Hard Landings

A White Paper on the Financial Markets Impact of Population Aging

January 16, 2001

By Robert Stowe England Director of Research of the Global Aging Initiative Center for Strategic and International Studies Washington, D.C.

Executive Summary and Findings

It will almost be like the Mississippi River will change the direction its waters flow to run north instead of south. Population aging in the coming half century will first push up cash flows into pension plans for the next decade or so. And, then the flow will switch directions and cash will flow out of pension plans, eventually requiring them to sell assets by the mid-2020s. Most market observers expect that these flows will tend to drive up equity values over the next 10 years and then eventually drive them down decades that follow. The U.S., which in 1999 had 59% of the worlds pension assets, will be the key player in the worlds pension cash flows. Beginning in 2024, after the majority of the baby boom generation in the U.S. has retired, traditional defined benefit pension plans may have to begin to sell off assets to pay current benefits to retirees, according to a 1994 study.1 Pension plan dissaving in the U.S. could reach 1.5% of payroll by 2040 and 4.0% by 2065. A 2000 study2 of the worlds four largest funded pension systems by Merrill Lynch in London found that cash flows will turn negative in those pension plans after 2025. These assets are contained in only four countries: the U.S., the United Kingdom, Japan and the Netherlands. They represented 86% of the worlds total pension assets in 1999 ($11.1 trillion out of $13 trillion total global pension assets.) In the U.K. pension funds net cash flows could fall from a positive 2% of Gross Domestic Product in 2010 to a minus 1% of GDP by 2035. In Japan, pension funds net cash flows are expected to fall from the current positive 0.50% of GDP to a minus 1% of GDP by 2050.

A number of other developments could also put downward pressure on equities. Pension plans will switch more assets from equities to fixed-income investments. They will do this to better match their liabilities to the risk of paying benefits for more and more retirees. This will increase the number and volume of sellers of equities. Further, the consequent rise in demand for fixed-income investments could drive down the returns on bonds.

Schieber, Sylvester J. and John B. Shoven (1994). The Consequences of Population Aging on Private Pension Fund Saving and Asset Markets. National Bureau of Economic Research, Working Paper No. 4665. Cambridge: National Bureau of Economic Research. 2 Study by Mantel, Jan (2000), Demographics and the Funded Pension System. London: Merrill Lynch & Co. Global Securities Research and Economics Group.

3 Rising government debt also poses dangers to financial markets. As developed nations borrow to pay benefits in pay-as-you-go pension systems in the developed countries, it may drive up interest rates around the world and even crowd out investment in the real economy. Indeed, steep rises in debt in a single major country can raise real interest rates around the globe, according to an IMF study.3 Absent reforms that either cut benefits or raise taxes, debt levels could rise to 200% of GDP in some European countries and Japan. These are clearly crisis levels and nations will need to work diligently to avoid this outcome. Population aging is expected to lead to a slower and more frail global economy. In the years between 2025 and 2050, Europes potential growth rate is expected to fall to only 0.5%, Japans to 0.6%, and the U.S. to 1.5%.4 Sluggish economic growth will likely reduce return on investment for many sectors of the economy. Lower growth potential will also dampen equity prices.

The outlook for financial markets points to the need for reforms in nations around the globe. There is some potential relief for global equity markets from the trend toward establishing funded pension schemes, such as those in Australia, Chile, Mexico, Poland and Hungary. If more such plans are adopted, it will not only help deepen capital markets in those nations, but provide future buyers for some of the equities being sold by pension plans in developed countries. Nations that adopt funded systems need also to adopt prudent man rules that require the assets be invested in the sole interest of the plan participant. This, in turn, would require the removal of some of the onerous restrictions on foreign investments. Equity markets may actually find more likely relief from the expansion of employer-sponsored defined benefit system in the U.S., U.K. Japan, Germany and the Netherlands, as well as the introduction of employer-sponsored plans in Italy, France and Spain, as well as from the partial privatization of Social Security in the U.S. and the introduction of supplementary pensions in Germany. Similarly, defined contribution schemes, such as the 401(k) plans in the U.S., could provide new demand for equities if they are more widely adopted around the world. Reforms will also be needed to prevent debt levels from reaching crisis levels. These include reforms that reduce benefit levels or raise revenues, as well as delaying retirement. Reforms that increase labor market participation of women and all workers 50 and over will help.

Ford, Robert and Douglas Laxton (1999). World Public Debt and Real Interest Rates, Oxford Review of Economic Policy, Vo. 15, No. 12, pp. 77-94. 4 Turner, Dave, Claudio Giorno, Alain DeSerres, Ann Vourch and Peter Richardson (1996), The Macroeconomic Implications of Ageing in a Global Context. Economics Department Working Paper No. 193. Paris: Organization for Economic Cooperation and Development.

Introduction Demography is the new fault line in global financial markets. Over the next 50 years the portion of the population over 65 is expected to double in industrial nations even as birth rates are expected to remain low or even fall. This, in turn, will put intense pressure on government deficits as governments try to pay for senior benefits without substantial tax hikes. The slow-moving demographic shock will also slow down economic growth, drive down saving rates and lead to increasing capital flows to developing nations, wide swings in exchanges rates and other market effects. The question for policy makers looking at the potential fallout is to gauge to what extent the effect on financial markets will be slow and deliberate, and therefore manageable. And, to what extent, there may be sudden global financial market meltdowns with possibly negative economic feedback. The process at work is not all that dissimilar to the pressure that slowly builds up below the surface of the earth. Tectonic plates move slowly along a fault line for decades with no perceptible change on the surface. Some fault lines may yield only rare tremors and no major catastrophes. Others, however, can lead periodically to major earthquakes. While its too early to know if the fault line of global population aging is going to be merely worrisome or potentially dangerous, its easier to paint the broad strokes of how demographic change will affect the world. Except for the potential impact of wars, disease pandemics and mass migrations, the broad contours of future population structures can be foreseen with a fair degree of certainty. Thats because most of what we need to know to fashion a rough model of the future we already know. Most importantly, we already know the size of various age cohorts. While demographers do not know the precise course of future changes in longevity and fertility, which could alter the course of demography, they have a pretty good handle on where things are headed. We know that the population of industrial nations in the future will contain an increasingly larger share of elderly people and a smaller share of people of working age to support them through pay-as-you-go Social Security and publicly financed health care benefits. Lower birthrates, longer lives and the retirement of the baby boom generation all will contribute to a rather sudden arrival of an aging population unprecedented in its size beginning during the next decade and reaching critical mass by 2020. One can see dramatic changes by looking at official projections for key industrial nations. The portion of the population over 65 in Japan will increase from 17% today to 32% in 2050.5 In the U.S. the over-65 population will rise from 13% of the total today to 22%. In Italy, it will rise from 18% to 35%. In Germany, it will rise from 16% to 29%.

United Nations (1999). World Population Prospects: The 1998 Revision. New York, United Nations Secretariats Population Division.

5 The populations of developing countries in Asia, Southeast Asia and Latin America will follow the same pattern of population aging, with only a delay of a decade or two behind the industrial nations. Only the populations of South Asia, the Middle East, and Africa are expected to sustain high birth rates that will keep their populations relatively young. Here, too, people will be living longer and societies will age, but at a much slower pace that the rest of the world. The strain of the coming demographic shock could very well lead to the collapse of some publicly-funded, pay-as-you go pension systems and health care provision may be sharply curtailed. (See a companion paper6 for a discussion of the fiscal impact of population aging.) Some nations will run up huge levels of debt that could prove destabilizing. Aging will also adversely impact the global economy. Aging industrial nations will see a decline in the pace of economic growth and a slower improvement in living standards. Growth rates could fall to an average of a paltry 0.5% a year in the European Union in the years between 2025 and 2050, according to a major study7 of the macroeconomic impact of aging by the Organization for Economic and Cooperation and Development, a research organization that represents 21-member nations, including the U.S., Germany, the United Kingdom, France, Italy and Japan. This growth rate is only one-fifth the average growth rate between 1990 and 1999, according to OECD data.8 The pool of total saving in the world is also expected to decline, putting pressure on interest rates and increasing the cost of the debt burden in highly indebted countries. Innovation and productivity are expected to decline. (See a companion paper9 for a discussion of the macroeconomic impact of population aging.) Capital flow patterns will also be significantly altered over time as money flows out of aging nations into younger nations and industrial nations first build up net foreign reserves and then spend them down. The varying pace of aging among the very largest economies will also affect their capital flows with slower aging countries exporting less capital than fast-aging countries. Nations will see very wide swings over time in the net foreign asset positions. As a portion of the Gross Domestic Product, net foreign assets may approach levels not seen since before World War I, according to the OECD.10
6

England, Robert Stowe (2001a). The Fiscal Challenge of an Aging Industrial World. Forthcoming white paper of the Global Aging Initiative of the Center for Strategic and International Studies, Washington, D.C., January. 7 Turner, Dave, Claudio Giorno, Alain DeSerres, Ann Vourch and Peter Richardson (1996), The Macroeconomic Implications of Ageing in a Global Context. Economics Department Working Paper No. 193. Paris: Organization for Economic Cooperation and Development. 8 Organization for Cooperation and Development (1999). OECD Economic Outlook, No. 66, December 1999. Paris: OECD, Annex Table 1, p. 195. Annual average real Gross Domestic Product rates for European Union for years from 1990 to 1999 are, in order, 3.0, 1.8, 1.2 0.4, 2.7, 2.4 1.6, 2.6, 2.7, 2.1 (estimate for 1999). Thats an average rate for the decade of 1.99%. 9 England, Robert Stowe (January 2001b), A New Era of Economic Frailty? Companion White Paper of the Global Aging Initiative of the Center for Strategic and International Studies, Washington, D.C., January. 10 Turner et al.

6 With so much money flowing into developing countries, the global economy and financial markets may be more or less periodically susceptible to the kind of meltdown that occurred in 1998 -- when Russia defaulted on its bonds -- and markets and securities everywhere collapsed, with especial vigor in Russia and some East and Southeast Asian countries plus Brazil. Beginning in August of that year there was a massive flight to safe U.S. Treasury bonds. U.S. banks had to move quickly to rescue a prominent U.S. hedge fund, Long Term Capital Management. A run-up in debt also poses dangers to global financial markets and the global economy. Japan currently is the lead worry in this category, as its debt has steadily climbed over the past decade as it has borrowed to spend heavily on stimulus packages to spur on its moribund economy. If Japan Government Bonds, for example, were to suffer a long slide in value, driving up interest rates in the process, it would push Japan into a debt-trap. This, in turn, would cause a prolonged recession in East Asia and weaken growth in the U.S. and Europe. In Europe, rising debt levels in some countries, such as Italy, could put pressure on the euro to raise interest rates, thereby pushing down growth in the euro-zone. Population aging may also lead to a run-up in the value of equities over the next decade, as baby boomers save for retirement and then a long decline (and perhaps a market collapse) in the value of those equities unless new investors from the developing world or new classes of retirement savers in the developed world step in and purchase those equities in sufficient quantity to keep up their value. Some economists, however, have doubts about how serious the equity decline might be and predict instead a long stall in values. Researchers also suggest that bonds, too, may see their coupon rates decline as demand overpowers supply when retiring baby boomers convert risky equities to riskfree bonds. Some economists predict housing prices will also to decline as retirees flood markets with houses and there are fewer younger people to buy them.

World Markets May See an Equity Boom in the Next 10 Years Before the surge in the number of elderly potentially puts a drain on equity markets, there is going to be a boom in these markets. There are two important reasons this is happening. First, the baby boomers are now and will continue to be in the prime saving years throughout this decade. In the U.S. the first year baby boomers born in 1946 turn 65 in 2011 and the last year baby boomers born in 1964 turn 65 in 2029 (although by then the official retirement age for full Social Security benefits will actually be 67 so it might be more accurate to put the retirement of the last baby boomers in 2031). So the baby boomers will have a maximum positive effect on equity markets in the next 10 years. Sometime after that the rising number of baby boomer retirees will begin to take some of the drive out of the equity boom.

7 U.S. retirees are expected to call on their saving to support them in retirement, either drawing down private savings in 401(k) plans or draining resources from defined benefit plans. While the impact may be small at first and overwhelmed by new saving by younger baby boomers, by the time half the baby boomers have retired in 2020, there may be downward pressure on equities. A rising trend toward pre-funding retirement benefits around the globe is another factor driving up total investment in equities. More and more nations are adopting some form of pre-funding, either for their Social Security system, or as a supplementary retirement saving scheme. To the extent that this flow of funds is new money going into capital markets, it will tend to drive an equity boom. In a number of countries the sums being pumped into local equity markets by new funded retirement schemes is quite substantial for the size of the local economy. In Australia, there is a mandatory contribution into a retirement plan through payroll deductions that began in 1992 at 3% of salary11 and is rising gradually to 9% of salary by 2002. The superannuation funds, as they are known in Australia, had Australian $23 billion in 1983. Last year total assets in these funds for 19.6 million accounts reached Australian $415 billion (about U.S. $239 billion based on recent exchange rate of one Australia dollar equal to 59 cents in U.S. currency.) Workers can also contribute additional amounts voluntarily to these superannuation funds and 31% of the contributions in some years have been voluntary.12 Hungary, Poland, Croatia, Kazakhstan and Latvia are former Soviet-dominated countries and republics that have set up fully funded second pillars to their retirement systems. Hungary and Kazakhstan were first to set up systems in 1998. In Hungary 6% of payroll is invested in the funded system, which covers 45% of Hungarys workforce so far. In Kazakhstan, 10% of payroll goes into the funded system and 100% of the workforce is covered, according to Michal Rutkowski, head of the Social Protection Group for the Europe and Central Asia Region at the World Bank. Poland was next in 1999 to add a funded system in which workers save and invest 7.2% of their payroll. About 70% of Polands workforce is participating, according to Rutkowski, who as formerly Director of the Office of Social Security Reform in Poland. Its new funded second pillar for retirement incomes directs 7.2% of payroll into individual accounts. Latvias system gets underway in July 2001 with 2% of payroll dedicated to new funded retirement accounts and 72% of the workforce participating. The former Yugoslav republic of Croatia will added a funded system in January 2002, with a 5% of payroll contribution and 60% to 70% of the workforce participating.Latvias new funded system gets underway in July 2001. Assets in the pension systems in Poland and Hungary have already reached 3% to 4% of GDP, according to Rutkowski, and will rise substantially over the next 20 years.
11 12

The Superannuation Guarantee Charge Act of 1992 set up the mandatory retirement system in Australia. Harris, David O. (1998), Bold Steps: Australia and Other International Examples of Social Security Reform. Heritage Lectures Series, No. 616, May 27. Washington, D.C.: Heritage Foundation.

