In Part I of our “Why Do We Own Stocks” series we reviewed the first loans, government bonds, and the first publicly traded company. We broke those three into two categories with loans and bonds representing Lenders and stock ownership representing, well, Owners. The difference between the two is the upside for Lenders is constrained to principal and interest (if held to maturity) while Owners receive earnings over the lifetime of the company and hopefully appreciation if they sell the stock.

The next piece in our puzzle is the incredible increase in life expectancy over the past hundred years and the Industrial Revolution. For most of human history, life was not par excellence. If you survived childhood, you could expect to live thirty to fifty years before you returned to the earth. Retirement wasn’t a concept for most people; you worked until you died. If you were in a settled society and lived long enough to where you couldn’t physically work, then maybe your children would take up the family farm and support you. If you lived in a nomadic society then tough luck. If you couldn’t keep up with the herd, the herd moved on. I was reading about the Lewis and Clark Expedition in Undaunted Courage and Meriwether Lewis wrote about the elder care of the Native Americans living on the Great Plains. When the elderly couldn’t keep up, they were given a meal, some water, and then left behind*.

Then, coinciding with the Industrial Revolution, life expectancy began to rise. Larger shares of the population reached the age where you’re still alive but not terribly useful in an economic sense. The problem was that these workers didn’t have farms with porches and rocking chairs to drink sweet tea from. Europe and North America were rapidly expanding their manufacturing and eventually service economies. There was no asset for these workers to fall back on after they were too old to work the assembly line. New tools would need to be created to serve this vulnerable population.

The Pension Plan

Pensions or defined benefit plans are sponsored by governments and companies to provide former employees with guaranteed income in retirement. The amount of the pension is usually tied to some formula that may look like the 2.5% of the average of the employee’s income for their last three years of employment, multiplied by the number of years they worked. Let’s say John averaged $70,000 in income his last three years and worked at the company for 20. John’s annual pension income would be $35,000 ($70,000 x 2.5% x 20 years).

By now you might be wondering why the title picture of this post is a Roman Legion. Though pensions had been implemented spontaneously by victorious parties after ancient military campaigns, the Roman Empire was the first to institutionalize the concept by giving legionnaires a pension after 20 years of military service. The problem the Romans were trying to solve was a little different from ours though. They were trying to keep retired legionnaires from returning to their soldierly profession. During the Late Republic period, retired legionnaires in need of work had a habit of supporting coups and rebellions. Rather than fight these experienced and able-bodied veterans, a pension was created so these potential rabble rousers could live peacefully without working for a paycheck or Roman denarii.

Some 1,800 years later, pensions would continue their military tradition by being provided to American Revolution and Civil War veterans. Eventually the first private pension plans arrived with the American Express Company leading the way in 1875. Railroad companies would follow, requiring 30 years of service to qualify for a pension with a mandatory retirement age of 70. This had the benefit of encouraging loyalty to the company since benefits would go away if you left and allowed the offloading of older and less physically productive workers in a humane fashion. Public and private pensions would then continue to grow in popularity in the United States up until the latter half of the 20th Century. On the public side, Social Security was introduced in 1935, while private pensions were encouraged with tax benefits such as firm contributions being tax deductible and income earned in pension trusts being excluded from taxation.

Then something happened. This wasn’t a new problem since it had occurred throughout human history, but companies began to develop the nasty habit of underfunding their pension plans. This meant they didn’t have enough cash/liquid securities, inflows from current earnings, or both, to pay their former employees. It usually wasn’t intentional. Forecasting spending needs, returns on investment, and contribution rates while trying to run a business with existing employees, generating tolerable earnings, and investing in R&D, is a tough challenge. Except for negotiated bankruptcy proceedings, private companies can’t reduce their obligations by fiat like a Roman Emperor and tell legionnaires their contract has been extended a few years or act like a bloated municipality and tell retired teachers to pound sand. Naturally the federal government got involved to regulate the solvency of private pension plans with the Employment Retirement Income Security Act (ERISA) of 1974. After a while a few smart executives asked, “Why would I want to be responsible for this ongoing liability?”

Rise of the 401(k)

The same ERISA of 1974 that created solvency rules also introduced a new retirement plan: the Individual Retirement Account (IRA). IRAs were created to allow employees without access to a pension to save for retirement. They operated then as they do now by allowing tax deductible contributions (presently $6,000 or up to $7,000 if you are 50 or older). The challenge for these individuals was they would now have to invest their own accounts and map out a retirement plan while dealing with the same uncertainty the pension plan managers dealt with.

This idea would expand in 1978 with the implementation of the 401(k) plan after Section 401(k) of the Revenue Act of 1978 went into effect. 401(k)s are tax advantaged which is a term for economic incentives that reduce, defer, or eliminate tax obligations. In the case of the traditional 401(k), contributions reduce your present taxable income with the expectation you’ll pay taxes in the future through required minimum distributions. Let’s look at an example:

John’s (from earlier) pension has magically disappeared, and he now has a 401(k) plan. John still makes $70,000 a year but he has decided to contribute $5,000 a year to his 401(k). John’s employer matches with $1,000. John has his present taxable income reduced to $65,000 and John’s employer gets to deduct their $1,000 contribution from their taxes.

The big change is that the employer is no longer responsible for guaranteeing a particular cash flow in retirement for John. John is responsible for contributing enough money to his accounts and selecting or building a portfolio that will reach his retirement goals.

In Part III of Why We Own Stocks, we’ll put all these puzzle pieces together. We’ll examine how portfolios are built, how their allocation shifts over time, and the desirable contribution amounts to secure retirement.

As an aside, I would like to briefly bring up the title of this post. It was initially titled “Outliving Our Usefulness” since most people can’t perform much physical labor after 70, but upon reflection I decided to change it to “Outliving Our Physical Usefulness.” I’ve grown soft in my old age and believe value is not always tied to economic productivity and how much you can deadlift. Even if someone can’t work, they can provide immeasurable value as a role model, family elder, or community member.

Author’s Note: I’m not going to take the time to fact check Meriwether Lewis since I’ve read similar accounts of nomadic societies in Europe and Asia. But who knows, it could just be settled society propaganda against the pesky nomads who had a habit of wrecking empires until the invention of gun powder.