The original state retirement pension program was instituted by Chancellor Otto von Bismarck for Germany in 1889. The retirement age was 70. Adult life expectancy in those days was about 72. If work back then began, on average, at 16, that gave 54 working and tax-paying years to finance 2 years of retirement, a work-to-retirement ratio of 27:1. The state could easily afford it.

Now move to the present. Imagine yourself as a person who started work at age 22 and wants to retire at 62, expecting to live until age 82—pretty much in keeping with the current U.S. averages. How much of your income must you save during 40 working years to provide enough income for 20 nonworking retirement years?

Suppose we take 70 percent of the wages you earned in your last year of work as a reasonable retirement-income goal. Many financial planners say you can get by on that. In addition, suppose that labor productivity and wages grow at a reasonable 1.5 percent annual rate during your career. And assume that you can save in a tax-deferred investment account. We need to specify one more variable: The real, after-inflation rate of return on your savings. The long-run historical average of pretax, real yields on long-term U.S. Treasury bonds is about 3 percent. Going forward, a conservative portfolio of stocks and bonds might be expected to return 4 percent over inflation, on average. Now let’s calculate what savings rate is needed to have enough at retirement to purchase a 20-year annuity, which would provide the target retirement income.

Bad news: The required savings rate is over 14 percent of pretax income. Every working year, you need to save more than 14 percent of your total pretax income and invest these savings at a compound real return of 4 percent to finance 20 nonworking retirement years at 70 percent of the final year’s wages. Compare this 14 percent required savings rate to the current U.S. savings rate, which averaged about 1.5 percent during the past five years. (You might add the appreciation on your house, but the experience of 2006 and 2007 suggest that would not be wise.)

Even a 14 percent savings rate might be too low a savings rate to generate financial security. Even from 1950 to 1990, the average U.S. personal savings rate was an insufficient 7.7 percent. If we take this as defining a historical norm and make the extreme assumption that the savings were entirely devoted to retirement, in a scenario of 40 working years and 20 retirement years, the savings would generate a retirement income of about 38 percent of ending wages.

These required savings can include some part of Social Security taxes, although the return on those taxes varies substantially with income and the future politics of Social Security. The savings also can include other involuntary savings, such as pension-plan contributions made by an employer—if an employee has a pension plan and if the employer remains solvent. In any case, providing for 20 retirement years with savings from 40 working years requires an intense commitment to saving large chunks of pay.

Fortunately, the retirement ages of 62 or 65 are neither magic nor unalterable. If you are going to live another 20 years, you could work longer. But Americans generally are going in the opposite direction. They are choosing shorter careers and longer retirements, if they can afford it.

Corporate early-retirement programs, designed to save compensation expense today by putting increased costs into the pension plan tomorrow, notably move the fundamental work-to-retirement relationship in the wrong direction and make adequate pension finance that much harder to achieve. If we change our example to early retirement at 57, the work-to-retirement ratio drops to 1.4:1. The required savings for a 70 percent wage replacement will be saving 20 percent of pay.

If you do continue working, the ratio rises rather quickly. Say you started work at 22 and matched the Bismarck plan’s retirement age of 70, then lived to 82. That’s 48 years of work and 12 years of retirement; the ratio rises to 4:1. The required savings for the annuity with 70 percent wage replacement falls to 7 percent of pretax income.

You also can put the question the opposite way: If you are saving for retirement at a given rate, how many years should you plan on working to have sufficient money for your life expectancy when you retire? Assume again that your career-long investment returns beat inflation by 4 percent a year, on average. If your savings rate is 6 percent of your pretax income, you will need to work 50 years to retire for 10 years at the age of 72, with a work-to-retirement ratio of 5:1. Save less than that, and retirement will be financially less pleasant. If you can manage to save 10 percent, your requirement falls to 44 years working, with 16 years of retirement, beginning at age 66, a work-to-retirement ratio of 2.8:1. Remember, you need a savings rate of 14 percent to retire at 62 with an expected retirement of 20 years. If you could adjust your personal work-to-retirement ratio to 5:1 by delaying retirement, your Social Security tax alone would provide the target retirement income—if it were invested in a personal retirement account. This would leave your employer’s Social Security tax to cover the disability, survivors, and other “safety net” aspects of Social Security.