8 By 2020, Rutkowski estimates, pension assets in the five countries will reach the following levels of GDP: Hungary, 31% of GDP, Poland, 33%; Kazakhstan, 30%, Latvia, 20%, Croatia, 25% to 30%. The grandfather of funded Social Security systems is Chile, which replaced its pay-as-you-go system in 1981 with a system based on fully-funded private retirement accounts. Beginning with only $305.7 million in 1981, Chiles system had $34.2 billion by 1999.13 Largely as a result of the new system, the savings rate in Chile has increased from 10% in the late 1970s to over 25%, according to J. Jacobo Rodrquez.14 The impact of more funded plans in smaller countries may, however, have only a modest impact on the next few decades on global financial markets because they will still remain a relatively small part of the total world pension assets. (They are expected to lead to deeper, stronger home equity markets.) In 1999, for example, total world pension assets stood at $12,977 billion, according to InterSec Research Corp. By 2004, the total will reach $17,539 trillion. The assets of some of the smaller countries will be only a drop in this huge ocean of investments. Table 1. Six Nations Comprise Most of the Worlds Pension Assets 1999 Assets (Billions US$) $ 7,765 1,544 1,365 427 351 345 $11,797 $12,977 90.9% 2004 Assets (Billions US$) $ 9,985 1,979 2,025 582 477 466 $15,514 $17,539 88.5%

Nation United States Japan United Kingdom Netherlands Switzerland Canada Total for Six Nations World Total (All Nations) Six Nations Percent of Total
Source: InterSec Research Corp.

The pension assets of only six countries -- the U.S., Canada, United Kingdom, Japan, the Netherlands and Switzerland -- comprised a stunning 91% all the pension assets in the world in 1999 ($11,797 billion, according to InterSec. By 2004, they will still constitute $15,514 billion or 88% of total assets. See Table I above. To put these numbers into context, the total value of all equities in the world is estimated to be
13

According to a May 1999 press release from Superintendencia de Administradoras de Fondos de Pensiones. 14 Rodrquez, L. Jacobo (1999), Chiles Private Pension System at 18: Its Current State and Future Challenges. Project on Social Security Privatization, Brief No. 17, Washington, D.C. Cato Institute, July 30.

9 $55.373 trillion,15 while the float-adjusted value is $22.704 trillion16 that is, the global universe of equities that are actually traded.

Challenge for Worlds Nations: Develop a Workable Retirement System In fact, worry about the fiscal pressures on pay-as-you-go systems is driving the push to increase the amount of retirement financed by workers while they are working and, thus, to rely less on generational transfers. This growth in equities will, in turn, boost global economic growth ahead of the slowdown that is expected sometime after 2020. There is a window of opportunity for industrial nations to soften the blow of population aging if there is an increase in saving over the next two decades. David Hale, global chief economist at the Zurich Insurance Group, Chicago, describes it this way: The great challenge which every society will have to confront is how to develop effective retirement funding system for the elderly which do not undermine private savings and investment through crippling levels of taxation on the young.17 What are the implications of a huge surge in retirement savings around the world? It potentially gives you a huge institutional part of pension savings instead of people just saving individually. Whether this will raise the saving rate we dont know yet, says Hale. The evidence from Chile is that it will raise savings rates, he adds. It is also an important force for creating capital markets in the developing world. It will also create high rates of capitalization in markets of developed countries, such as Germany and France, which lag behind other industrial countries in capitalization levels of their markets because they do not have extensive funded pension plans. There will be important economic fallout from this surge in retirement saving, according to Hale. Anything that increases savings is a positive for economic growth. There are more resources to create investment and diversify asset allocation. This coming build-up, however, creates a dilemma for those saving for retirement. Will the value of those equities hold up as the impact of population aging begins to take hold? In 20 years, one of the challenges will be who will buy those equities? says Hale. Obviously, it will be those countries with current account surpluses who will be in a position to buy equities, he says. At first glance, this presents a challenge for the stock markets of the old industrial countries. Theres a risk of an asset value decline, he says. What can be done to avoid this risk? Theres no single thing to do unless you make pension funds so well-funded, they wont have to liquidate to pay benefits out to retirees, Hale says. He predicts that most in the U.S. will have to liquidate sometime

15 16

FactSet Research Systems Inc. Salomon Smith Barney 17 Hale, David (1998). Has Americas Equity Market Boom Just Begun, Or How the Rise of Pension Funds Will Change the Global Economy in the 21st Century. Mimeo.

10 between 2015 and 2020. Thus, increasing pension contributions now to pension plans could help avoid a potential equity meltdown. Other market observers share the view that pensions around the globe will liquidate assets. Will pensions liquidate assets at some point? The answer is probably yes, says Christopher Nowakowski, Managing Director of InterSec Research Corp. of Stamford, Conn., a firm that measures the performance of money managers around the world. He then offers two assessments. If you use a static model, the answer is definitely yes. If, however, you accept a dynamic model, then defined contribution plans are going to grow and take some of the monkey off the back of defined benefit plans, he says.

Pension Fund Cash Flows Will Play a Starring Role in Financial Markets To understand how pension funds may affect financial markets in the coming decades, one has to know a little about the types of pension and retirement plans and how they work. Defined contribution plans are those where the final benefit remains uncertain, but the pace of annual contributions for each employee is defined, as suggested by the name. These plans are always fully-funded and employees have separate accounts which they own and can begin to spend without tax penalty after age 59 in the U.S. Contributions are usually tax deductible, but not in all countries, and income often builds up tax-free, again not in all countries. Usually money taken out of these plans is taxed and a penalty is added if the money is taken out before 59 in the U.S. Contributions are made either by the worker or employer or both and sometimes worker contributions are match by the employer, as in the 401(k) plans in the U.S., which are being imitated around the world. The traditional pension plan is a defined benefit plan. In these plans the final benefit is defined and there are no individual accounts. Workers accrue a benefit based on the number of years of credited service, which is then usually multiplied by an annual accrual rate. For example, a worker might get a final benefit equal to 2% of his final average salary times 20 years of service or 40% of his final average salary. Sponsors of defined benefit plans, often set up in conjunction with negotiations with organized labor, contribute to the plan and either manage it or have professional managers oversee the assets. When workers retire they received the regular retirement pay from the pension plan. There are variations on this basic framework in various countries. The employersponsored pension plan is not the norm, but may increasingly become so. From the view of many financial market observers, countries around the world will increasingly take steps to create defined contribution plans, either employersponsored or as part of a privatized or partially privatized Social Security system overseen by the government. Depending on how quickly these plans are developed and continue to grow after 2015 or 2020, they may be able to offset the expected drain on defined benefit plans, as well as older defined contribution plans. For example, if a worker has spent most of his career at companies that only offered 401(k)-type plans,

11 when he retires he will have no retirement income without drawing down some of the assets in the plan, either for consumption or to convert into an annuity. Efforts to set up supplementary defined contribution plans have been stymied in some of the larger countries in Europe, particularly Germany, France and Italy. (See companion paper18 on demographics for a discussion of Italy.) Yet, the Social Security benefit is being reduced gradually in Italy over the next three decades. It will likely have to be reduced in Germany and France, as the cost of the more generous European pension systems is unsustainable.

Global Integration in Developed Countries Drives Demand for More Equities In a 1997 report, Goldman Sachs published a report19 on The Global Pension Time Bomb and the author Mark Griffin predicts that the equities markets of the world will boom as more and more people save for their own retirement through governmentsanctioned savings vehicles. The level of cross-border equity holdings will also increase among the 15 mostly developed countries studied by Goldman Sachs.20 Within these countries Griffin found a correlation between rising levels of trade and rising levels of foreign equity holdings. Between 1991 and 1995, overall imports in the 15 countries rose from 14% of Gross Domestic Product to 18.8% of GDP. At the same time the overall ratio of international equities to total equities rose even faster, almost doubling from 12.1% of GDP to 21.3% of GDP.21 Increasing integration of the 15 nations into the global economy was also associated with a slightly higher level of foreign bond holdings within the countries. Griffin examined bond portfolios in the 15 countries and found that holdings of foreign bonds rose only marginally between 1991 and 1995, from 6.4% of to 7.3% of total bonds.22 Why the divergence in trends between equities and bonds? Griffin offered this possible explanation: A significant portion of pension funds liabilities are fixed, non-inflationsensitive cash flows that can be matched with domestic (but not international) bonds. The remainder of the liability is much harder to define, but contains a positive link to domestic wage inflation. If pension funds associate equity investment with this second portion of their liability, this may help to explain a focus on imported inflation. Thus, the need for international diversification would be present in equities to a much larger degree than in bonds. This explanation
18 19

England, (2001a) Griffin, Mark (1997). The Global Pension Time Bomb and Its Capital Market Impact. New York: Goldman Sachs Global Research Center, May 28. 20 Countries studied: Australia, Canada, Chile, Denmark, France, Germany, Holland, Ireland, Italy, Japan. South Africa, Sweden, Switzerland, the United Kingdom and the United States. 21 Griffin, p. 13. 22 Griffin, p. 13.

12 would also be supported by the historical trend of increasing diversification within equity portfolios as trade increases, while bond portfolio diversification has been relatively static.23 Because of these trends outlined by Goldman Sachs, the demand for international equities is expected to outstrip the demand for domestic equities. The study projected that pensions would increase their equity holdings in the 15 countries from $7.3 trillion in 1995 to $12 trillion in 2000. Most of this growth, $4.7 trillion, was expected to occur as an increase in the value of existing assets, with the remaining $2.2 trillion to come from new investments. Among these new investments, $1.1 trillion would be international equities with $761 million in new domestic equities. Griffin expects these basic trends to continue beyond 2000. See Table 2. Table 2. Estimated Incremental Demand for Different Pension Fund Asset Classes ($ Billion) 1995 Portfolio Holdings 15 Countries Total: Domestic Equity International Equity Domestic Bonds International Bonds Real Estate & Other Cash
Source: Goldman Sachs, 1997

2000 Projected Assets

2000 Growth of Existing Assets

2000 Net New Investments

2,848 769 2,567 203 624 340

4,573 2,092 3,395 404 1,007 545

3,812 1,029 3,435 272 835 455

761 1,063 (40) 132 172 90

Presumably, the rise of defined benefit pension plans in more and more countries around the world could drive up demand for U.S. equities. The question remains open, as noted earlier, whether that expected demand after 2020 will counter the downward pressure on pension assets from aging populations in developed countries.

How Limits on Pension Contributions in the U.S. May Harm Baby Boomers Worries about a future market meltdown due to demographic changes have occasionally appeared in the public press over the last decade. The New York Times five years ago had this jarring headline in its Sunday paper: The Year is 2010. Do You Know Where Your Bull Is?24 The author, Peter Passell, wrote:
23 24

Griffin, p. 13. Passell, Peter (1996), The Year is 2010. Do You Know Where Your Bull Is? Sunday New York Times, March 10.

13

Nobody is suggesting that Rip Van Investor is going to wake up one day to discover that no one wants to buy his shares of Netscape Communications. But John Shoven, an economist at Stanford [University], does imagine 1970s-like stagnation in stock prices, which would extinguish many a dream of Mediterranean cruises and lazy mornings on the golf course. To protect that dream, Rip may have to save a lot more than he expected. By 1997 there were already a number of studies that predicted a potential drain on equity markets after 2020. One of those studies25 was done in 1994 by Sylvester Schieber and John Shoven. While noting that much of the public policy focus at the time was on the impact of population aging and the retirement of the baby boom generation on Social Security. Yet, the authors suggested, there may be reason for concern on the pension front as well.26 They were particularly concerned that over the prior decade or so concern about budget deficits had led to cutbacks of one provision after another that encouraged employers and individuals to save for retirement. Schieber and Shoven summed up Washingtons changing attitude toward the purpose of pension policy. It may seem odd to worry about the funding of employer-sponsored pension obligations, at least those of private plan sponsors, when the federal government has seemingly established strong funding and disclosure standards to assure that promised benefits would ultimately be delivered. The problem is that there is an inherent neurosis in federal law governing pensions between the provisions aimed at providing retirement income security on the one hand, and limiting the value of preferences accorded pensions in the federal tax code on the other. From the passage of the [Employee Retirement Income Security Act] in 1974 until the early 1980s concerns about benefit security held the upper hand in driving federal policy towards pensions. Since 1982, policies aimed at limiting tax leakages related to employer-sponsored retirement plans have played the dominant role. While a number of tax law changes have had an effect on defined contribution plans since 1982, the effects on defined benefit plans have been considerably more profound. This was especially true of the Omnibus Budget Reconciliation Act of 1987 (OBRA87). OBRA87, as its is known by short-hand, ended the right of employers to fund 100% of their future pension liability for all workers in defined benefit plans and replaced it with a new limit of 150% of benefits, accrued to date. The net effect of this change was to delay the funding of an individuals pension benefit relative to prior law. Furthermore, Schieber and Shoven contended, it was short-sighted, given the coming pressures on defined benefit plans.
25

Schieber, Sylvester J. and John B. Shoven (1994). The Consequences of Population Aging on Private Pension Fund Saving and Asset Markets. National Bureau of Economic Research, Working Paper No. 4665. Cambridge: National Bureau of Economic Research. 26 Schieber and Shoven (1994), p. 6.

