Baby Boom Generation: Retirement of Baby Boomers Is Unlikely to Precipitate Dramatic Decline in Market Returns, but Broader Risks Threaten Retirement Security
Published: 2006-07-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The first wave of baby boomers(born between 1946 and 1964) will become eligible for Social Security early retirement benefits in 2008. In addition to concerns about how the boomers' retirement will strain the nation's retirement and health systems, concerns also have been raised about the possibility for boomers to sell off large amounts of financial assets in retirement, with relatively fewer younger U.S. workers available to purchase these assets. Some have suggested that such a sell-off could precipitate a market "meltdown," a sharp and sudden decline in asset prices, or reduce long-term rates of return. In view of such concerns, we have examined (1) whether the retirement of the baby boomers is likely to precipitate a dramatic drop in financial asset prices; (2) what researchers and financial industry participants expect the effect of the boomer retirement to have on financial markets; and (3) what role rates of return will play in providing retirement income in the future. We have prepared this report under the Comptroller General's authority to conduct evaluations on his own initiative as part of the continued effort to assist Congress in addressing these issues.
section_title: What GAO Found
paragraphs: Our analysis of national survey and other data suggests that retiring boomers are not likely to sell financial assets in such a way as to cause a sharp and sudden decline in financial asset prices. A large majority of boomers have few financial assets to sell. The small minority who own most assets held by this generation will likely need to sell few assets in retirement. Also, most current retirees spend down their assets slowly, with many continuing to accumulate assets. If boomers behave the same way, a rapid and large sell off of financial assets appears unlikely. Other factors that may reduce the odds of a sharp and sudden drop in asset prices include the increase in life expectancy that will spread asset sales over a longer period and the expectation of many boomers to work past traditional retirement ages. A wide range of academic studies have predicted that the boomers' retirement will have a small negative effect, if any, on rates of return on assets. Similarly, financial industry representatives did not expect the boomers' retirement to have a big impact on the financial markets, in part because of the globalization of the markets. Our statistical analysis shows that macroeconomic and financial factors, such as dividends and industrial production, explained much more of the variation in stock returns from 1948 to 2004 than did shifts in the U.S. population's age structure, suggesting that demographics may have a small effect on stock returns relative to the broader economy. While the boomers' retirement is not likely to cause a sharp and sudden decline in asset prices, the retirement security of boomers and others will likely depend more on individual savings and returns on such savings. This is due, in part, to the decline in traditional pensions that provide guaranteed retirement income and the rise in account-based defined contribution plans. Also, fiscal uncertainties surrounding Social Security and rising health care costs will ultimately place more personal responsibility for retirement saving on individuals. Given the need for individuals to save and manage their savings, financial literacy will play an important role in helping boomers and future generations achieve a secure retirement.

section_title: Letter
paragraphs: The aging of the U.S. population is expected to present great fiscal and  economic challenges in the decades ahead. The first wave of the baby  boom generation, the 78 million Americans born between 1946 and 1964  and alive as of 2005, will turn age 62 and become eligible for Social  Security benefits beginning in 2008. The retirement of the relatively large  baby boom generation, combined with other demographic trends, is  expected to strain the nation’s retirement and health systems. This  impending event has also raised concerns about the potential market  effect should baby boomers sell off large amounts of financial assets in  retirement. If proportionally fewer workers are available to buy these  assets, some market observers fear that the increase in supply of stocks,  bonds, and other financial assets relative to demand may place downward  pressure on asset prices. At the extreme, some observers have raised the  possibility of a market “meltdown,” a sharp decline in stock or other asset  prices, precipitated by the baby boom retirement. In contrast, others have  noted that such an outcome could be mitigated by a rising demand for U.S.  financial assets from developing countries and by immigration.
Returns on investment are important in helping many Americans  accumulate sufficient savings throughout their working lives to meet their  retirement needs. From 1946 to 2004, U.S. stocks have returned an average  of 8.0 percent annually, adjusted for inflation. From 1986 to 2004, U.S. 10- year Treasury notes have yielded an annual average of 3.4 percent,  adjusted for inflation. Importantly, returns on financial assets provide  retirement income for many Americans, accounting for 12.6 percent of  total income for Americans age 65 and over in 2004, and over half of this  cohort received some income from financial assets. If the baby boom  retirement were to reduce asset returns, retirees would generate less  income from investments and workers would have more trouble saving  adequately for retirement.
