Glenn Stevens: Finance and the ageing population
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the Financial
Planning Association of Australia Limited, Gold Coast, Australia, 16 November 2005.
* * *
There has been much talk about the phenomenon of population ageing in recent years. Some of the
figures, on their face, are stark. As a result of declining fertility, and rising longevity, the median age of
the world's population is increasing by about three months each year.1 In Australia, whereas today
there are about five people of 'working age' for every person over 65 years, by mid century there will
be just over two, according to ABS population projections.2 Assuming all other things unchanged, that
implies a substantial impact on the rate of growth of per capita national income, and on the proportion
of national income required to sustain the non-working part of the population. That, in turn, would raise
thorny issues of income distribution and require careful management of the policies which affect that
distribution.
Whether such an assumption - that all other things remain unchanged - should be made is another
thing altogether. Indeed, if we know anything about economic behaviour at all, it is that everything else
won't remain constant in the face of such profound changes in society's age structure (forecasts of
which, themselves, assume that recent fertility rates persist, even though we know that fertility rates
have varied a lot, in both directions, in the past eighty years). Individuals, markets and economies will
adjust to these changes. I would like to explore some of the possible adjustment issues today.
Much of the discussion of the ageing issue to date in Australia has been about the impact on
government budgets (a lot of which seems to come via the health system, rather than solely through
age-specific payments per se). Those matters are important, but surely there will be counterpart
issues for private financial markets. In addressing a group of financial planners, it would seem
appropriate at least to pose some of those questions, even if we cannot provide many of the answers.
What is ageing and why does it occur?
In popular discussion we often hear about the ageing 'baby boomers'. This generation - those born
between 1946 and about 1965 - is getting close to retirement. Indeed, some members of the leading
edge of this cohort have presumably started retirement over the past few years, and many more will
be thinking about it in the next few years. There has been considerable speculation about the impact
that this may have had, and prospectively might have, on asset market prices and returns. Some
commentators have attributed the share market boom in many countries in the late 1990s to the
efforts of 'boomers' to accumulate assets in their high-income, immediate pre-retirement working
years.3 There is a corresponding concern in some quarters that, as boomers move through their older
years, they will sell assets to facilitate consumption, leading to a slump in asset values.
There are a few problems with that story, not least of which is that saving rates have tended to fall,
rather than rise, in the past decade at the time when boomers were supposed to be seeking rapidly to
build their net worth.4 But there is no doubt that the baby boom is an important demographic
phenomenon. It was the result of a surge in fertility rates during and after the Second World War, after
a slump which had started in the early 1920s and extended until the mid 1930s. Baby boomer women
themselves, on the other hand, had lower fertility rates than their mothers, so that the succeeding
generation, the children of the boomers, is relatively smaller. Thus the boomers are disproportionately
large in the age distribution compared with both the previous and succeeding generations, and as they
age, all other things equal, the median age of society rises.
But it is worth noting that there would be ageing even if the baby boom had never occurred. Declining
fertility is a long-term trend observed in all countries as part of the 'demographic transition'. Indeed,
maybe the baby boom is best seen as a temporary departure from the long-term trend decline in
fertility, in which case it actually put off ageing by a generation or so.
Furthermore, aside from the influence of declining fertility, increasing longevity contributes to ageing of
the population. Importantly for financial markets and planners, life expectancy has continued to
increase, presumably due to numerous factors including advances in medicine and nutrition, and
healthier lifestyles (e.g. a large decline in smoking).
So ageing is not just about the baby boomers, as prominent a cohort as they (or we) are. The effects
of the baby boomers are superimposed on a longer, more profound, trend, and they will eventually
pass (though, admittedly, that is still some time off). The more far-reaching and long-lasting economic
effects of ageing will come about more from the effects of longevity and declining fertility than from
'boomer' effects.
Why should individuals care about ageing?
Insofar as ageing occurs because of increased longevity, it's hard to see it as a bad thing. Unless
increased longevity is of the type that involves an elongated period of being seriously unwell before
death, and there is no evidence that that is the case, it is surely a good thing. People can look forward
to being productive at things they enjoy, to consuming goods and services, and to enjoying the
non-pecuniary 'goods' of life for longer.