14

Schieber and Shoven give an example how the change affects the amount that a employer would have to contribute into a fund each year in order to fund a retirement benefit for a typical worker who begins a job at a firm at the age of 25 earning $25,000 a year. They assume this workers pay increases at the rate of 5.5% a year throughout his career. The pension plan accrues 1.25% a year for 40 years to earn a benefit equal to 50% of his final pay at age 65. The authors assume that the contributions into the plan for this worker as well as all assets in the funds will earn a rate of 8% a year. If the employer can fund 100% of the benefit as the worker earns it, the employer can steadily put in an amount that ranges from 4.2% of pay at age 25 and rises slowly and steadily to 10.4% of pay at age 64. If, however, the employer must limit the assets of the pension plan to no more than 150% of the accrued benefit, the pace of funding is quite different. It allowable annual contribution starts much lower, at 0.9% of salary and rises at first slowly, picking up the pace after the worker is in his mid 40s, reaching a peak of 18.2% when he is 54 and then declining to 11.1% at age 64. The amount of money in the pension plan for the first 20 years of the workers career is much lower under the 150% limit. This is why contributions have to be higher in the second half because there were fewer assets in the plan earning funds needed to pay the final benefit. When OBRA87 was implemented, the oldest baby boomers were 42 years of age while the youngest were 24. What does this mean for this generation? The gross effect of OBRA87 is that it has significantly delayed the funding of the baby boom generations defined benefit retirement promises, Schieber and Shoven conclude.27 OBRA87 was only one of several pieces of legislation in the 1980s and the first half of the 1990s that curtailed the ability of employers to make additional contributions to their defined benefit plans, the authors state. Congress in the last five years has slowly begun to undo some of the damage that was done by OBRA87 and other legislation. During the last Congress, however, the proposal raise the funding limit to 175% of the accrued liability did not escape President Clintons veto pen. Such legislation is likely to fare far better under President George W. Bush, especially since the Congress, too, will be Republican. Even so, pension funds have now missed 14 years of funding. It would be far better now if the original 100% of their future (not accrued only) pension liability. Schieber still views OBRA87 is detrimental to the welfare of baby boomer retirees in spite of the big run-up in equity values that occurred in the second half of 1990. In a recent paper28 by Brown et al (including Schieber), the adverse effect of OBRA87 is tied to an effort by major employers in the U.S. to reduce their pension costs

27 28

Schieber and Shoven (1994), p. 12. Brown, Kyle N., Gordon P. Goodfellow, Tomeka Hill, Richard R. Joss, Richard Luss, Lex Miller and Sylvester J. Schieber (2000). The Unfolding of a Predictable Surprise. Washington, D.C.: Watson Wyatt Worldwide. This report is available at the following website: http://www.watsonwyatt.com.

15 by converting their traditional defined benefit plans to a new form of hybrid called cash balance plans. Cash balance plans in the U.S. have some of the characteristics of both defined benefit and defined contribution plans, although it is technically a defined benefit plan. Workers accrue a benefit under a hypothetical account in a pooled group of pension assets. Workers are credited each year with a contribution and this amount builds up year by year as a cash balance. It also earns an interest rate usually in the range of 5% to 7% (which is a fairly modest return when compared to most retirement portfolios). These benefits can be portable and rolled over to another similar plan, a 401(k) or a tax-favored individual saving vehicle, such as an Individual Retirement Account. Employers can invest the assets in the pool as they see fit consistent with fiduciary standards, and the surplus earnings can be claimed by the employer under certain circumstances. Under most conversions of a traditional plan to a cash balance plan, the final benefit for retirees is lower than under the old plan. However, younger workers can accrue a larger benefit earlier in their working career under a cash balance plan, which is also portable, as noted. For these reason, employees under 35 often favor the cash balance plan while older workers, who stand to see their benefit reduced, often oppose such conversions. A number of large U.S. firms which converted to cash balance plans have offered their currently employed older workers the option of remaining with the old plan.

Accounting and Funding Rules Have Worked to Reduce Pension Benefit Levels After OBRA87 was passed by Congress in 1987, it began to work immediately to the disadvantage for baby boomer retirees, according to Brown et al. The authors state the following: Under the new rules, many employers that had been contributing to their plans under alternative funding method suddenly found that their plans now held excess funding. This basically meant that further contributions had to wait until accruing liabilities caught up with the assets put into the plan under the earlier rules. Many of these employers thus enjoyed contribution holidays, where their plans required no funding at all for some years. But as these plans have matured, their funding status has fallen, and many have had to resume funding their plans. After a contribution holiday, having to restart contributions has affected some companies attitudes toward their plans, motivating some to modify their plans in order to keep funding requirements low. Brown et al devised a method to assess to what extent funding issues, including OBRA87, influenced the decision to convert to a cash balance plan. They obtained data from federal forms29 reporting on the assets of pension plans and which are filed annually
29

Form 5500 in the U.S. must be filed for all employer-sponsored retirement plans. The data is shared by the Internal Revenue Service and the Department of Labor.

16 by employers. The authors worked with 1996 data (the most recent available when their research was being conducted in late 1999). They looked at data for 4,296 plans with at least 100 active participants and at least $10 million in assets, and which based their benefit formulas on an employees salary. Brown et al compared the funding levels hybrid and traditional plans and found that slightly higher number of employers with hybrid plans were making no contribution, when compared to employers with traditional plans. This finding was inconclusive. The authors then looked at the impact of a change in accounting standards for pension plans that was also seen as a possible reason employers wanted to convert to cash balance plans. Financial Accounting Statement 87 (FAS87)30 required employers to show on their income statement a liability for the total future cost of pension fund plan benefits for each worker, reflecting future assumed salary growth until the expected departure of each employee. For a typical 50-year old, FAS87 rules meant that employers might have to calculate a future benefit obligation at retirement age 65 that was twice the accumulated benefit obligation this employee would receive if he was terminated at age 50. Under the old funding rules from the IRS, employers could fund the full future benefit obligation and not the less accrued benefit that would be paid if the worker were terminated. Under the 150% limit of the accrued benefit, employer cannot fully fund its pension liabilities. The gap between the full pension liability and the termination benefit liability grows particularly steep as workers age and approach age 55. And, this gap serves as an incentive to switch from traditional pension plans to cash balance plans, according to Brown et al. In cash balance plans, the benefit accrues at a steady pace, making it easier for employers to at meet the funding requirements of OBRA87 without showing a gap in funding under the accounting rules of FAS87. Brown et al explain the incentive as follows: For plan sponsors, accumulating pension obligations that cannot be funded until later is the equivalent of buying on credit. For employers that are able to handle lots of debt, these unfounded pension obligations will not be a problem. For other employers with a very limited debt capacity, having large unfunded pension obligations is a problem because they limit their ability to borrow funds required to make investments in their operations. We expect these employers to arrange their financial operations so they can fund more of their pension obligations as they accrue.31 Brown et al also undertook an analysis of 78 different plans that converted from a traditional to cash balance plan. They used a synthetic workforce of 10,000 workers to value the plans before and after the shift. The synthetic workforce was taken from a random sample of workers from the pool of 165,000 workers from 15 of Watson Wyatts
30

FAS87, like all official Generally Accepted Accounting Principles, was promulgated by the Financial Accounting Standards Board. 31 Brown et al, p. 17.

17 larger clients. They compared the level of benefits before and after the shift. They found that 56.4% of the plans were able to reduce costs through the shift, 20.5% were cost neutral and 23.1% had higher costs. Overall, the average costs across all plans were reduced by 10.3%. Schieber suggests that the potential drain on pension assets by the baby boom retirement and population aging is so enormous that employers are faced with a stark choice. Its clear employers are going to have to put more money in these plans o than can curtail benefits. I believe that some of the move toward cash balance plans as emanated from long-term effects of OBRA87, Schieber says.

Drain on U.S. Pension Funds May Dampen Financial Markets for Decades Schieber and Shoven plotted the drain out of pension plan assets over a 75-6year period ending in 2069 in their 1994 paper, following the long-term view taken by the Social Security Administration in its annual report on the status of its trust funds. In their model the authors relied on the Social Securitys 75-year projections of the U.S. population and the numbers in the work force each year. They divided the workforce into three separate sectors: the private employment sector, the state employment sector and the federal employment sector. Separate calculations were made for defined benefit and defined contribution plans. For some broad details of the model see the description in the footnote.32

32

Schieber and Shoven also incorporated computations from other government surveys (March 1992 Current Population Survey and the 1991 Survey of Income and Program Participation) to develop age and sex specific participation and vesting in and receipt of benefits from defined benefit plans, including data on the distribution of tenure. They relied on other federal data (Bureau of Economic Analysis in the National Income and Product Accounts) to develop estimates of total wages. They authors used published data and made their own computations from the federal forms filed for pension plans each year that report existing assets, among other things (Form 5500 annual reports filed with the Internal Revenue Service and shared with the Department of Labor ) In addition, they relied on data compiled by the Employee Benefit Research Institutes Quarterly Pension Investment Report to estimate the starting total distribution of assets and contributions between defined benefit and defined contribution plans in public and private plans, as well as the broad asset allocation of investments within those plans. Schieber and Shoven found that equities formed only 36% of defined benefit plan assets, and only 41% of defined contribution plans, somewhat impairing the overall return because the level of assets allocated to equities was too low. They used an average real rate of return for equities of 5.0% (somewhat below the 7% average of the Standard & Poors index between the years 1926 to 1992). One of the reasons for using the lower rate of return for bonds is that the authors expected equities to provide returns lower than the historically high levels seen in the last two decades, Schieber says. They assumed a blended portfolio of government and corporate bonds would earn an average 2% real rate of return. The authors also assumed that workers with a defined contribution plan who terminated prior to retirement would use some portion of the benefit for a purpose other than retirement. (There was an underlying assumption that there would be a 14% turnover of workers between jobs each year.) They assumed there would be 4% inflation per year and that wage growth will average 5.1% a year.

18 With a starting portfolio defined, Schieber and Shoven calculated the annual contributions of employers and employees into the plans.33 Workers were assumed to begin retiring at age 54, with all workers retired by age 80. They looked at the impact on private-sector defined benefit pension plans, the universe of employer-sponsored defined contribution plans, as well as state and local government defined benefit pension plans. However, the bulk of the study, including its key findings, is devoted to cash flows into and out of private sector defined benefit plans. In their simulation Schieber and Shoven found that the real value of total assets in private sector defined benefit plans would peak in 2024 and thereafter decline, with consequent negative effects on U.S. equity values. Even as this occurred, the rising value of defined contribution assets would represent a modest gain in demand for equity assets.

Chart 1. Potential Real Saving of Private Pensions Relative to Total 4Private Payroll for the Years 1996 to 2065 Assuming Current Plan Characteristics and Contribution Rates Persist
0.04 0.03 0.02

Real Saving/Payroll

0.01 0 -0.01 -0.02 -0.03 -0.04 1996 2000 2004 2008 2012 2016 2020 2024 2028 2032 2036 2040 2044 2048 2052 2056 2060 2064

Year

33

Private sector employees were assumed to contribution 2.8% of payroll for all contributions with onethird of this going into defined benefit plans. Employee contributions to private plans were estimated at 1.7% of payroll, with only a tiny portion (2%) of this going to defined benefit plans. Employer contributions to defined contribution plans were estimated a 1.13 times employee contributions.

19 The early effect of the baby boom will be seen as soon as 2006, as many will retire before normal retirement age of 65). In that year the aggregate benefits of defined benefit plans are expected to begin outstrip annual contributions in 2006 and continue at the pace through 2065. In nominal terms, the total assets of the private pension system (including defined contribution plans) would continue to rise until 2052. Pension assets will continue to rise as a ratio of total payroll until around 2013 and 2014, when the ratio reaches 1.362. By 2040 the net real dissaving of pension plans will equal 1.5% of payroll and by 2065 it will reach 4.0%. The important story coming from our analysis is that private pension will gradually cease being the major engine of aggregate saving that they have been for the past twenty years or more, Schieber and Shoven state.34 Different assumptions on investment returns will not necessarily change the outlook for a draw dawn in pension assets after 2024, the authors argue. Schieber and Shoven write: If investment returns exceed our fairly conservative assumptions, then the decline of the saving contribution of pensions will be delayed in time. Still, the demographic structure is such that the decline will by necessity occur. Higher investment returns would result in more saving in the early years and even more dissaving in the later years of our analysis. It is not even correct to think of the dissaving as a negative development. After all, pension assets are accumulated to provide for the resources needed by the elderly in retirement. It is only natural that when we have an extraordinarily large number of retirees, the real assets of the private pension system will shrink and the system will at least temporarily cease being a source of new investment funds for the economy.35 This is not a forecast of doom, the authors insist, but simply a what if experiment.36 If real rates of return are only 5%, employers will have to raise their pension contributions above the 2.8% of payroll in the simulation. Or, alternatively, cut benefits. Schieber and Shoven found long-run outlook for defined contribution plans is more optimistic. Their model shows that assets in defined contribution plans will rise from the then current level of 37% of payroll to 52% in 2000 and 70% by 2010 and then level out at 85% of payroll around 2025. Thus, the defined contribution system might be a modest net source of saving in the economy, even after most baby boomers have retired.

U.S. Pension Assets Play Larger and Large Role in Financial Markets
34 35

Schieber and Shoven (1994), p. 22. Schieber and Shoven (1994), p. 24. 36 Schieber and Shoven (1994), p. 26.

20

The considerable influence of cash flows from U.S. defined benefit pension plans and other world financial markets has remained substantial over the last five years in spite of rapid growth of the defined contribution plan system (along with rising revenues in Independent Retirement Accounts (IRAs), which are individually-owned accounts that can receive rollovers from pension plans and direct contributions by savers. In the third quarter of 2000, for example, outstanding U.S. equities total $19.047 trillion, according data collected to the U.S. Federal Reserve System.37 Of that total, $4.405 trillion was held by defined benefit pension plans -- $2.451 trillion in private pension plans and $1.954 trillion in state and local government retirement plans. Combined, private and government pension plans represented 23% of total outstanding U.S. equities. In 1995, by comparison, total U.S. equities stood at $8.495 trillion, with pension plans holding $2.070 trillion, representing 24% of the total. Increasingly, retirement assets represent more and more of total mutual fund assets a pool of retirement assets above and beyond those found in defined benefit plans, as described in the preceding paragraph. In 1990, for example, $207 billion of the assets (equities, bonds, etc.) held in the mutual fund industry represented were held in defined contribution plans and individual retirement accounts (IRAs). That represented 19% of the total mutual fund industry, according to the Investment Company Institute.38 By 1999, IRAs and defined contribution plans totaled $2.426 trillion and represented 35% of mutual fund assets.