These basic, sobering calculations explain why most Americans and their pension plans are hoping for high returns on their investments in stocks and real estate. They can’t reach a long and comfortable retirement any other way, unless they want to face saving a lot more each year or working long past age 62.

At the same time, however, the national debt and the expenses of government are pushing the capitalist economy toward higher taxes, less private investment, more consumption, and slower productivity growth.

There’s more to the Social Security crisis than just the Social Security program. As the baby-boom generation ages, it will also start drawing on the Medicare program.

The annual reports of the Social Security and Medicare trustees tell us that the combined annual costs of Medicare, Social Security retirement, and Social Security disability programs amount to about 40 percent of total federal revenues and about 7 percent of gross domestic product (GDP). These costs are projected to double to 14 percent of GDP by 2040 and then to rise further to 17 percent of GDP in 2080.

Since World War II, the average size of total federal revenues as a percentage of GDP has been 18 percent and has never exceeded 21 percent. The anticipated growth in costs for Social Security and Medicare as they exist indicate that the total federal revenue share of GDP must increase to wholly unprecedented levels, assuming that the rest of the government’s activities remain important to the citizens.

Another way to look at the funding problem: The United States of America has unfunded promises to retirees and disabled persons that have a present value of more than $39 trillion over the next 75 years. Present value here means that if we had the cash (we don’t) and invested it in world stock and bond markets at current market rates (we won’t), the earnings and principal plus pay-as-you-go taxation at current rates would be enough to pay the liabilities of Social Security and Medicare for 75 years. (But the problem would rise up again in the 76th year.)

Social Security is the simpler program, and its imbalances would be easier to resolve if we wanted to do so and had sufficient political capital. Actuaries estimate that, over the next 75 years, Social Security benefits will have a present value that exceeds the revenue due under current law by $6.5 trillion. This includes $1.9 trillion from the so-called Social Security trust fund because it is just an accounting device. It measures the cumulative Social Security revenues spent on other government programs during the current period in which revenue has exceeded expenses.

To redeem the bonds in the trust fund, the government will have to tax or borrow $1.9 trillion in the open market. It will need another $4.6 trillion of present value, from taxes or borrowing, to supplement revenues from the existing tax to pay all promised benefits after the trust fund runs out in 2040.

The more-or-less easy way to do this is to raise Social Security taxes today from 12.4 percent to 14.4 percent (half of it nominally paid by employers and the other half deducted from employee pay), as long as the extra revenues are invested in private markets, not Treasury bonds. Another more-or-less easy way is to cut everybody’s benefits, current and future, by about 13 percent, again with the proviso that the savings be put in the global capital market and not shifted from one of Uncle Sam’s pockets to another. A third way is to raise the retirement ages for a given benefit by about five years.

Higher taxes are not universally popular. Benefit cuts would turn members of AARP (the former American Association of Retired Persons) into angry radicals. And most Americans are eager to retire at 62, not 67 or 72. But the Social Security problem can be fixed this way, although we have given the job to shortsighted lawmakers who can’t see beyond the next election. What’s hard and maybe politically impossible about Social Security is the job President George W. Bush tried to begin in 2005: Turning it from a pay-as-you-go welfare program into an advance-funded, individual retirement-savings program.

In any case, Social Security benefits are driven only by demographics: More people are going on Social Security payrolls as the baby-boomer generation retires, and all people are living longer, getting older, and collecting more benefits. If medical science delivers on our optimistic speculation about much longer life spans, the whole idea of retirement will have to change. Social Security and pensions can’t cover 85 years of retirement on savings from 45 years of work.

Medicare, however, is driven by demographics, plus the rising cost of medical care and the rising desire for more and more care to live longer. The result is a bigger problem: Whereas actuaries compute the 75-year deficit of the Social Security program at 1.3 percent of annual GDP, Medicare’s hospital insurance deficit over the same period is 2.27 percent of annual GDP.

The Medicare hospital insurance trust fund surplus is much smaller than that of Social Security, and we are already drawing it down. Moreover, there’s more to Medicare than the hospital insurance program, also known as Part A. Hospital Insurance at least is partly funded by a 2.9 percent payroll tax. At $200 billion in 2007, it paid for a little less than half the total program.