The problem comes about simply because people have to make decisions with significant long-run
consequences at various points in their life. They make decisions about saving and asset allocation
through their lives. And, of course, one of the biggest decisions is when to retire from the workforce. If
this decision is more or less irreversible, then the individual has to ask: have I got enough assets to
last me until I die?
Rising life expectancy undermines the assumptions typically made in this area. Since the mid 1970s,
life expectancy at age 65 has risen by about four years, to about 83 for men and 86 for women. Quite
possibly it will keep edging up at that rate.
Consider then someone who is today about 50 years of age, and intends retiring a decade from now.
By retirement, they will probably face a world in which they can expect to live five or six years longer
than they would have anticipated (had they thought about it) when they started work in the mid to late
1970s. Which means, if they were planning to provide for their own retirement needs out of
accumulated savings, based on assumptions made earlier in their lives, they quite possibly will find
that they won't have enough. The fact that most of us didn't think about this when we started work, of
course, won't help matters.
This is a complex area, and I am conscious that all of you in this room have far greater technical
expertise than I in the actuarial intricacies of retirement income sufficiency. But if we imagine an
individual with an expected forty-year working life, and a plan to accumulate enough assets to provide
a reasonable fraction of pre-retirement income after they retire, with plausible assumed saving rates
and asset returns, we can ask what effect a rise in life expectancy of, say, five years would have on
the calculations for asset sufficiency. Roughly speaking, there would need to be a rise in the saving
rate of several percentage points of income through their whole working life. Alternatively, asset
returns would need to be perhaps 50 to 75 basis points higher, risk adjusted, through their whole
working life. A third possibility is that our representative person could simply accept a lower retirement
income. Finally, he or she could decide to retire later than originally planned, so accumulating more
assets and shortening the draw-down period. Some combination of these possibilities could also be
adopted, of course.
These sums are arrived at in a hypothetical, modelled situation for the representative individual. But in
practice, for many people, by the time they realise that they will have a problem of insufficient assets,
it is quite likely to be late in their asset accumulation phase. So they can't save a few extra percentage
points of income over their whole life; they would have to save a great deal more over a short period
towards the end of their working life. Nor will extra yield equivalent to half a percentage point or more
every year for forty years be easy to find, at least without taking much more risk (wherein lies a major
issue). It would be even harder to find if everyone is simultaneously attempting to save more since
rates of return would be bid down. Equally, most people would find the prospect of noticeably lower
post-retirement income hard to accept.
So, in the end, my guess is that while people will adjust their saving behaviour to some extent, and
this will have an effect on financial markets, a large part of the adjustment to the recognition of
increasing life expectancy will ultimately need to take the form of prolonging working lives. The
existence of the old-age pension, on which people can fall back if their own funds are inadequate,
naturally complicates the analysis. Even so, one way or another, surely increasing longevity means we
will have to get used to the idea of retiring later than we might once have done. In fact, the rule of
thumb is likely to be that the proportion of total expected life spent working will need to be roughly
constant, as life expectancy increases.
People will start to make that adjustment naturally. I think it is probably already beginning. Presumably
a role for public policy is to foster the adjustment, by making sure that the retirement income system
does not inadvertently offer incentives in the opposite direction. That is a big topic, and would take me
outside my usual area of expertise. So I shall turn instead to some of the implications of ageing for
financial markets.
Why should financial markets care about ageing?
We have established that, for individuals, ageing in the form simply of living longer means that earlier
notions of retirement age and asset sufficiency will be revisited. We need then to think about the
various effects on financial markets. For as individuals seek to adjust their own behaviour, including
through saving, investment and work/retirement decisions, there will surely be effects on market
pricing and structure.
In a world in which people live longer and enjoy longer retirement, they will need to build a higher
stock of savings with which to retire. For a given length of working life (an assumption to be relaxed in
a moment), this would require a higher rate of saving in each of their working years, and lower annual
consumption every year of their life. The total size of accumulated assets would be higher in every
year of life than would be the case with shorter life-spans. The amount of savings to be invested in the
economy would be higher.
The question would then arise: how would the additional capital which becomes available be
deployed, and by whom? And what price changes are required to induce them to do so?
Businesses may be inclined to adopt a more capital-intensive production technology if the availability
of labour diminishes relative to capital as the population ages. But economics teaches that this shift in
the capital-labour ratio would be associated with a higher real wage, relative to the return on capital.