Will There Be a Financial Market Meltdown? Whether rightly or not, the forecasts made by Schieber and Shoven in 1994 were widely noted among pension policy observers and consultants. It became known as the asset meltdown paper, recalls Schieber. The paper, of course, did not predict this outcome but merely postulated it as a possibility. In their discussion of the impact of the draw down of pension assets on capital markets, Schieber and Shoven noted the even though the benefits paid out would be greater than contributions in 2006, the earnings on assets would still be enormous, pushing up the value of the portfolio. In 2006, an estimated $7 trillion in pension assets would earn $450 billion ($170 billion in real terms), according to the authors. Because of these earnings, there would be no reason for pension plans to be net sellers of assets at this point. Indeed, pension plans would not be net sellers of assets until the early part of the 2030s. If there is a downward effect on capital markets, it will affect all long-term assets. What we think may happen is that high real interest rates could depress the prices of stocks, bonds, land, and real estate.39
37

Flow of Funds Accounts for the U.S., 3rd Quarter 2000, Board of Governors of the Federal Reserve System. 38 Investment Company Institute (2000). Mutual Funds and the Retirement Market, Fundamentals, Vol. 9, No. 2, May. Washington, D.C> Investment Company Institute. 39 Schieber and Shoven (1994), p. 25

21

In 1997 Schieber and Shoven did a follow up paper40 to their 1994 study and found a similar effect of population aging on pension funds and assets. In this study the authors elaborate on their view that the rate of return on equities will fall to a real 5% rate return, down from historic trends of 8% a year. This effect will begin around 2010 and last until 2030, reducing equity returns by 45% over what they would have been if historic trends had prevailed. It is probably more reasonable to interpret the implication of the demographic trend in this manner (i.e. a couple of decades of sub par returns) than to predict actual absolute price declines, Schieber and Shoven wrote.41

Chart 2. Employer Contributions and Benefits Paid by Private Pension and Profit-sharing Plans for the Period 1950 - 1994 in 1994 Dollars
Billions of 1994 dollars 200 180 160 140 120 100 80 60 40 20 0 1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

Source: National Income and Product Accounts

Contributions Benefits

Schieber and Shoven also made the case that pension saving has been the chief driver of national saving since around 1980, when both government dissaving began to take off and personal saving rates began to decline. They cite data from the Federal Reserve Boards Flow of Funds Division to assert that since 1980 the growth in real wealth in pension funds has been greater than the growth in real wealth of the country. In
40

Schieber, Sylvester J. and John B. Shoven (1997). The Aging of the Baby Boom Generation: The Impact on Private Pensions, National Saving and Financial Markets. Mimeo 41 Schieber and Shoven (1997), p. 19.

22 this sense all of the saving in the U.S. has been accounted for by pensions42 This statement was made, of course, just before the U.S. budget moved into surplus and before personal saving gradually sank to negative levels. Yet, despite the positive role in saving played by pensions, their contribution may have been declining since the 1980s, according to Schieber and Shoven, further depressing overall saving rates in the U.S. They identify declines in the annual contribution to defined benefit pension plans is a key indicator of this trend. This number has been declining since 1980 for two reasons: returns on existing assets have been rising and companies have been increasingly converting to defined contribution schemes to escape the onerous regulations that govern defined benefit schemes, the authors claim. (See Chart 2 below.) Schiebers views on the findings of the 1994 paper still hold today. I think that unless a number of West European countries back themselves out of promises theyve made to future retirees. And also, unless Japan and the U.S. can do the same thing, theyll all have to go to the debt markets to pay for these promises. When they borrow, they take money out of the capital markets and this will drive up interest rates, says Schieber.

Merrill Lynch London Study Sees Cash Outflow From Pension Plans After 2025 Merrill Lynchs London office recently looked into the potential affect of capital flows out of pension funds for both Europe and the U.S. in a 2000 study43 by Jan Mantel, and found effects that were similar to those found by Schieber and Shoven. The study compared the effect of aging populations on pension fund asset allocation and cash flows in the United States, the United Kingdom, the Netherlands and Japan. Mantel found that demand for investments will be strong for the next five to ten years, but that between 2025 to 2035 the net cash flow into pension funds will become negative and pension funds will have to start selling their assets. The study also found that in the future, pension funds are likely to hold fewer equities and more fixed income products in their portfolios. This will happen because, as the number of retirees increases relative to workers who pay into a pension fund, they are likely to become more conservative in their investment policies. Merrill Lynch predicts that an eventual 10 to 15 percentage points of portfolio holdings will move out of equities in the United Kingdom, the United States, Japan and the Netherlands over the next 50 years. To evaluate the impact of aging on pension funds, Mantel created the Merrill Lynch Funded Pension model. This model shows how changes in rates of return and wage growth can affect the funding needs for pensions. It also gives some indication of

42 43

Schieber and Shoven (1997), p. 4. Mantel, Jan (2000), Demographics and the Funded Pension System. London: Merrill Lynch & Co. Global Securities Research and Economics Group.

23 the changes in net cash in flow and out flow from the funded system as populations age over the coming decades. In each country the model assumes that all pension plans are defined benefit plans. This was done partly because most plans are, in fact, defined benefit plans, and because it is difficult to forecast the cash flows into and out of defined contribution plans. With the defined benefit plan, there is a guaranteed benefit and it is possible to calculate how much funding will be needed to meet that obligation. The four country models also include a fixed percentage of the working age population as enrolled in a defined benefit plan. Also, to simplify the model, for every worker age 25 there are contributions to the fund for 40 years, and it is assumed workers retire at age 65. The model uses average salaries and average pensions for all workers. The model also attempts to model the impact of increasingly longer lives. To do this the population in each country is split into age cohorts. Cohort 1 is segment of the population born between 1895 and 1900. Cohort 2 is born between 1900 and 1905, and so on through Cohort 26, whose members are born between 2020 and 2025.

Chart 3. Pension Fund Assets as % of GDP (1999)

180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Netherlands Switzerland Portugal Sweden Belgium Italy Denmark Ireland Germany Austria France Finland Europe USA Spain Japan UK 2.4% 3.3% 5.1% 6.1% 6.7% 6.8% 13.4% 19.7% 33.4% 37.6% 59.1% 42.7% 45.2% 85.9% 115.1% 106.1% 157.6%

Source: Merrill Lynch & Co. and InterSec Research Corp.

Mantel takes the models of the four countries and devises several possible scenarios to tease out the impact of various influences. The baseline scenario relies on the United Nations 1998 forecasts of population changes. The real long-term rate of return for the investments in the pension fund is 4%. Real wage growth is projected at the same pace as expected productivity gains, or 1.5% per year. The model then calculates the contribution needed to fund the expected pensions for workers in each of the countries over the next 50 years. The calculations are made separately for each 5-year age cohort.

24 The model for each country is adjusted so that it accurately predicts the current assets to GDP, changing amount of the benefit or the number of people in the population covered, for example. For the United Kingdom, the model calculates that if 40% of the working age population is covered by a funded pension, and the final benefit is equal to about 45% of final wages, pension fund assets would equal 92.2% of GDP in 2000, which is close to the actual situation. InterSec, for example, estimates the value of pension assets in the U.K. in 1999 at 106.1% of GDP.44 In the U.S. 41% of the working age population is covered and retirees receive a pension benefit equal to 40% of their wages. These assumption produce pension assets equal to 82.2% of GDP, close to the level reported by InterSec for 1999, or 85.9% of GDP. In Japan, 18% of the population is covered, and retirees receive a retirement benefit equal to 30% of their wages. This yields pension assets equal to 35.8% of GDP, again close to the level InterSec reports for 1999, which is 37.5% of GDP. And, finally, in the Netherlands, the model assumes 50% of the workforce is covered and retirees receive a benefit equal to 50% of their wages. These assumption produce pension assets equal to 112.2% of GDP, again close to the level InterSec reports for 1999, which is 115.1% of GDP. As populations age the funded pensions in each of these four countries begins to see a decline in the level of incoming cash flow anywhere from 2005 to 2010. Sometime after 2025, each begins to experience negative cash flow and, in some cases, the drop is dramatic. In the Netherlands, cash flow goes from just under a positive 2% of GDP in 2010 to cash negative in 2025, then to a level that is lower than a negative 2% of GDP in 2035. The negative impact in the Netherlands is more severe on cash flow than the other countries, mostly because its population is aging faster than the U.K. and the U.S. Also, it has a higher portion of the population covered, so its impact is greater than in Japan, which, while aging fast, has a lower portion of the workforce covered by a pension plan. The effect in the U.S. is more benign, but hardly encouraging. Cash flow falls from nearly 2% of GDP positive in 2010 into modestly negative territory sometime after 2035. In the United Kingdom, cash flow goes from a peak around 2010 that is nearly 2% of GDP positive to cash flow negative in 2025, then falling further to more than 1% negative in 2035. Finally, in Japan the peak for pension assets has already been reached back in the late 1970s at less than 1% positive. It has been trending slightly downward even since. As a percent of GDP, Japans cash flow slips from less than 0.5% positive today into negative territory sometime after 2015. It continues to slip gradually to 2050, when it is still less than 1% of GDP negative. Mantel then runs various scenarios where the real wage growth increases faster than or less than the 1.5% assumption in the baseline scenario. This produces significant changes when and by how much cash flow will change. In the U.K., for example, a 2.5%
44

According to InterSec data released in late 1999, the United Kingdom has $1,365 billion in pension fund assets, of which $1,165 billion is in the private sector and $200 billion is in the public sector.

25 average wage growth leaves the pension funds cash flow positive throughout the 50-year period. A slower gain in productivity representing only a 0.50% average wage gain per year, would push pension funds into negative cash flow earlier, 2015, and push them much lower to nearly 3% of GDP by 2040. Mantel also models differing rates of return, 1% to 5% (as opposed to 4% in the baseline scenario). If the markets perform less well (1%, 2% or 3%), more money is contributed to the plans and they tend to remain cash flow positive instead of going negative. If the markets earn 5%, less money is put into the system and it goes cash flow negative sooner and ultimately deeper.

Chart 4. Pension Funds Net Cash Flow (% of GDP) Merrill Lynch Baseline Scenario
3%

2%

1%

0%

-1%

-2%

-3% 1950 1960 1970 1980 Japan 1990 US 2000 2010 2020 2030 UK 2040 2050

Netherlands

Source: Merrill Lynch & Co.

Mantel does not contend that negative cash flows from pension plans will lead to a decline in equity prices nor will a shift of more assets from equities to bonds. For example, if the demand for equities declines, theoretically equities become cheap for investors and expensive for issuers. This means that corporations will use bonds rather than equities to finance their business and, therefore, the demand for equity capital will diminish, Mantel explains. As the supply of equity falls it might come closer to being in balance with the demand, thereby avoiding declines in value. Other factors can have also an influence on pension cash flow that could alleviate the expected negative cash flow. Mantel states the following: High real wage growth, for example, would improve the cash flow situation of the pension system. Although we do not expect that we will return to the situation

26 seen in the 1960s when wages substantially exceeded inflation in many countries in Europe, some acceleration cannot be ruled out. Funnily enough, low investment returns are good for asset markets, as low returns mean higher cash flow flowing into the funded system. If investment returns over the next 10 to 20 years end up below the returns we experienced over the last 20 years, this means that plan sponsors will have to start putting more money into their pension schemes again and pension schemes will have to increase their net purchases of assets.45 Governments might also adopt policies to expand pension coverage and new retirement saving from more of the population could drive new funds into pension systems after 2010 to counter the demographic effect. If, for example, the portion of the population covered by a defined benefit plan in the Netherlands is gradually increased from 50% for those who started work before 1995 to 70% for those entering the workforce in 2020, there is a substantial positive impact on cash flow in pension plans. (They go from negative 2.7% GDP to negative 1.5% GDP). In the U.S. a gradual increase in pension coverage from 40% to 60% of the workforce has a much different impact. In this scenario, cash flow remains positive throughout the next 50 years, first peaking at 1.8% of GDP 2010, then dropping to 1.1% in 2030 and remaining near the level for the next 20 years. If, an even more ambitious U.S. were able to expand workforce participation in defined benefit plans to 70%, net cash flow would reach a high of 2.0% of GDP in 2010, then fall to 1.6% of GDP in 2030 and remain close to that level for another 20 years. If this scenario, U.S. pension funds could continue to support asset market with their positive cash flow, Mantel concludes.

Pension Plans Likely to Reduce Equity Holdings, Increase Fixed Investments The Merrill Lynch paper also structured a model to predict changes in asset allocation in pension funds in the four countries. Investments are expected to move from higher to lower risk assets as populations age. Among the four countries, the U.K. begins with the highest allocation to equities, 72%, with the U.S. at 63%, the Netherlands at 45% and Japan at 40%.46 By 2050 the asset allocations will have shifted most dramatically in nations which currently have the highest equity holdings. The line-up in 2050 will be: U.K., 60% equities, U.S., 54% equities, the Netherlands, 30% equities, and Japan 28% equities. Such shifts might have a significant downward impact on equity markets considering how large U.S. and U.K. pension fund assets are. In 1999, for example, the U.S. alone had $7,765 billion in pension assets, 59% of the worlds total pension assets of $12,977 billion. Japan is the next largest holder of pension assets with $1,544 billion, or 12% of the world pension assets. The third largest is the U.K. with $1,365 billion in pension assets, more than 10% of the worlds pension assets. Indeed, the U.S., Japan and the U.K. combined represent 82% of the worlds pension assets.
45 46

Mantel, p. 29. According to 1999 data compiled by InterSec Research Corp.

27

Individual retirees, too, may shift their assets from equities to fixed-income investments, according to a 2000 study47 by IMF economist Robin Brooks. Using a neoclassical growth model with overlapping generations, Brooks simulates the market effects of a baby boom and baby bust. The model assumes that people shift from equities to bonds as they age. An overlapping-generations is one where the differing behaviors of individual age cohorts is modeled separately to capture the impact of demographic change. Thus, for example, the behavior of various parts of a baby boom generation could be tracked and predicted.

Chart 5. Asset Mix of Pension Funds (1999 Estimates)

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Italy Finland Japan Switzerland Europe USA Sweden France Germany Austria Belgium Spain Denmark Portugal Netherlands Ireland UK 25% 26% 28% 29% 17% 22% 4% 12% 42% 45% 35% 40% 52% 53% 59% 63% 72%

Equities

Cash, Bonds and Other

Source: Merrill Lynch and InterSec Research Corp.