In view of such concerns, we have examined (1) whether the retirement of  the baby boom generation is likely to precipitate a dramatic drop in  financial asset prices; (2) what researchers and financial industry experts  expect the effect of the baby boom retirement to have on the financial  markets, and (3) what role rates of return will play in providing retirement  income in the future. We have prepared this report under the Comptroller  General’s authority to conduct  evaluations on his own initiative as part of  a continued effort  to assist Congress in addressing these issues.
To analyze whether the retirement of the baby boom generation is likely to  precipitate a dramatic drop in financial asset prices, we examined  financial information from the Survey of Consumer Finances (SCF) to  determine what financial assets are held by baby boomers and the Health  and Retirement Study (HRS) to determine how current retirees spend  down their assets. To identify the views of researchers and outside  experts on the financial effects of the baby boom retirement, we reviewed  simulation-based and empirical studies analyzing the baby boom  generation’s impact on financial markets and interviewed financial and  public policy experts from mutual fund companies, pension funds, life  insurance companies, broker-dealers, financial planning organizations, and  financial industry trade associations. We also conducted our own  econometric analysis of the historical importance of demographics on  financial asset returns. To assess the role rates of return will play in  providing retirement income, we reviewed past GAO reports, academic  literature, and obtained insights from interviews with outside experts. We  conducted our work between August 2005 and June 2006 in accordance  with generally accepted government auditing standards. A more extensive  discussion of our scope and methodology appears in appendix I.
subsections: section_title: Background
paragraphs: In the 21st century, older Americans are expected to comprise a larger  share of the population, live longer, and spend more years in retirement  than previous generations. The share of the U.S. population age 65 and  older is projected to increase from 12.4 percent in 2000 to 19.6 percent in  2030 and continue to grow through 2050. At the same time, life expectancy  is increasing. By 2020, men and women reaching age 65 are expected to  live another 17 or 20 years, respectively. Finally, falling fertility rates are  contributing to the increasing share of the elderly population. In the 1960s,  the fertility rate was an average of three children per woman. Since the  1970s, the fertility rate has hovered around two children per woman,  meaning relatively fewer future workers are being born to replace retirees.  The combination of these trends is expected to significantly increase the  elderly dependency ratio—the number of people age 65 and over in  relation to the number of people age 15 to 64. In 1950, there was 1 person  age 65 or over for every 8 people age 15 to 64. By 2000, the elderly  dependency ratio had risen to 1 person age 65 for every 5 people of  traditional working age, and by 2050 this ratio is projected to rise further  to about 1 elderly to every 3 working age people (see fig. 1).  Consequently, relatively fewer workers will be supporting those receiving  Social Security and Medicare benefits, which play an important role in  helping older Americans meet their retirement needs.
By causing a large shift in the U.S. population’s age structure, some have  suggested that the baby boom generation may affect stock and other asset  markets when this cohort retires. This concern stems from hypothetical  spending and saving patterns over people’s lifetimes, which economists  describe in the “life cycle” model. The model hypothesizes that people  attempt to smooth their consumption over their lifetime. As individuals’  earnings typically grow over their working life, this suggests that younger  workers, with relatively low earnings, may save relatively little or borrow  to finance current consumption (or to buy a house); older workers may  save significantly more in preparation for retirement; and retirees may  spend down their savings. The model therefore predicts that the saving  rate is hump-shaped over an individual’s lifetime.
Over the course of their lives, individuals make decisions about not only  how much to save but also how to distribute their savings among a mix of  assets, such as stocks, bonds, real estate, and bank accounts. For example,  older workers are expected to shift their portfolios toward less volatile  assets, such as bonds or cash accounts, because they will tend to prefer  assets with a more predictable flow of income since they will have less  time to weather potential price declines in riskier assets such as stocks.