Supplementary medical insurance, or Part B, pays a large share of beneficiaries’ bills for physician and outpatient services, and it cost about $175 billion in fiscal 2007. Part C is a private insurance alternative to Parts A and B. Part D is the new prescription-drug coverage, which cost more than $50 billion in fiscal 2007.

Beneficiaries pay 25 percent of the cost of Parts B, C, and D; the rest is automatically transferred from the general operating budget of the federal government.

Some might say Parts B, C, and D can never have a deficit because their spending is covered by the federal deficit. It’s better to say they are a main cause of the federal deficit.

Add up 75 years of expenses for Medicare’s Parts A, B, C, and D, and subtract all the different revenues that pay for them: the Medicare payroll tax, the premiums paid by beneficiaries, a tax on upper-income Social Security benefits, and an involuntary contribution from the state Medicaid programs. The result: dedicated revenues that gradually rise from under 2 percent of GDP today to about 3 percent in 2080. Meanwhile, expenses will rise not so gradually, from under 2 percent of GDP to around 11 percent.

Add up the whole operation—Social Security plus Medicare in all its parts—and you’ll discover that we are in the first years of a growing funding disaster. Never mind the widely publicized and far-off dates when the trust funds go broke. They serve only to make us complacent. The first year that the Social Security tax surplus failed to cover the general revenues needed for Medicare was 2006. Here we are.

From here on, the social safety net unravels. Its actuarial claim on general revenues rises to nearly 3 percent of GDP by 2020, nearly 7 percent in 2040, more than 8 percent in 2060, and nearly 10 percent in 2080—over and above payroll taxes and other revenues.

If percentages of GDP are too abstract to understand, U.S. Comptroller General David Walker offered figures in cold, hard cash in a 2007 report from his Government Accountability Office: Using present value, which is the amount of money we would have to invest now at today’s interest rates, adjusted for inflation, to have enough money to pay all benefits in the future, he reported the present value of the Social Security shortfall is about $6.5 trillion—a little more than today’s national debt held by the U.S. public and foreign investors. The present value of the Medicare shortfall is about $30 trillion.

These numbers could turn out to be too small. Congress might expand either program, as it did recently by adding the Medicare prescription-drug benefit without funding the $8 trillion additional shortfall. Or a medical breakthrough might let everyone live longer and collect more benefits. The present value of the whole problem is already three times the nation’s annual economic output and 15 times annual federal revenues.

This is a problem that even dynamic capitalism can’t solve without hurting someone.

The natural result of the Social Security–Medicare mess is a brewing political rebellion, still muffled for the time being but growing more potent with every year that passes without fundamental reform.

President George W. Bush thought the time was ripe for reform in 2005, but he was wrong. Sooner or later, probably later, today’s working Americans are going to have to recognize that they paid for the first generations of Social Security retirees, rich and poor, but no crowd of younger people is going to pay so much in turn for their retirement.

Unless the system invests in private enterprise, and those investments continue to earn historically high returns, the back end of the baby-boomer generation—born in the 1950s and early 1960s—will pay for its own retirement. It can pay now with higher taxes, while most of its members are still employed, or pay later during retirement, with reduced benefits. If the boomers don’t like it, that’s tough. Most of those to whom they should complain, such as President Franklin D. Roosevelt and the members of Congress who made funding and benefit decisions in the 1960s and 1970s, are dead.

A democracy cannot easily handle any issue if successful resolution creates many economic losers and few winners. Just look at the strikers in 2006 and 2007 protesting changes in the government pension schemes in France and elsewhere in Europe. Those governments promised more than their economies could deliver, in part because their welfare taxes hamstring economic performance.

For their whole lives, baby boomers have been the 400-pound canaries of American society. The children born between 1946 and 1964 have been the birds who sit anywhere they want, whose whims rule the nation. When they were children, the country moved to the suburbs and forced municipalities to build thousands of new schools. The government built the interstate highway system, which let Mom and Dad take them on a new kind of vacation. When they were teenagers, the country went youth-crazy and idolized idealistic college students. The government provided a new system of college loans and subsidized the construction of college facilities. When they were young adults, the country changed its banking system to provide credit cards and mortgages so that they could go deeply into debt to have it all right then and there. The government changed the bankruptcy laws and eventually taxed everybody to bail out the thousands of lenders who accommodated profligate boomers.