This stands to reason: if the situation is one of an impending relative scarcity of workers and a relative
abundance for saving looking for a use, then the relative prices of the two factors of production would
alter accordingly. So overall, this sounds like a scenario in which long-run returns to capital are lower
(perhaps after an adjustment period in which the bidding down of yields produces a rise in asset
values).
Two things potentially moderate that tendency. First, the length of working life is not fixed and as I
noted above, it seems likely that people will tend to delay their retirement. The mooted relative price
change between capital and labour would reinforce that tendency by changing the incentives between
work and retirement, in the direction of it being more rewarding to make the adjustment partly in the
form of a longer working life, rather than entirely in the form of higher saving.
Second, in a globalised world, 'surplus' capital arising from higher saving in any given country might,
instead of simply lowering returns at home, flow abroad with little impact on home rates of return.
One general prediction is that capital will flow from 'old' societies to 'young' ones, though it is actually
more complex than that. Most societies are ageing; it is the different rates of ageing, and the different
positions in the 'demographic transition', which would drive the potential capital flows. The 'older'
societies are now seeing a decline in the share of their populations which is of working age, but some
other countries, such as India and some other countries in Asia, will see a rise in this share for some
time yet even though they too are ageing. This so called 'demographic dividend' arises now because
their fertility rates declined more recently than in the developed western countries. In such countries,
investment rates will presumably need to be relatively higher, in order to provide the capital for the
larger workforce to work with. So one might expect capital to flow towards them from countries which
are more 'advanced' in the ageing process.5
One might have expected this to mean capital would flow into many developing countries in Asia. Over
recent years, as it turns out, the reverse has been occurring. National investment rates fell in many
countries in Asia after the financial crisis in 1997-98, and have not recovered much as yet. So
'surplus' saving in Asia has been flowing out of the region, towards the developed world.
This reminds us that financial flows are responsive to a great many forces; demography is only one of
them. Perhaps it is not surprising, then, that attempts to distil empirically the effects of changing
demographic structure on asset prices and returns in the past have had mixed results. Some studies
do find a significant relationship but others don't. Even in studies where demographic effects are
statistically significant, the amount of variation in asset prices and returns that is explained by
demographic factors is often small relative to the total degree of variation in those things. It would
seem that, given our present state of knowledge at least, the cycle of euphoria and gloom still does
much of the work in driving asset prices and returns.
For that reason alone, not to mention the complexity of demographic effects themselves, any
hypothesis about how ageing will affect financial prices shouldn't be held dogmatically. Added to that
is the fact that the long-run state we are imagining is a long time away - assuming we ever get there.
The transition towards it will have its own complications, not least because many people will only
gradually recognise the implications of increasing longevity, and accordingly will adjust their behaviour
only slowly. Nonetheless, a reasonable working hypothesis for the moment, in my judgement, is that
we would expect to observe a tendency toward higher rates of saving, lower returns and longer
working lives.6
Moving from these general points to more specific concerns of financial markets and institutions, a
major issue exists in managing longevity risk for providers of defined-benefit pension plans. Such
providers, of course, have an obligation to provide a stream of payments to pensioners for the
remainder of their lives after retirement. If those lives turn out to be longer than expected, the pension
plans will be under-funded.
In some countries (not Australia), funding of defined-benefit obligations is turning out to be a major
issue for household-name companies who carry the legacy costs of a large number of former
employees with pension and other entitlements. Only a small part of these problems seems to be due
to people living longer - mainly they reflect a period of less-than-expected returns and funding
holidays taken by businesses. Nonetheless, they are a picture of the sorts of problems that could arise
more frequently in an ageing scenario. A public policy question which we could expect to emerge in
these countries is the extent to which shareholders of the companies in question will be able to shift
these obligations on to their country's taxpayers, or indeed the pensioners themselves.
But even if adequate funding is available, with the longer duration of obligations, the question is
whether there are sufficient long-duration assets to hold. These factors can affect financial markets.
Regulations requiring closer matching of duration in some countries in Europe have been nominated
as one factor (though far from the only one) behind apparently strong demand for long-dated
government securities in global markets. Some European governments have recently issued very
long-dated securities - up to 50-year maturities - to tap this demand. There are also proposals to
create 'longevity bonds' to help pension providers manage longevity risk. A more daring idea still is
that of a swap of exposures between pension funds and those industries which might expect to profit
from longer life-spans.