Brooks model goes beyond previous literature by also using a general equilibrium model. General equilibrium, as opposed to partial equilibrium, is one that is structured in a way that various prices and measures adjust to bring into balance various imbalances that occur in the economy. This model can, thus, measure the impact of changes in the some of the factors that affect the course of the economy on prices, interest rates, and other factors. For example: if demand for a consumer goods go down
47

Brooks, Robin (2000), Life Cycle Portfolio Choice and Asset Market Effects of the Baby Boom. Mimeo.

28 relative to the supply, the prices adjust downward as long as the supply of consumer goods remains constant. The two approaches (1) general equilibrium and (2) overlapping generations have been rarely combined in a single model design. For example, three sophisticated general equilibrium, multi-country models that were adapted for studies48 of the macroeconomic impact of aging did not rely on the overlapping generations approach as a way to include demography in the model design. (Those studies are discussed in detail in a companion paper.49) These three studies by the IMF, OECD and the European Commission were not designed from the ground up with algebraic equations that measure the relationship between rising dependency ratios (brought on by population aging) and overall saving rates. This key relationship was instead grafted on to pre-existing models by picking out a relationship between dependency ratios and saving rates that the authors thought would best represent what is likely to occur in the future. The authors of these studies agreed that overlapping generations models would better capture the demographic effect, a point on which many economists would agree. Brooks is one of only a handful of economists who have, in a sense, carried the ball forward by incorporating the overlapping generations model into a general equilibrium model. Another general equilibrium, overlapping generations study50 in1999 by Andrew Abel is also discussed in this paper. Neither Abel nor Brooks, on the other hand, use a multi-country model where capital and goods flow between countries and can alter the impacts being measured in the study. Brooks recounts that there are two views among economists on what will happen to financial assets. One is that baby boomers will be selling their assets to a small generation of young investors when they retire and the excess supply of assets lead to a decline, perhaps a crash. An opposing view is that forward-looking financial markets are pricing assets to incorporate the aging of baby boomers. Brooks contends there is mounting evidence from data that there is an asset shift from equities to fixed-income investments as people age, and he cites the work of several researchers to support this view. One is Federal Reserve Bank of St. Louis economist Peter S. Yoo51, who analyzed cross-sections of the U.S. Survey of Consumer Finances and found that the share of financial wealth in equities increases over the working life and declines after retirement, generating a hump-shaped pattern. James Poterba and Andrew Samwick52 use pooled data from three cross-sections from the Survey of Consumer Finance and found a hump-shaped pattern where holdings of equity increase at
48

Masson and Tryon for the IMF; Turner et al for the OECD; and McMorrow and Roeger for the European Commission 49 England (2001b). 50 Abel, Andrew B. (1999), The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security, Mimeo, October. 51 Yoo, Peter S. (1994), Age Dependent Portfolio Selection, Federal Reserve Bank of St. Louis Working Paper 94-003A. 52 Poterba, James M. and Andrew A. Samwick (1997). Household Portfolio Allocation Over the Life Cycle. Working Paper No. W6185. Cambridge, Mass.: National Bureau of Economic Research.

29 younger ages and decrease a later ages. And, a 2000 study53 by John Heaton and Deborah Lucas using three separate cross-sections of data from the Survey of Consumer Finances found that householders older than 65 hold a smaller share of financial wealth in stocks than do younger households. Finally, in a 2000 study54 John Ameriks and Stephen P. Zeldes used pooled data from Surveys of Consumer Finances and panel data from pension fund manager TIAA-CREFF to show that the portion of assets held as equity has a hump-shaped pattern as one first accumulates it and then sells it off after retirement. Brooks model has one key uncertainty: a demographic shock (the baby boom followed by a baby bust). Productivity gains are held constant. While the model is a closed economy, Brooks notes that most countries with developed asset markets have very similar demographics, so the model can be viewed as representing the developed world as a whole. The model ignores the effects of home ownership on holdings of financial assets. It includes a pay-as-you-go Social Security system. Brooks simulation of a baby boom and baby bust is more exaggerated and longer than actual historic experience. The baby boom begins in 1950 and continues 40 years. Then in 1990 a baby bust begins and lasts another 40 years. After 2030 the ratio of births to deaths returns to equilibrium. Brooks then plots the effect of these demographic changes on stocks and on bonds. Both the boom and bust have two distinct effects on asset returns, Brooks writes.55 During the baby boom returns on both stocks and bonds rise because aggregate saving is relatively low because of the expense of a high youth dependency ratio. Later returns on both stocks and bonds fall as aggregate saving becomes large and boomers increase their saving for retirement. The downward swing in bond returns is greater than it is for stocks. Thus, the demographic changes will cause more of a negative impact on bonds than on stocks. The main effect of these changes will be that the second generation of boomers will have returns on their investments that are 20% lower than the returns earned by their parents, and 15% below the returns that will be earned by the first baby boom generation. Although a pay-as-you-go Social Security system could be expected to offset this effect, Brooks finds that it fails to do so for realistic levels of the payroll tax.56

Opposing View: Institutions Buying Power Does Not Determine Equity Prices In a 1981 paper57 economist R. David Ranson and market analyst William G. Shipman argued that the buying and selling power of mutual funds do not determine stock prices. If this is true, then some of the findings of studies of the cash flows in and
53

Heaton, John and Deborah Lucas (2000), Portfolio Choice in the Presence of Background Risk, The Economic Journal 110: 1-26. 54 Ameriks, John and Stephen P. Zeldes (2000). How Do Household Portfolio Shares Vary with Age? Mimeo, February. 55 Brooks (2000), p. 18. 56 Brooks (2000), p. 21. 57 Ranson, R. David and William G. Shipman (1981), Institutional Buying Power and the Stock Market. Financial Analysts Journal, September-October, pp. 62-68.

30 out of pension funds may be drawn into question. Further still, it would suggest that when pension funds are required to sell assets after 2020 to pay for benefits, it may not put downward pressure on stock prices. While this view defies conventional wisdom, it is worthy of consideration in an overall analysis of the financial markets impact of population aging. Ranson and Shipman stated the institutional buying power hypothesis thusly: Since the supply of stocks is essentially fixed, variations in the liquid asset balances and cash flows that constitute the significant sources of demand are prime determinants of stock rice changes.58 The authors focused on mutual funds and pension funds in their 1981 study because they had steadily gained a larger and larger share of the total U.S. equity market. Mutual fund equity assets, for example, has risen from 24% of total outstanding equity shares in 1955 to 40% in 1976. Looking back in 1981, one could say that equity assets of mutual funds had peaked at $72 billion in 1972 before declining to $32 billion in 1979. On a proportional level, mutual funds share of total stock outstanding rose from 2.2% in 1955 to 4.5% in 1976 (before falling to 3.2% in 1977).59 Pension assets were becoming even more of a market factor. From $6.1 billion in 1955, pension assets rose to $101.9 billion in 1977. As a share of total equity outstanding, pension equity assets rose from 2.0% in 1955 to 11.7% in 19975 and then fell to 10.2% in 1977. Pension funds were taking an even larger share. Pension funds were receiving a substantial and rising flow of cash each year, estimated at $22 billion in 1979. Overtime, then, both mutual fund assets and pension fund assets were increasingly becoming a larger and larger portion of total institutional investor holdings of pension funds, as well as a larger and larger share of the total equity market. That process, of course, has continued and strengthened since Ranson and Shipman did their 1981 study. Ranson and Shipman found that cash to asset ratios of mutual funds defined conventional wisdom and investment logic. Conventional wisdom is that the market is bullish when mutual fund liquid assets are highly and bearish when they are low. Conversely, one would expect mutual funds to be close to fully invested in the market as long as the outlook remained positive for equity values. At the same, one would expect mutual funds to reduce their exposure to equities when the outlook was about to turn bearish. Yet, historical data showed the opposite of this conventional wisdom. Cash-asset ratios are low at the peak and high at market troughs. There is, in fact, a negative a statistically significant correlation between the percentage changes in the cash-asset ratio and the Standard & Poors 500 index, the authors found. How does one explain the counter-intuitive cash-asset ratios of mutual funds? There are two conventional explanations. One is that mutual funds have been consistently
58 59

Ranson and Shipman, p. 62. Data source: Flow of Funds Accounts, Federal Reserve Board

31 wrong at their investment decisions at market extremes. In short, they have behaved like a bunch of amateurs. The other explanation is that variations in liquid assets at mutual funds cause stock price levels to change. Thus, when mutual funds are low on cash, market prices peak because they are low on buying power. Conversely, when mutual funds are flush with cash, market prices are at their lowest ebb. Ranson and Shipman reject both conventional explanations because neither can be reconciled with the theory that markets are efficient. As for the first explanation, the idea that mutual funds always get it wrong defies logic as much as getting it always right. The explanation regarding the level of cash in mutual funds affecting stock prices does not satisfy efficient market theory either. For one thing, institutional buyers will buy a stock based on the after-tax present value of all future returns. Changes in buying power by an institutional investor do not change the underlying investment fundamentals that determine whether stocks will be bought or sold. Ranson and Shipman instead find a third, more satisfying explanation of why cash-asset ratios are high when markets are low and low when markets are high. The authors analyze the data and find that changes in the value of equities alone explain the changes in the ratio. In other words, higher equity values lower the cash-asset ratio while lower equity values raise the cash-asset ratio. This positive relationship is statistically significant. Ranson and Shipman then tackle the view that increasing cash flows from pension plans into the markets can drive up stock prices. (In 1972 stocks were 73% of pension assets but the portion invested in equities fell to 51% in 1979, a 14-year low.) In 1979, maintaining half the portfolio invested in equities, would have theoretically meant pumping $11.1 billion into the equity markets -- $9.4 billion of additional equity investments above those made in 1978. With the supply of equities constant, presumably the additional $9.4 billion of stock purchases would drive up stock values. Yet, historical data from 1960 to 1978 shows no correlation between the amount of allocation of cash flow by private pension funds and the size or direction of stock price changes. Increasing flows are accompanies by increases, declines and no change. Yet, there is a correlation between the value of the S&P500 and the fraction of total assets that pension funds hold in equities. Shipman, who is now a principal with State Street Global Advisors in Boston, says that he reviewed the historical data again in 1996 and got the comparable results as he and Ranson found in their 1981 paper. Whether or not the amount of capital flows from pension funds into equities increases or decreases, it will not affect the price level of equities, he still contends. Pension plan percentage holdings of equities will be positively correlated with the equity prices. Shipman explains the situation thusly: I would say money is neither going into the market or going out of the market. The market is just a place where investors make exchanges to meet their preferences. The equities that exist are the same pre and post the exchange. Investors will continue to evaluate equities based on their estimate of the

32 after-tax present value of all future returns. From this view, however, declining economic growth rates in the future could still depress equities irregardless of whether changes in patterns in cash flows from pension plans have an effect. Equities would decline as expectations for earnings declined in line with more sluggish economic growth. Shipman does not, in fact, rule out any role for changes in the supply and demand for equities. He just thinks the influence is largely unknowable. If I knew perfectly well ahead of time how much money would go into the market, I would not know whether the market would go up, go down, or stay the same, he says.

Economists Debate the Effect of Baby Boom on Stock Prices Schieber and Shoven, whose studies were discussed earlier in this paper, relied on a model incorporating the dynamics of pension fund cash flows to measure the potential impact of population aging on equities. In 1999 economics professor Andrew B. Abel of the Wharton School at the University of Pennsylvania did a study of the economy that modeled the theoretical potential impact of the retirement of baby boomers on stock prices. Abel, like Brooks, used a general equilibrium, overlapping-generations model to measure the impact on stock prices. Abel developed the model, he says in a paper60 describing the project, to test the logical consistency of the argument that the baby boom is helping to fuel the booming stock market. Potentially offsetting the argument that purchases of stocks by middle-aged baby boomers is driving up stock prices is a similar argument that these investors will eventually sell large amounts of stock during retirement, thereby causing a decline in stock prices. And if these investors are forwardlooking in the first place, would they so eagerly buy stocks that are destined to fall in price eventually?61 Abel modifies a neoclassical production and capital accumulation model to incorporate a way to measure the impact of population changes on the price of capital. He also includes a pay-as-you-go- Social Security system with a trust fund and a distribution of wealth from higher to lower income retirees. Why is this done? Because, he says, in an overlapping generations model in which consumers have no bequest motive, private saving is motivated only by the desire to consume during retirement. Since Social Security provides a substantial portion of retirement income for many consumers, Abel wanted to take account of this income when analyzing the saving behavior of people in their working years. Abel finds in his analysis that the price of capital rises while boomers are working and saving, and then reverts toward the mean after the baby boom passes into retirement. This finding by Abel lends theoretical support to the conclusions of Schieber and Shoven,
60

Abel, Andrew B. (1999), The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security, Mimeo, October. 61 Abel (1999), p. 1.

33 as well as Mantel, who modeled the capital flows in and out of pension plans, as noted earlier in this report. Other economists are more skeptical about the potential of the baby boomer generation to drive down stock prices when they retire. In a 2000 paper62 James M. Poterba quotes Jeremy Siegel as encapsulating the worry about a future market meltdown: The words Sell? Sell to whom? might haunt the baby boomers in [the coming decades]. Who are the buyers of the trillions of dollars of boomer assets? The [baby boomer generation] threatens to drown in financial assets. The consequences could be disastrous not only for the boomers retirement but also for the economic health of the entire population.63 Poterba, in response to views of a potential market meltdown, points out that various preceding studies were hampered by the fact there have been few systematic studies of the historical relationship between asset prices, population age structure, and asset returns. His states that his paper is an attempt to begin to fill that gap. Poterba looked at returns on Treasury bills, long-term government bonds, and corporate stock in the U.S. over the last 72 years. He then attempted to find links between these data and demographic changes. He also looked at additional data in Canada and the United Kingdom to see if there are similar patterns. Poterba then took a look at data from the Survey of Consumer Finances going back to 1983 to measure average levels of asset holdings for people in different age groups. He found that there are important age-related differences in the levels of assets and net worth. For those between their early 30s and early 60s, average holdings of net financial assets rise with age. Poterba found that while there is a decline in the rate of increase in financial assets for older people, there is no evident decline in net financial assets when we compare those above age 75 with those in somewhat younger age groups. He also found a similar pattern in holdings of corporate stock and net worth. His conclusion: there is only a limited downturn in average asset holdings at older ages.64 Poterba does, however, find that there is some downturn in the holdings of corporate stock. Age-specific ownership peaks between the ages of 55 and 59 at $38,319 and declines by nearly $10,000 for those in the next two age categories. On the other hand, net worth -- which includes financial assets, home ownership, equity in unincorporated business and assets held in defined contribution pension plans, such as 401(k) plans -- rises in value up to age 55 and then stays relatively constant for the rest of a persons life. See Table 3 below for more details.

