risk, Americans hold on
To reach these results, the economists start with a look at asset data: How do Sweden and the United States compare in terms of assets held by individuals as they age? (Sweden is not an outlier; they also look at data from Austria, Denmark, Germany and the Netherlands.)
Differences are dramatic. “Net worth decumulation among retirees is slower in the U.S. than in all the sample Northern European countries.” The average 90-year-old American holds over half the wealth she or he held at age 65, while a comparable Swede holds just 21 percent as much as at age 65. The figure drops to 3 percent in Germany. This is particularly true for financial assets. Continental Europeans hold hardly any financial assets at age 90, while 90-year-old Americans retain as much as 100 percent of their median income at age 65.
The economists then measure health expense risk in the two nations and again find sharp differences, with Americans facing much higher uninsured health care cost risks. “A single individual of age 91 in the U.S., with median income and in poor health, has a 5.7% chance of spending $99,768 out of pocket per two years,” they write. A comparable Swede “has a 6.7% chance of spending just $9,061.”
These facts form a base for their mathematical analysis, quantifying the extent to which differences in medical expense risk explain the contrast in retirement savings. They build a model that allows them to hold all other factors constant while changing U.S. expense risk to Swedish levels and then gauging the impact on savings patterns. “This allows us to isolate the influence of medical expenses on net worth decumulation.”
In essence, they measure how American retiree savings patterns would change if the United States adopted Sweden’s insurance model so that seniors wouldn’t need to cover expensive out-of-pocket medical and long-term care costs.
Further steps
The economists don’t pretend to have solved the retirement savings puzzle. They plan to further explore why retirees in most industrialized countries continue to hold onto their homes​​—perhaps it’s preference for a familiar house and neighborhood, the desire to leave a debt-free home to children or an inability to borrow against their home’s equity. In any case, the authors acknowledge that their research is a first step “in order to design policies and programs affecting the elderly, … a crucial policy issue in the U.S. and globally as the population ages.”