When they reached middle age, Wall Street rebuilt itself to provide mutual funds and brokerage accounts to help them pay off debts and build some wealth. The government created new tax-advantaged retirement accounts and enhanced the attractiveness of old ones.

What other generation has had its music playing on the radio for their whole lives? There were no big-band oldies stations when the boomers were kids, but every city now has two or three oldies stations playing the boomers’ favorites.

No other generation enjoyed a 17-year bull market, marred only by one big recession and one little one. Their parents weathered three recessions during the Eisenhower administration alone. Sure, it’s coincidence that microchip technology got started when the boomers were teens and it was just good luck for everybody that shrinking transistors made computing and communications ever more powerful, as if on a schedule. But it’s not coincidence that the national economy struggled when the boomers were young and inexperienced, and it then took off as the boomers hit their productive stride.

Boomers are frequently condemned, even by their own pundits, as spoiled, self-absorbed, and greedy. Some say they were nursed on demand feeding according to the theories of Dr. Spock, and they never got over it. But with all their annoying flaws, boomers in their vast numbers are the best thing that ever happened to the American economy. The demand of 77 million credit card–wielding consumers, many of them well educated to demand the best, has driven producers all over the world to do their best on price and performance. And the engineers, scientists, doctors, and managers turned out by those expanded schools and colleges have provided the means to design and supply better products and services valued around the world.

That’s a trend that should continue for as much as two more decades. But it’s equally true that boomers will impose at least one more major shift on the American economy, and this one not for the better. As they retire, boomers will convert themselves from producers to pure consumers. A huge percentage of U.S. cash flow will be devoted to paying their Social Security and their Medicare.

How this will be done has never been clear. Without changes in the programs, Social Security and Medicare will shoulder aside most other nondefense government spending by the 2030s or impose huge tax increases on younger generations of working people.

But it has always seemed clear that this would be done, somehow. The boomers are too numerous to mess with, and they have always gotten their way.

We have also heard that boomers pose another financial threat, to themselves and other investors. Private retirement savings, though for the most part fully funded, are funded in securities markets, and some analysts have warned that as boomers tap pensions and investments to finance consumption in retirement, they will drain capital from the markets and cause a Wall Street crash in 2020, or thereabouts.

It seems logical, even just, and certainly a bit ironic. If boomers’ saving and investing have driven the market up tenfold from the base of 1982, and even if that goes on smoothly for many more years, won’t boomers’ spending down their investments ultimately tank the market?

No.

Sure, markets will fluctuate. Corrections and probably one or two meltdowns will occur before we get to 2020, and probably more thereafter. And the U.S. government has so much power to affect markets and the economy that it’s always possible that some future statesman will lead us into another Great Depression. But the flow and ebb of boomer capital will not cause the crash of 2020 or any other year.

This tide will move very slowly. Even the most speculative boomers will become more cautious as they approach retirement age. They will gradually shift their new investments toward bonds and stocks that pay dividends. In retirement, they will consume dividends and coupon payments rather than reinvest them, but this will not change the flow of funds into the market much. Accommodating this trend, companies themselves will also become more cautious as they age. A company that was a successful speculation in the nineties reached comfortable prosperity in the aughts and gradually will reflect that prosperity in dividends paid in the teens.

The key word is gradually. No boomers with sense or a financial adviser will cash in all their growth stocks on their 65th birthday. The typical boomers will sell securities only as needed, mindful of the tax consequences. The capital-gains tax will hike the price of disinvestment, and the regular income tax will take a major bite out of funds withdrawn from individual retirement accounts (IRAs), 401(k) plans, and other tax-deferred retirement vehicles.

Even if demography is destiny, and even if boomers want to sell in a mad rush, buyers will exist—foreign buyers, putting newly earned wealth to work in the safest markets in the world. As long as the U.S. government does not do anything to spoil the national economic reputation, boomers in millions will be able to sell to foreign investors in even greater millions.

Perhaps more interesting to American trend-spotters, lots of American investors will be buying, too. The overlooked demographic feature of twenty-first-century America is this: The baby boomers recently ceased to be the most numerous generation in U.S. history.