In Australia, there are relatively few defined-benefit plans these days; the growing pool of
superannuation assets is predominantly of an accumulation type. Hence, these issues of funding
adequacy and long-duration asset availability do not arise to quite the same extent for our
superannuation funds. The risk that a retirement plan might be under-funded has been transferred to
the retiree.
Nonetheless, there is presumably a qualitatively similar, if quantitatively less pressing, issue on
duration once people get to retirement, if we assume that it is desirable for them to purchase an
income stream. Increasing longevity still presumably implies a requirement for assets of an
appropriately longer duration to support these sorts of products; the question will be at what price they
can be acquired.
In fact as a general proposition, completeness in the set of financial markets and instruments is likely
to be important in managing the various issues associated with ageing. Instruments which facilitate the
transformation of assets into long-run income streams will presumably be increasingly needed. It is to
our advantage, therefore, that Australia's financial market participants are at the dynamic and
innovative end of the spectrum when it comes to creating and adopting new instruments, and we can
expect them to respond well to the changing needs of the population. Along with that will come, of
course, all the associated issues of pricing and risk, and the requirement for user education.
Financial planners and ageing
What then are we to say to financial planners about the implications of ageing for their work?
It is obvious that as people come to terms with all the issues around ageing, they will focus
increasingly on their saving, investment and retirement decisions. So there will be no shortage of
demand for the services of good financial planners. But because the issues are of such importance,
the performance of the financial planing industry will surely be subject to heightened scrutiny.
It is not for me to prescribe how you should respond to these challenges. The Reserve Bank certainly
has no regulatory power over, or supervisory responsibility for, the financial planning industry. Let me
simply offer two broad observations.
The first is that while financial planners have much to offer their clients in the form of advice on asset
allocation and tax management, it still seems to me that probably about the biggest decision most of
your clients are going to make is when to retire. I grant that for more than a few who have retired over
the past two decades, the decision was not entirely voluntary. But I suspect that many people have
been content to take early retirement, because they held an optimistic - probably too optimistic - set
of assumptions about the future earning potential of their assets. They may well also have
underestimated longevity. It gradually will be dawning on people that in a world of lower yields on most
assets and increasing longevity, they are going to have to work hard at making their assets last - or,
simply, work in the more normal sense of that word.
Retirement ages will tend naturally to rise in the future as people realise that they need more
resources for their lengthening lives. Financial planners can probably assist that natural, and
inevitable, development by giving appropriate advice. As time goes by, I think that we will see a world
in which later retirement is more feasible than it might have been in the past, because the
demographic changes occurring themselves mean that an excess supply of labour, common from
1970 to 2000, will more than likely give way to excess demand for labour in the future. Surely firms are
going to find it to their advantage to keep their older employees, and will need to offer effective
inducements to them in order to do so. So while people will need to be productive for longer in order to
adjust to longer life expectancy, it will hopefully be not only more feasible, but also more rewarding, for
them to expend their energies in that fashion.
Second, because increasing longevity will likely mean an ever-increasing focus on the adequacy of
assets, rates of return (and, one trusts, risk), it surely follows that there will also be more attention paid
to the fee structure of the service providers in the funds management and advising businesses. For
fund managers, the era of high nominal yields on many assets disguised the fee structure - just as
high inflation distorted a great many price signals in the economy. When yields are lower, and people
have a keener appreciation of the importance of the earnings on their savings, fees are more visible.
Those offering advice, who usually (and rightly) point out to people the power of compound interest,
will surely see people concerned about that power being weakened through a long flow of
commissions. One can easily imagine the fees for financial advice and managing funds being of more
community interest than the fees on bank accounts. This will be a challenge for the industry.
Conclusion
The phenomenon of ageing is one of the key long-run developments our society faces. To the extent
that it reflects greater longevity, there is no reason to fear it (though of course declining fertility, if it
proceeded far enough, would bring much bigger concerns). We simply need to adjust to it. To date
much discussion has, understandably, been focussed on the impacts on government finances. As
important as they are, participants in private financial markets should also take an interest. Financial
arrangements will be able to adapt to the needs of an ageing population, I expect, but they will adapt
more smoothly if we have some realistic discussion of the issues.
I am sure that this will provide business opportunities of one form or another for the more alert and
innovative market participants, including in the financial planning industry. I wish you well in your
deliberations here today, and in your future efforts to serve the community.