Be cautious in accepting long-term projections of compound growth. The “miracle of compounding” can transform even small deviations from assumptions into large differences between predictions and actual outcomes.
Unfortunately, in much current debate about Social Security, both sides assert as incontrovertible fact predictions that are based on long-term projections of uncertain compound growth.
We can see how this plays out with an individual investor. If a 25-year-old puts $1,000 into a retirement account earning 6 percent per year, there will be $10,286 after 40 years. If, however, the growth rate is 3 percent, then the young investor will get only $3,262. Cutting the growth rate in half does not halve the ending amount. Instead, it falls by 68 percent.
I just read an assertion that by 2030, the number of retirees will have doubled but the labor force will have grown by only 18 percent. Is this certain?
The estimate of the number of retirees in 25 years is the more reliable of the two. All those who will be retired in 25 years already are living. Life expectancies may change slightly, as may the ages of average retirement. These factors don’t affect the projection much, however.
Projecting an exact percentage increase in the labor force is riskier. Yes, most additions to the labor force over the next 25 years from natural increases have already been born. But immigration is a wild card. An 18 percent increase over 25 years works out to two-thirds of 1 percent per year. Suppose, instead, the labor force grows by 1 percent a year. Then, the 2030 labor force will be 29 percent larger than now — not 18 percent.
Remember that during the Great Depression, the U.S. Census Bureau projected that the nation’s population, then about 125 million, would top out at 135 million and decrease thereafter. It actually hit 150 million by 1949 and 270 million in 1998 – twice the bureau’s “will never exceed” number.
In recent years, the U.S. population has continued to grow, in contrast to Japan and Western Europe, where both birth and immigration rates are lower. The U.S. grew 1.2 percent per year in the 1990s, the same rate it averaged between 1950 and 2000.
If that growth continues, the U.S. population will hit 470 million by 2050. If, instead, it grows by only 0.50 percent per year, the 2050 figure will be 345 million, a quarter less than at the higher rate.
The point of this is not to attack or support either side in the Social Security debate. It is rather to caution citizens to treat any conclusions from projections on compound growth rates as estimates — not perfect forecasts of what must inevitably happen.
Kenneth Boulding, a great but largely forgotten economist of the last century, once said, “Anybody who believes exponential growth can go on forever in a finite world is either a madman or an economist.” Those were wise words.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.