Poterba, James M. (2000), Demographic Structure and Asset Returns. Delivered as a Review of Economics and Statistics lecture at Harvard University, March. 63 Siegel, Jeremy (1998), Stocks for the Long Run. Second Edition. New York: McGraw-Hill. 64 Poterba, p. 8.

62

34 Poterba, to test whether a single survey in 1995 might contain distorting age cohort effects, decided to do cross-sections of the Survey of Consumer Finances from 1983, 1986, 1989, and 1992 as well to estimate age profiles of asset ownership. These sets of data contain 30,553 individuals. Poterba found the same pattern he had observed in the data for a single year, 1995. That is, he found again that holdings of common stock and total financial assets increase as individuals grow older; however, the decline in asset holdings in old age is much less pronounced than the pace of increase during middle-age. According to the data from five surveys analyzed by Poterba, real holdings of common stock peak between the ages of 55 and 59 at $32,515 (in constant 1995 dollars). They decline to $28,219 for people between the ages of 70 and 74, and then down to $24,722 for those over 75. Again, net financial assets peak between ages 70 and 74 and hardly decline at all after that. Net household worth peaks between ages 65 and 69 at $201,509, and declines to $144,316, or about one-fourth below the peak, for those 75 years and older. See Table 4 below for more details. In a separate review within the same paper Poterba looked at the relationship between population age structure and real returns on Treasury bills, long-term government bonds and large corporate stocks, as measured by the return on the Standard and Poors 500 index. He looked at data for a 72-year period beginning in 1926 and ending in 1997, as compiled by Ibbotson Associates.65 He found little evidence that returns were affected by the size of various age cohorts. Poterba found a negative link between the fraction of the population that is 40 to 64 years old and returns in fixed income markets, particularly the Treasury bill market. This means that a relative increase in the size of this asset accumulating market would tend to reduce the return on fixed income assets like government and corporate bonds. The potential effects are implausible, Poterba found, because they were so large. For example, a 5 percentage point increase in the population between 40 and 64 years old would drive down real yields on Treasury bills by 700 basis points, and drive down real returns on bonds by 1,000 basis points. These effects were larger than those predicted by others66 67 who had researched this relationship. The very large values of these predicted effects raise the possibility that the demographic variables are capturing other omitted variables, rather than the relationship between notional asset demand and equilibrium returns.68 Poterba found different relationships between demographic changes and asset returns in different time periods. For example, he found a stronger effect of demography on Treasury bills before World War I than afterwards. He also found no strong evidence of a link for the postwar baby

Ibbotson Associates (1998), Stocks, Bonds, Bills, and Inflation: 1998 Yearbook. Chicago: Ibbotson Associates. 66 Brooks, Robin J. (1999), What Will Happen to Financial Markets When Baby Boomers Retire? Federal Reserve Board of Governors. Mimeo. 67 Yoo, Peter S. (1994), Age Dependent Portfolio Selection, Federal Reserve Bank of St. Louis Working Paper 94-003A. 68 Poterba, p. 20.

65

35 boom, even for Treasury bills. And, he found no clear link between population age structure and corporate stocks.

Table 3.

Cross-Section Estimates of Age-Specific Asset Demands 1995 U.S. Survey of Consumer Finances
Age of Individual 15-19 Common Stock Holdings $ Net Financial Assets 0 $ Net Worth

1,610 $ 10,144 (2832) (5,406) 20-24 384 -1,340 7,635 (73) (1660) (5,308) 25-29 3,073 4,322 19,798 (510) (1339) (2,984) 30-34 4,666 7,806 30,666 (1515) (3334) (8,891) 13,692 53,767 35-39 7,438 (4399) (8019) (12,171) 40-44 14,593 26,564 90,606 (3584) (6168) (18,701) 42,442 131,932 45-49 21,762 (4554) (9915) (26,660) 50-54 29,965 59,083 169,574 (20,628) (25,660) (42,454) 65,781 186,505 55-59 38,319 (17,943) (27,798) (54,645) 60-64 29,416 63,066 178,648 (16,167) (28,842) (54,312) 65-69 29,219 82,538 189,068 (16,605) (37,538) (65,026) 70-74 31,367 76,835 190,729 (30,067) (45,798) (70,800) 75 & up 34,558 84,806 167,279 (26,645) (42,151) (62,174) All Ages 18,272 38,351 106,399 (3,407) (5,475) (9,612) Note: Common stock holding includes assets held through defined contribution pension accounts. Net financial assets subtracts consumer and investment debt from gross financial assets. Net worth is the sum of net financial assets, the gross value of owner-occupied housing, and holdings of other assets such as investment real estate, less the value of housing mortgage debt. Standard errors are shown in parentheses.

36
Table 4.

Age-Specific Asset Demands Estimated, Allowing for Age and Cohort Effects U.S. Surveys of Consumer Finances, 1983-1995
Age of Individual 15-19 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60-64 65-69 70-74 75+ Common Stock Holdings
$ 0 (0) 470 (134) 1477 (214) 3391 (367) 5906 (908) 10795 (1175) 18631 (1996) 23913 (2805) 32515 (3882) 31004 (4857) 30822 (5791) 28219 (7186) 24722 (7482)

Net Financial Assets

$ 2285 (2823) 2170 (2939) 4477 (3010) 9402 (3126) 14325 (3352) 20236 (4789) 37122 (4668) 57396 (6634) 71884 (7505) 80931 (8757) 92262 (9901) 92366 (11707) 92239 (12091)

Net Worth
$ 11042 (5391) 13656 (6337) 25471 (6848) 37706 (6648) 60758 (7166) 86808 (7939) 123683 (10136) 151981 (15641) 177522 (17133) 189134 (19670) 201509 (22973) 173796 (25961) 144316 (27026)

Notes: Estimates are based on regression models that relate real holdings of various assets by age cohorts in different survey years to a set of cohort intercepts and indicator variables for various age groups. Standard errors are shown in parentheses. See text for further discussion.

37 Poterba uses the age-specific asset holdings (from the Surveys of Consumer Finance), together with age-specific population data and projections, to calculate a time series of projected asset demand. He found that the dividend/price ratio of stocks has been positively related to his projected demand variable based on historical data. Looking into the future, Poterba uses his findings to predict that asset values will rise for the next 20 years and will then level off. There will be no asset market meltdown. The limited decline in financial asset holdings as individuals age suggest that the rush to sell financial assets that underlies predictions of a market meltdown in 2020 or 2030 may be less pronounced than some suspect,69 he wrote.

Stock Prices May Decline Even if Retirees Do Not Spend Down Assets Quickly Abel was asked by the Review of Economic Statistics to respond to Poterbas conclusions from the data he examined. This exercise prompted Abel to rethink the theoretical conclusions he had found in his general equilibrium model, as described earlier. He stated the following: Jim [Poterba] found that people dont sell stock as sharply as the models predict. If people arent selling of stock, you wont get a meltdown. Thats a pretty important finding on his part. Abel was also interested in some rational inconsistencies of the asset meltdown hypothesis. Would people rationally buy stock when they are young to sell when they are old, knowing the price would decline? he asked. To answer that question and to respond to Poterbas findings, Abel decided to modify his general equilibrium model to include a bequest motive, which prompted him to write another paper.70 The bequest motive both influences the rate of accumulating assets and decumulating them after retirement. Those who have a bequest motive attempt to accumulate more assets, so they can maintain their lifestyle after retirement and still have some assets left over to live their heirs. Abel notes that Poterba rejects the asset market meltdown hypothesis while maintaining the notion that the baby boom contributed to the increase in stock prices that occurred in the 1990s. Abel accepts Poterbas conclusion that the demand for assets will not decline sharply when the baby boomers retire, but argues that a decline in demand for equities does not necessarily mean that equity prices will not decline. Abel reached this conclusion because when he added the bequest motive to his model, he still got the same result a decline in equity prices. Abel contends the answer to the riddle is that Poterba did not consider changes in the supply of capital (equities), only changes in the demand for capital. Abel contends, in fact, that even if demand for capital does not decline in the future, there will be a slowing
69 70

Poterba, p. 10. Abel, Andrew B. (2000), Will Bequests Attenuate the Predicted Meltdown in Stock Prices When Baby Boomers Retire? Mimeo.

38 of the supply of capital. The effect of this dynamic will be to push down the value of equities, Abel concludes in his paper. What will happen, Abel explains, is that with a bequest motive there will be more demand for capital when there is a bequest motive, thus pushing up the price of assets ahead of retirement when there is a large age cohort like the baby boom. At the same time, as the economy accumulates more capital, it makes it cheaper to produce more capital. This means more capital. Essentially, Abel finds that the overall dynamic interplay of supply and demand for capital will not change with a bequest motive. There is still a gradual decrease in the demand and a gradual increase in supply in both instances as baby boomers age and retire. However, the effect is delayed71 with a bequest motive. The result, there is still an eventual decline in asset prices and the bequest motive does not attenuate the decline. Will there then be a meltdown? Yes -- but I have to qualify this, he says. Demographics do not account for all the rise in the market over the last 15 years. Other things are going on. The recent meltdown in the Nasdaq has nothing to do with demographics and more to do with an asset bubble in technology stocks, he says. Abels conclusion is also tempered by the failure of another paper72 in the late 1980s by Gregory Mankiw and David Weil to accurately predict, based on demographics, what would happen to house prices as baby boomers aged and were replaced by young baby busters forming households. Mankiw and Weil predicted that the real price of houses would fall by 47% by 2007. But so far, that didnt happen, Abel says. Housing prices did, however, stagnate for much of the 1990s, falling in real value during the recession and staying there until after 1995. Since then the first slowly recovered and finally surged ahead. Abel thinks Mankiw and Weil erred when they assumed that the same household would demand the same level of housing. However, as households became wealthier, demand for housing, as measured in thousands of dollars of house value, also went up. The models couldnt account for that. Despite the cautions he has offered, Abel says his finding of a downward impact on stock prices after 2020 is not fragile. Its only a question of how it will play. Its a tough thing to go from the world of abstract models to the world we live in. A model will be silent on how this occurs. Abel says he would guess there will be a gradual erosion of prices. To the extent prices were trending upwards for other reasons, the upward trend will be less. He does not think it will be sudden or unexpected, so it is likely to show up more as a change in trend rather than a big crash. There may, however, be sudden changes in investor sentiment in some areas, such as debt, Abel says. A nation may be increasing its debt levels to pay for the costs of more
71

Abel contends that both the demand and supply curves move to the right with a bequest motive, leaving the downward pressure on equities intact that was found in his original paper. 72 Mankiw, N. Gregory and David N. Weil (1989), The Baby Boom, the Baby Bust and the Housing Market, Regional Science and Urban Economics 19, pp. 235-258.

39 elderly people and investors may think that the underlying economic strengths of the country can sustain the debt increase. On the other hand, there may be hidden weaknesses in this assumption and in the nations economy that investors had not noticed or taken into consideration and they could suddenly lose confidence in the nations government bonds. Thats a case where demographics could lead to something cataclysmic, Abel says. Slow moving events could lead to something that bursts, just as high blood pressure, high cholesterol and being overweight can lead to a heart attack, when one is not expecting it. A crash could happen if rising interest rates reach a point where investor confidence is lost and the countrys currency collapses, provoking a global asset meltdown as occurred in 1998 when Russia defaulted on its bonds.

Will Housing Prices Fall When Baby Boomers Retire? In 1989 Mankiw and Weil, as noted earlier, wrote one of the earliest papers on the potential negative impact of baby boomers on asset prices. They predicted that housing demand would grow more slowly in the 1990s and the first decade of the 21st century than in any time since the end of World War II. The deflation in asset prices would be the mirror image of the run-up in values that occurred in the 1970s when baby boomers were forming households and driving up the price of real estate. During the 1970s the real price of housing rose between 19% and 32%. Mankiw and Weil examined the U.S. Census Bureau data to analyze what factors drove up the prices. They found that the number of children do not drive up housing prices. Thus, during their childhood years in the 1950s and 1960s, the baby boomers as children had no effect on the housing market. Looking at the housing and demographic data for the 1970s and 1980s, the authors found the impact of the baby generation on demand for housing begins at age 20 and continues to rise to age 30. After 40, the impact of the baby boom begins to reduce demand for housing by about one percent a year. This decline is probably attributable to the fact that, because of productivity growth, older cohorts have lower lifetime income than younger cohorts and therefore demand less housing, Mankiw and Weil wrote.73 The real value of housing increased almost 50% between 1970and 1980, the authors found. Part of this increase can be attributed to a 22% increase in real disposable personal income per capita, which reflects rising productivity. They attributed much of the rise, however, to the fact the demand outstripped supply as real age-specific housing prices rose 20% to 30%. Mankiw and Weil believed in 1989 that the baby bust generation would have the opposite effect of the baby boom generation and drive down the real value of housing by 47% by 2007. The authors caution about the perils of forecasting, noting we cannot be confident about precisely what effects this slow growth [in housing demand] will have. The magnitude of the effect could be less than forecast, they note. Even if only half the
73

Mankiw and Weil (1989), p. 240.

40 amount predicted it would sill be one of the major economic events of the next two decades.74 In a 1995 paper75 Craig Swan, then a visiting economist at the Federal Reserve Bank of Minneapolis, faulted the methodology used by Mankiw and Weil. He found that authors demand variable did not take into account all the factors that affect housing demand and that they had misinterpreted this variable. Mankiw and Weils housing demand measures need to also include real income, relative prices and real interest rates, Swan states. Swan claims that changes in the costs of building houses were important in determining the price of housing during the period from 1947 to 1987 that Mankiw had examined and that the authors had not fully taken this into account. The price of housing affects the supply of housing, Swan noted. If its too costly to build houses, fewer will be built and, therefore, the costs will rise in the face of steady of increasing demand. Swan found from historic data a correlation between the supply of new homes and the cost of constructing homes. Any forecast needs to taken into account such costs that affect supply, such as shifts in lumber prices, construction wage rates and productivity, along with environmental and building regulations. Swan claims that Mankiw and Weil offer no evidence that any of these factors will change in a way that would support a forecast of a 47% decline in the price of houses. Swan also notes that Mankiw and Weil do not include land prices in their analysis and that in some areas of the country, such as California and the Northeast, the cost of land is driving up the cost of housing. Despite the criticisms of Mankiw-Weil and the fact that prices have not fallen as they predicted, a number of economists continue to suggest that expected demographic changes can depress both housing prices and financial assets, although the impacts will hit and different times. Gurdip Bakshi and Zhiwu Chen in a 1994 paper76 explore the two theories: the life cycle investment hypothesis and the life-cycle risk aversion hypothesis. The life cycle investment hypothesis states that at different stages of an investors life cycle he or she requires different types of assets. Investors in their 20s and 30s find housing a desirable investment. As the investor grows older, the demand for housing stabilizes or decreases, and the demand for financial assets rises in preparation for retirement. The life-cycle risk aversion hypothesis claims that an investors relative risk aversion increases with age. If this is true, the market risk premiums should be correlated with demographic changes, specifically for the average or representative investor. As the average investor ages, risk premiums would rise.