The aging of America has been a widely expected trend, but the twenty-first century may not be ruled by graying boomers after all. The boomers must make way for Generations X and Y, otherwise known as the birth dearth and the baby rebound.

Generation X followed the baby boom, and its spokespeople were feeling lost and unloved in the early nineties when they named the generation. We don’t know what Y stands for—neither do they as yet—we just know it follows X.

Boomers had fewer children, but they also delayed having families, so lots of their kids missed Generation X and are concentrated in the cohorts born after 1980. Joining them in Generation Y are the children of immigrants who came in the large waves of migrants—legal and illegal—arriving here since 1975.

The result is that there are roughly 77 million boomers, born between 1947 and 1964; 60 million Gen Xers, born between 1965 and 1980; and 80 million members of Generation Y, born between 1980 and 1995. (The next generation is still too young to have its own nickname. Generation Z is obvious but not foreordained.)

If demographics is destiny, then the United States could have a different destiny from the one we have expected. Perhaps the baby boomers will not be permitted to tax Generations X and Y into poverty or bind the government to the bidding of AARP and its allied groups of lobbyists for greedy geezers.

The less-numerous postbaby-boom generations will inherit financial rubble if the Social Security and Medicare systems fall apart on schedule, sometime between 2030 and 2060. But at least the better-off people of the older generation could do something remarkably practical to help their younger relations get ready for the Social Security crisis.

Current law allows parents and grandparents to make tax-free gifts of up to $10,000 a year to children. As soon as the kids start earning money, they can open tax-deferred IRAs. Oldsters can give the youngsters money—$2,000 a year, let’s say, to leave room for the kids to put some of their own money in—to fund the IRAs. The kids can’t pull the money out without a tax penalty. The reason early investment is so important is that money invested at 10 percent doubles every 7.5 years if it isn’t taxed. So the earlier somebody starts a tax-deferred retirement savings plan, the more doublings will take place.

If your grandchild started retirement saving at age 20, the $2,000 put away in the first year would become $256,000 at age 70 if it earns an average 10 percent a year (a generous return, no doubt). But $2,000 put away by scrimping at age 27 would become only $128,000 at age 70. And $2,000 put away at age 62 would be only $4,000 at age 70.

Almost nobody is wise enough and prudent enough to start saving for retirement out of earnings from a paper route or an after-school job. Wisdom and prudence come with long experience. The IRA gift is a way for older people to share their wisdom and prudence with the young before it’s too late.

The federal government could make it easier by allowing IRA contributions for any living person, regardless of age or income. Another 20 years of deposits and another 20 years of compounding would make retirement savings that much more powerful. If the government also made a donation itself on behalf of each of its youngest citizens, IRAs could go much farther in replacing the unsteady Social Security system.

Social Security could be converted to something that works more like a private retirement plan. Genuine reform would reduce guaranteed benefits and make up the difference with a forced savings plan, in which participants would keep ownership and investment control of their retirement accounts. The government would select and regulate a variety of investment vehicles; the participants would allocate their assets among them.

Unfortunately, the current system was created and is defended by those who stress the “social” aspect and ignore financial security. They believe in making everyone secure without reference to their effort or savings. They reject the idea of giving participants power to make investment choices, fearing that too many would make bad choices.

A capitalist Social Security system should place its assets in private markets. Even if stocks don’t continue to produce greater returns than Treasuries, Social Security funds won’t be used merely to finance the government deficit.

But many Americans see danger in individual ownership of retirement assets. Some are simply afraid of the stock market and the bond market, where invisible and impersonal economic forces rule. Others fear political pressure to open tax-sheltered retirement savings to other, more immediate uses, such as down payments on homes, college tuition bills, medical expenses, or covering expenses during a period of unemployment. In other words, they fear people making their own choices about what to do with their own money. That’s nothing to fear—it’s something to welcome.

Saving for retirement is no more sacred than saving for any other purpose. Savings is money, and money is fungible, which means that if you don’t use it here, you can use it there: People with hefty retirement accounts do not fear putting a medical bill on a credit card or college tuition on a second mortgage. Lenders look at their entire net worth and won’t turn away business just because much of their wealth is retirement savings.

The key is making savings a foundation of society by making it an individual responsibility.