74 75

Mankiw and Weil (1989), p. 248. Swan, Craig (1995), Demography and the Demand for Housing. A Reinterpretation of the Mankiw-Weil Demand Variable, Regional Science and Urban Economics 25 (1995), pp. 41-58. 76 Bakshi, Gurdip S. and Zhiwu Chen (1994), Baby Boom, Population Aging, and Capital Markets, Journal of Business, Vol. 67, No. 2, pp. 165-202.

41 To explore these theories in historical data, the authors use the average age of those over 20 to represent the degree to which a society has aged. This average age is then correlated with the Standard & Poors 500 index and the real price of housing. Since 1945, as the average age has risen, housing prices have gone down and stock prices have gone up. Also, when average age has fallen, housing prices have risen and stock prices have fallen. The data then support the life cycle investment hypothesis. To test the risk aversion hypothesis the authors consider a representative-agent model in which the agent (a typical consumer) has an age the same as the average age of the population. Since the average age fluctuates, so does the agents age. This approach more clearly fits the data from 1900 to 1990, when both the change-in-average-age and the dividend yield variables are statistically significant predictors of future stock returns and risk premiums. Here, an increase in average age correctly predicts an increase in the risk premium. Housing prices in the late 1990s have also likely been pushed forward by big strides in productivity driven by information technology. This, in turn, has allowed more households to afford larger and more expensive homes. (For a discussion of productivity trends see a companion paper on the macroeconomic impact of aging.77) Additionally, low interest rates have made housing more affordable for first-time home buyers, driving up the size of the population that owns a home from 64% to 67%. Finally, a large influx of immigrants has increased the demand for home ownership above levels that might have been anticipated in 1989. Beyond the studies done in the U.S. is another hard reality regarding housing. In a number of nations, the population is expected to decline. This more clearly will drive down the value of real estate in the future. Japan, Italy, Germany, Spain, and a number of other countries face the prospect of a population decline.

High Debt Levels Are Likely to Push Up Interest Rates, Depress Equities The widely held view that the debt situation in industrial nations will deteriorate as a result of population aging is based on a the assumption that absent major reforms, rising debt levels in major industrial nations will overwhelm the supply of capital and tend to push up interest rates. The industrial nations are likely to see big run-ups in their debt positions as a result of population, absent significant reforms. So far, in spite of considerable effort, the industrial nations have made little headway in reducing the enormous liabilities that lie ahead. In Germany and France recent efforts to reduce benefits and set up supplementary funded pension schemes overseen by the government have failed in the face of determined and powerful opposition from organized labor. Italy enacted major reforms in 1993 and 1995, which will reduce the average pension benefit

77

England (2001b).

42 for the typical male worker from 80.9% to 54.7% in 2035, according to an analysis by Agar Brugiavini.78 Japans debt levels are already reaching worrisome levels due to the fact that the government borrowed frequently during the lost decade of the 1990s to stimulate the economy, only to find that once the spending had ceased the economys growth rate slowed, or fell into recession. Furthermore, Japans reductions in Social Security benefits announced last year will be gradually phased in over a long period, so that the budget savings will not appear for some time to come. Getting a handle on how bad the debt situation might become over the next five decades is challenging task. The OECD first calculated the net financial liabilities to fiscal positions posed by aging populations in a 1996 paper79 that later came under protest from member governments. They projected that in 2030 debt would rise to a staggering 339% of GDP in Japan, 241% of GDP in Italy, 247% GDP in Germany, 193% GDP in France, 115% GDP in the U.S., 144% GDP in the United Kingdom. This projection did not take into account reforms, such as those in Italy, and is now viewed as the worst case scenario, according to Vincent J. Truglia, Managing Director and Co-Head of the Sovereign Risk Unit at Moodys Investors Service in New York. A different projection by OECD was done in 1998 by Turner et al, which incorporated more of the pension reforms. This study of the macroeconomic impact of aging found that public sector finances would deteriorate by an estimated 10% of GDP in Japan by 2050, while it would deteriorate by about almost 6% of GDP in the European Union and 2% of GDP in the U.S. After 2050 there would be a recovery as the small birth cohorts since the baby boom years reach retirement age and all the baby boomers die off. OECD also predicted that public health spending, too, will contribute to a deterioration of public finances. It would be equivalent to 2% of GDP in the U.S. in 2050, and 3% in Japan and the European Union. Turner et al assumed governments would, however, take steps to limit the rise of debt. To capture this expected behavior, the study used a rule of thumb that assumed the increases in net government debt as a percent of GDP would rise no more than six times any net increase in spending. Thus, a steady 2% per GDP increase would translate into no more than a 12% of GDP increase in debt. This, in turn would drive debt up from 43% of GDP in the U.S. to nearly 70% in 2050. In Europe, it would rise from 57% to over 110%. For Japan, it would rise from 23% to 100% of GDP.

78

Brugiavini, Agar (1999). Social Security and Retirement in Italy, Editors: Gruber, Jonathan and David A. Wise, Social Security and Retirement Around the World. A National Bureau of Economic Research Conference Report. Chicago and London: University of Chicago Press, p. 222. 79 Roseveare, Deborah; Leibfritz, Willi, Fore, Douglas; and Wurzel, Eckhard, Ageing Populations, Pension Systems and Government Budgets: Simulations for 20 OECD Countries. Working Paper No. 168, Organization for Economic Cooperation and Development, Paris, 1996.

43 These 1998 OECD debt projections may be too optimistic because the authors started with GDP-per-capita levels that were unrealistically low. Net debt in 1998 was already considerably higher than the studys starting point, according to the OECD Economic Outlook of 1999. It reported that Japans 1998 net debt stood at 97% of GDP, while it was 74% of GDP for the European Union and 62% of GDP for the U.S. The 1999 book also contained estimates for 2000: Japan: 114% of GDP, European Union: 71% of GDP, U.S.: 57% of GDP. A back-of-the-envelope calculation80 starting with the OECDs 2000 estimate for net debt and adding a relative increase similar to that in the original OECD estimates, would put Japans net debt in 2050 under the long-term aging reference scenario in the OECD closer to 191% of GDP. This debt level would occur even under the debt limit rule in the OECD study. Net debt in the European Union would be 124% of GDP. In some countries that start with high debt levels, like Italy, could find their debt-to-GDP ratios higher than the Japanese levels. Declines in net debt in the next 10 years could, however, put countries in a better starting position. In the U.S. a back-of-the envelope calculation would push debt from an estimated 57% of GDP in 2000 to 84% of GDP.81 Canada could face considerable difficulty since it would be starting with an estimated 2000 debt level of 83%. If the effect in Canada is similar to that in the U.S., net debt could rise to 110% of GDP in 2050.82 The European Commission has also looked at potential increases in debt in a 1999 paper by McMorrow and Roeger. The authors include a debt rule in the baseline that is more ambitious than the debt rule used by the OECD in the study by Turner et al. The baseline assumes broad respect in the European Union for the Stability and Growth Pact. The EU's deficit at the general government level is assumed to disappear by 2003 and the debt- to-GDP ratio is expected to be around 60% in the same year and to stay at that level through 2050. The model imposes a debt rule of 60% on the EU, U.S. and Japan, which ensures that, once that level is achieved, it doesn't change very much over the simulation horizon.
83

The studys central aging scenario assumes that government outlays for pensions and health care for the elderly will rise dramatically as a percent of GDP (9 2.75 and 5.25 percentage points of GDP in Japan, the U.S. and the European Union).

80

This calculation is made by taking the number of percentage points added to the starting point in the OECD simulation and adding them to OECD estimated net debt for 2000 for Japan, the European Union and the U.S. 81 This is calculated using the OECD 2000 estimate of 57% of GDP in the U.S. and adding 27 percentage points, the gain for the U.S. in the reference scenario in Working Paper No. 193. 82 This is calculated using the OECD 2000 estimate of 83% of GDP in Canada and adding 27 percentage points, the gain for the U.S. in the reference scenario in Working Paper No. 193, which does not simulate numbers for Canada. 83 McMorrow, Kieran and Werner Roeger (1999), The Economic Consequences of Ageing Populations (A comparison of the E.U., U.S. and Japan). Economic Papers of the Directorate-General for Economic and Financial Affairs, No. 138. Brussels, Belgium: European Commission, November.

44 In an alternative scenario, the authors do a calculation of the impact of paying for these additional costs in the European Union with additional debt only. Using the estimates for government spending and slower growth rates from the central aging scenario, McMorrow and Roeger calculate the impact of higher deficits in the European Union. This scenario is for illustrative purposes only since such a full scale resorting to debt financing would quickly run into problems, the authors state.84

Chart 6. Debt and Interest Payment Impact of Non-Respect for Stability and Growth Pact in the European Union
250 Source: McMorrow and Roeger, p. 48. 200

% GDP

150 Debt Interest Payment 100

50

0
00 03 06 09 12 15 18 21 24 27 30 33 36 39 42 45 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 48

The authors calculate the effective interest rate of public debt for 2000 and extrapolate it forward to 2050. On a EU-wide basis they found that by 2050 nations spending on old age benefits would have a 7 percent impact on the primary balance (without debt service), driving it from a surplus of 3% to a deficit of 4% of GDP. In addition, interest payments would rise from around 4% of GDP to around 15% of GDP. Thus the total budget impact would be closer to 22% of GDP. This would send debt soaring by 148% of GDP to a level above 200%. By contrast the level in 2000 is estimated by the OECD at 69.9% for the European Union.85 The authors note that this simulation does not take into account any potential deterioration in economic growth from debt dynamics and to measure the gap between real interest rates and real growth rates. The note that it is conceivable [that] the fiscal situation will be further stretched by higher rates of interest on Government debt.86

84 85

McMorrow and Roeger, p. 48. Organization for Economic Cooperation and Development. OECD Economic Outlook, December 1999. 86 McMorrow and Roeger, p. 48.

45

Rising Debt Levels in One Country May Raise Real Interest Rates for All Countries It is clear from the OECD and EC studies that there will be considerable borrowing pressure on world saving. The OECD calculates, in fact, that a shortage of saving would push interest rates up modestly. A number of studies predict that saving will be lower than the assumptions in the OECD paper. If true, this would push up interest rates more significantly. Also, if nations are unable to maintain the fiscal discipline that both the OECD and the EC assume in their main scenarios, then there would be far more borrowing demand and, thus, the potential for higher interest rates. A 1990 simulation of the macroeconomic impact by population aging found that real interest rates would be 2% higher by 2025, a big rise with potentially harmful effects on equities. The study87 was done by two economists then in IMFs Research Department, Paul R. Masson and Ralph W. Tryon. They projected higher interest rates would be occurring at the same time that Schieber and Shoven predict downward pressure on equities from pension fund dissaving and could aggravate any negative effect on equities from that phenomenon. Holders of equity in the U.S. may also face higher real interest rates even if the U.S. manages to keep its deficits under control. Thats because capital markets are essentially global and demands for debt financing in Europe and Japan could raise real interest rates around the world. An 1999 IMF study88 of real interest rates done by Robert Ford and Douglas Laxton found that that historical data suggest that the ratio of debt and government spending within OECD countries to world GDP has a substantial effect on interest rates. Ford and Laxton evaluated rates on 12-month Euromarket certificates of deposit, as compiled by the Bank of International Settlements, deflated by national consumer price indices. They examined interest-rate data beginning in December 1977 and ending in December 1997. This provided a window on the impact of rising real interest rates over the two decades. They authors looked at real interest rate trends in nine countries with liberalized capital markets: Belgium, Canada, Denmark, Germany, the Netherlands, Japan, Switzerland, the United Kingdom and the United States. They found a positive correlation between the real interest rates in one country and the real interest rates in the other countries. And, they found that the real interest rate in all of the countries is highly correlated with the average real interest rate. Ford and Laxton plotted the relationship between real interest rates in each of the nine countries against two key variables: total OECD government net debt and total OECD government consumption (including investment). They found that a oneMasson, Paul R. and Ralph W. Tryon (1990), Macroeconomic effects of projected population aging in industrial countries. Staff Papers of the International Monetary Fund, 37: 453-85, September. Washington, D.C.: International Monetary Fund. 88 Ford, Robert and Douglas Laxton (1999). World Public Debt and Real Interest Rates, Oxford Review of Economic Policy, Vo. 15, No. 12, pp. 77-94.
87

46 percentage point increase in OECD-wide debt would raise real interest rates in the United Kingdom by 45 basis points,89 a statistically significant effect. The effect was also significant in all the major industrial nations in the sample: the U.S., 28 basis points, Germany, 23 basis points; Japan, 30 basis points; Switzerland, 26 basis points. The effect was not significant in Belgium (9 basis points), Denmark (13 basis points), and the Netherlands (7 basis points). The authors found the relationship between real interest rates and total government consumption to be even stronger than it was with government debt. And, it was significant for all nine countries. For the U.S., the effect of a one-percentage point increase in government consumption on real interest rates was 205 basis points, or more than a 2 percent increase. The greatest impact was felt in the United Kingdom (560 basis points), Germany (384 basis points), the Netherlands (322 basis points), and Japan (303 basis points). The impact on the other four countries was as follows: Belgium, 268 basis points; Canada, 180 basis points; Denmark; 196 basis points; Switzerland, 288 basis points. These results broadly support the hypothesis that world debt is an important determinant of national real interest rates. Ford and Laxton wrote. Moreover, the underlying logic of interest rate determination in integrated capital markets suggests that world debt and deficits may affect each countrys interest rate equally. Although our model does not rule out the possibility that national debt variables are also important, we find little evidence that they add much to the basis model once the aggregate debt variable is included in the regression [formula],90 they authors stated. The findings of Ford and Laxton underscore points made in the OECD paper by Turner et al: that coordinated efforts at debt reduction would go a long way to reducing the negative impact of population aging. A corollary of this would be that one very bad actor among the major world countries could harm all countries. Or, as Ford and Laxton state it: Any country that issues a significant amount of debt will tend to raise interest rates, and induce crowding-out worldwide.91 This unfortunately acts as an incentive for nations to issue debt, since the impact is disbursed across the world, the authors conclude. This observation provides a building block for increased international concern about the fiscal policies of each country, which would no longer have only, or even predominantly, domestic effects, Laxton and Ford conclude.92 Concerns about Japanese government debt are already part of the current landscape. In a recent opinion piece93 in the Financial Times of London, economist Rudiger Dornbusch of the Massachusetts Institute of Technology stated his case that Japans government is so overextended that a crisis is inevitable:
89

A basis point is one one-hundredth of a percent. Or, to put it another way, 100 basis points equals one percent. 90 Ford and Laxton, p. 85. 91 Ford and Laxton, pp. 92-93. 92 Ford and Laxton, p. 93. 93 Dornbusch, Rudiger (2000), A Rendezvous With Bankruptcy, Financial Times, December 15.

47

[T]he risks are in Japan, where balance sheets beyond repair create the potential for a world crisis. Japans public sector is essentially bankrupt. The government has a public sector debt well above 200 percent of gross domestic product if unfunded pension liabilities are included, as they should be. The budget deficit is in the range of 6 to 7 percent of GDP and there is no prospect of a significant reduction. Dornbusch cites a recent report by the Japan Center for Economic Research that states: Because of rapid ageing of the Japanese population, the public medical insurance system as well as the public pension system is likely to collapse in the near future. Dornbusch does not think Japan will adopt policies that might help it grow out of its debt problem. Higher taxes to balance the budget will not work either and has already been tried with unfortunate results. Even inflating the economy out of the problem seems impossible, he states, as it might provoke a depression because Japanese consumers would save even more for retirement. Dornbusch thinks Japan will rely repressed finance and capital controls to assure its debt is rolled over by Japans savers. Thus ends the hope of a world of open, deregulated and efficient capital markets, Dornbusch concludes. A crisis of the proportions that Dornbusch predicts in Japan will lead to depressed economic conditions in East Asia with higher interest rates world wide, pushing down growth everywhere and depressing equities.

Conclusion: Population Aging Will Likely Bring Hard Landings for Asset Markets Absent major reforms in the large industrial nations, it is difficult to escape the conclusion that population aging will bring turbulence and uncertainty to world financial markets. From any number of perspectives, respected pension experts and economists make a persuasive case there will be a downturn in the value of equity assets in the industrial nations some time after 2020. This effect could persist for decades. From the viewpoint of pension assets, the case is compelling. Defined benefit plans, which constitute the overwhelming bulk of pension assets, will begin to see major cash outflows after 2025. Six industrial nations the U.S., Japan, the United Kingdom, the Netherlands, Switzerland and Canada comprise presently 91% of all pension assets and will likely hold a large share of world assets in two decades, even with the advent of more and more defined contribution schemes around the globe. Thus, the pension cash flows in six nations will be a very large force on the integrated global financial markets of the future. From the viewpoint of economists, the case is strong, too. The life cycle of saving suggests that retirees will spend down their assets (as they must if they have saved primarily through a defined contribution plan) to sustain their living standards in retirement. Even if retirees hold on to their assets and spend them down more slowly than

48 they were built up that is, even if there is a bequest motive there will still be downward pressure on equity assets in the future. The effect may only be delayed, even if savings rise in anticipation of longer lives and a desire to leave something to ones heirs. Indeed, there is two-edged sword of Damocles that hangs over the equity markets. One edge of the sword is declining demand for assets. The other is rising demand for borrowed funds by financially-strapped governments. This will drive up world interest rates, especially in the industrial nations. This, in turn, will down the value of equities. The switch by pension funds from equities into bonds also poses dangers for future retirees. Just when they will be looking for the security of fixed-income returns, the demand for such returns could push down real returns. This could counter some of the run-up in interest rates that will come from heavy demand for government debt. It is hard to know how the conflict might play out. Will government bond returns remain high while other bonds move lower, closer to government levels? Or even make government bond yields higher than private bond yields in some cases. The higher-yield government bonds of some governments might offer some respite for retirees, as long as there was no fear of default on foreign bonds or the prospect their value might sharply fall. Returns for U.S. government bonds might remain low in a flight to quality, especially if the U.S. adopts significant Social Security reforms. Some argue that the decline in demand for equities may be less harmful than it might appear on first blush. Lower equity prices due to falling demand could make the issuance of equities more expensive for corporations. As a result, business firms might rely more on corporate bonds and less on equity. This would reduce the volume of new equity issues. Thus, there might be less supply of equities to balance the reduced demand for equities. A benevolent outcome -- where equity supply adjusts to falling demand to keep equity values stable -- faces some obstacles. The downward pressures on equities are coming from several sources: liquidation of assets to pay pension outflows, the switch of more assets in pension fund portfolios from equities to bonds, the effect of higher interest rates on equities, and the declining economic growth rates. In addition, individuals will also be switching from equities to bonds and those whose entire retirement saving is through defined contribution plans, will be liquidating to buy annuities or pay for current consumption. The adjustment of supply to demand might, then, not be sufficient to prevent prices from falling. It may, for example, only keep prices steady. There is also another argument, not developed in the body of this paper, that societies may accept a lower expected risk premium in the future and that would, in and of itself, sustain equity prices at a higher level than most forecasters suggest. This is a view that needs further consideration. Expectations that the developing world can play a big role in providing demand for assets may prove elusive. Many of these nations now limit overseas investment opportunities and theres no prospect that this will change significantly. For example,

49 Mexicos private Social Security accounts are 100% invested in Mexican government bonds. Also, saving rates are expected to fall in East Asia and Southeast Asia, the one area where many policy makers are hoping high saving rates will help the world prevent a shortage of saving. Even developed Japan, with its high saving rate, might be forced to limit foreign investments to mitigate its own financial problems. All this is to say nothing of potential crises that could erupt if nations default on their government bond or if investor confidence collapses. The events of August and September 1998 may become more, not less common. The long decline in demand for equity markets could also lead to a crash rather a slow decline or a long stagnation. There are ways to mitigate the potential for hard landings, but the task of enacting these policies will be difficult. It would take ambitious reform programs in the largest industrial nations with the most troubled fiscal and economic outlook. The reforms should include the introduction and/or expansion of funded pensions schemes, whether they are supplementary pensions authorized under Social Security reform, or employersponsored funded pension plans. New funded schemes in developing nations could also help. Reforms that promote supplementary funded pensions in Germany, France and Italy would provide new demand for equities. Germany is, in fact, near to passing legislation for voluntary supplementary pensions that will probably be nearly universally adopted by workers. Italy has a supplementary pension system, but it needs more incentives for workers to take part in it. France faces strong political opposition to funded private retirement plans. New employer-sponsored defined benefit plans in Germany, Italy, and France would also provide a big boost to equity markets, as would the expansion of employerprovided pension systems in the U.S., the United Kingdom, the Netherlands, Switzerland and Japan. The potential of individual Social Security retirement accounts in the U.S. has been boosted by the election of George W. Bush to the Presidency. Even here, there are considerable political obstacles to overcome before it can be enacted. The potential impact of funded individual Social Security accounts will be modest at first, since only workers 40 or younger are likely to be allowed to voluntarily divert up to 2% of their payroll into private accounts. Yet, in time, this could generate large levels of demand for new investments that it could help offset much of the decline in the demand that is expected from demographic changes. This new demand for equities could be gathering critical mass by the 2020s when it will be needed the most. Finally, on the plus side, as the need for pension becomes more evident, the political support for them will likely rise to the point that reform is possible even where it is facing serious political difficulty now. And, while the adjustment may be more abrupt as a result of delay, the adjustment will of necessity have to take place.

50

BIBLIOGRAPHY

Abel, Andrew B. (1999), The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security, Mimeo, October. Abel, Andrew B. (2000), Will Bequests Attenuate the Predicted Meltdown in Stock Prices When Baby Boomers Retire? Mimeo, March. Ameriks, John and Stephen P. Zeldes (2000), How Do Household Portfolio Shares Vary With Age? Mimeo, February. Bakshi, Gurdip S. and Zhiwu Chen (1994), Baby Boom, Population Aging, and Capital Markets, Journal of Business, Vol. 67, No. 2, pp. 165-202 Brooks, Robin J. (1999), What Will Happen to Financial Markets When Baby Boomers Retire? Federal Reserve Board of Governors. Mimeo. Brooks, Robin J. (2000), Life Cycle Portfolio Choice and Asset Market Effects of the Baby Boom. Mimeo, September. Brown, Kyle N., Gordon P. Goodfellow, Tomeka Hill, Richard R. Joss, Richard Luss, Lex Miller and Sylvester J. Schieber (2000), The Unfolding of a Predictable Surprise. Washington, D.C.: Watson Wyatt Worldwide. This report is available at the following website: http://www.watsonwyatt.com. Brugiavini, Agar (1999), Social Security and Retirement in Italy, Editors: Gruber, Jonathan and David A. Wise, Social Security and Retirement Around the World. A National Bureau of Economic Research Conference Report. Chicago and London: University of Chicago Press, p. 222. Dornbusch, Rudiger (2000), A Rendezvous With Bankruptcy, Financial Times, December 15. England, Robert Stowe (2001a), The Fiscal Challenge of an Aging Industrial World. Forthcoming white paper of the Global Aging Initiative of the Center for Strategic and International Studies, Washington, D.C., January. England, Robert Stowe (2001b), A New Era of Economic Frailty? Companion White Paper of the Global Aging Initiative of the Center for Strategic and International Studies, Washington, D.C., January. Ford, Robert and Douglas Laxton (1999), World Public Debt and Real Interest Rates, Oxford Review of Economic Policy, Vo. 15, No. 12.

51 Griffin, Mark (1997), The Global Pension Time Bomb and Its Capital Market Impact. New York: Goldman Sachs Global Research Center, May 28. Hale, David (1998), Has Americas Equity Market Boom Just Begun, Or How the Rise of Pension Funds Will Change the Global Economy in the 21st Century. Mimeo. Harris, David O. (1998), Bold Steps: Australia and Other International Examples of Social Security Reform. Heritage Foundations Lectures Series, No. 616, May 27. Heaton, John and Deborah Lucas (2000), Portfolio Choice in the Presence of Background Risk, The Economic Journal 110: 1-26. Ibbotson Associates (1998), Stocks, Bonds, Bills, and Inflation: 1998 Yearbook. Chicago: Ibbotson Associates. Investment Company Institute (2000). Mutual Funds and the Retirement Market, Fundamentals, Vol. 9, No. 2, May. Washington, D.C> Investment Company Institute. Mankiw, N. Gregory and David N. Weil (1989), The Baby Boom, the Baby Bust and the Housing Market, Regional Science and Urban Economics 19, pp. 235-258. Mantel, Jan (2000), Demographics and the Funded Pension System. London: Merrill Lynch & Co. Global Securities Research and Economics Group. Masson, Paul R. and Ralph W. Tryon (1990), Macroeconomic effects of projected population aging in industrial countries. Staff Papers of the International Monetary Fund, 37: 453-85, September. Washington, D.C.: International Monetary Fund. McMorrow, Kieran and Werner Roeger (1999), The Economic Consequences of Ageing Populations (A comparison of the E.U., U.S. and Japan). Economic Papers of the Directorate-General for Economic and Financial Affairs, No. 138. Brussels, Belgium: European Commission, November. Organization for Cooperation and Development (1999), OECD Economic Outlook, No. 66, December 1999. Paris: OECD Passell, Peter (1996), The Year is 2010. Do You Know Where Your Bull Is? Sunday New York Times, March 10. Poterba, James M. (2000), Demographic Structure and Asset Returns. Delivered as a Review of Economics and Statistics lecture at Harvard University, March. Poterba, James M. and Andrew A. Samwick (1997). Household Portfolio Allocation Over the Life Cycle. Working Paper No. W6185. Cambridge, Mass.: National Bureau of Economic Research.

52 Ranson, R. David and William G. Shipman (1981), Institutional Buying Power and the Stock Market. Financial Analysts Journal, September-October, pp. 62-68. Rodrquez, L. Jacobo (1999), Chiles Private Pension System at 18: Its Current State and Future Challenges. Project on Social Security Privatization, Brief No. 17, Washington, D.C. Cato Institute, July 30. Roseveare, Deborah; Leibfritz, Willi, Fore, Douglas; and Wurzel, Eckhard (1996), Ageing Populations, Pension Systems and Government Budgets: Simulations for 20 OECD Countries. Working Paper No. 168, Organization for Economic Cooperation and Development, Paris. Schieber, Sylvester J. and John B. Shoven (1994), The Consequences of Population Aging on Private Pension Fund Saving and Asset Markets. National Bureau of Economic Research, Working Paper No. 4665. Cambridge: National Bureau of Economic Research. Schieber, Sylvester J. and John B. Shoven (1997), The Aging of the Baby Boom Generation: The Impact on Private Pensions, National Saving and Financial Markets. Mimeo Siegel, Jeremy (1998), Stocks for the Long Run. Second Edition. New York: McGrawHill. Swan, Craig (1995), Demography and the Demand for Housing. A Reinterpretation of the Mankiw-Weil Demand Variable, Regional Science and Urban Economics 25 (1995), pp. 41-58. Turner, Dave, Claudio Giorno, Alain DeSerres, Ann Vourch and Peter Richardson (1996), The Macroeconomic Implications of Ageing in a Global Context. Economics Department Working Paper No. 193. Paris: Organization for Economic Cooperation and Development. United Nations (1999), World Population Prospects: The 1998 Revision. New York, United Nations Secretariats Population Division. Yoo, Peter S (1994), Age Dependent Portfolio Selection, Federal Reserve Bank of St. Louis Working Paper 94-003A.