In addition to their saving and consumption patterns, baby boomers also  may affect stock returns in particular through broader macroeconomic  channels. Stocks represent claims on the profits earned by firms, and in  the long run the returns on these assets should reflect the productivity of  the firms’ capital. Generally, economic theory states that capital becomes  more productive with more and better quality labor to use that capital.  Because the baby boom retirement is expected to reduce the growth rate  of the U.S. labor supply, it may reduce returns to capital, which could  reduce the returns to stocks. More generally, investors may price stocks in  relation to the underlying value of the firm, taking into account the value  of firm’s current assets and stream of future profits.
section_title: Financial Evidence from Baby Boomers and Current Retirees Does Not Suggest a Sharp Decline in Asset Prices
paragraphs: Our analysis of national survey data indicates that the baby boom  generation is not likely to precipitate a sharp and sudden decline in  financial asset prices as they retire. Our analysis of the 2004 SCF shows  that just 10 percent of boomers own more than two-thirds of this  generation’s financial assets, excluding assets held indirectly in DB  pensions.  These wealthiest boomers may be able to support themselves  on the income from these investments without spending them down  significantly. About one-third of all boomers do not own any stocks,  bonds, mutual funds, or retirement accounts. As with the prior generation,  baby boomers may continue to accumulate financial assets in retirement  and liquidate their assets only gradually with the hope of leaving bequests.  The gradual entry of the boomers over a 19-year period into retirement  should further reduce the likelihood of a sudden decline in asset prices.  Further, boomers have indicated that they plan to retire later than  generations that retired in the recent past, with almost half not planning to  leave full-time employment until age 65 or later. Many may also continue  to work throughout retirement, reducing or delaying their need to sell  financial assets.   Housing represents a greater share of total wealth for  most baby boomers than do financial assets, and therefore the housing  markets present more financial risk to most boomers than the financial  markets.
subsections: section_title: Concentration of Financial Assets among a Minority of Baby Boomers May Lessen Their Market Effect
paragraphs: The potential for the baby boom generation to precipitate a market  meltdown in retirement may be substantially reduced by the fact that a  small minority of this population holds the majority of the generation’s  financial assets.  According to our analysis of the 2004 SCF, the wealthiest  10 percent of boomers owned over two-thirds of the approximately $7.6  trillion held by boomers in stocks, bonds, mutual funds, Individual  Retirement Accounts (IRAs), and other account-type retirement savings  plans in 2004. This wealthiest group held $1.2 million, on average, in these  financial assets, plus over $2 million in other assets such as home equity  and other investments. Figure 2 shows the concentration of financial  assets among boomers. This concentration of wealth is very similar to that  of current retirees and could mitigate a sharp and sudden impact on  financial asset prices if wealthy boomers need not spend down their  financial assets in retirement. Research on current retirees indicates that  the wealthiest of these individuals tend to not sell their financial assets,  contrary to what the life-cycle model would predict; instead, they choose  to live from the income these assets generate. Our analysis of the 2004  SCF also found that of the wealthiest 10 percent of current retirees born  before 1946, less than 16 percent spent money from their savings and  investments over and above their income during the previous year. In this  same group, over 65 percent responded that their income in 2003  exceeded their spending, indicating that they had accumulated more  assets without having a net sale from their holdings.
The possibility of an asset meltdown is further reduced by the fact that  those households that would seem more likely to need to sell their  financial assets in retirement do not collectively own a large portion of the  total stocks and bonds in the market. Although the majority of baby  boomers hold some financial assets in a variety of investment accounts,  the total holdings for all boomer households, $7.6 trillion, account for  roughly one-third of the value of all stocks and 11 percent of bonds  outstanding in the U.S. markets, and the wealthiest boomers own most of  these assets (see figs. 3 and 4).  Those households that are most likely to  spend down their assets in retirement—those not in the top 10 percent by  wealth—collectively hold just 32 percent of all baby boomer financial  assets. As a group, the influence of these households on the market is less  substantial. One-third of this group does not own any stocks, bonds,  mutual funds, or retirement accounts, and among those who do, their total  holdings are relatively small, with their median holdings totaling $45,900.
section_title: Analysis of Current Retiree Behavior Reveals a Pattern of Continued Accumulation and Slow Spending of Assets
paragraphs: Our analysis of national data on the investment behavior of current  retirees reveals an overall slow spending down of assets in retirement,  with many retirees continuing to purchase stocks. To the extent that baby  boomers behave like current retirees, a rapid and mass sell off of financial  assets seems unlikely. In examining retiree holdings in stocks, using  biennial data spanning 1994 to 2004 from HRS, we found that many people  continue to buy stocks in retirement. More than half of retirees own stocks  outside of an IRA, Keogh, or pension account and, among this group,  approximately 57 percent purchased stocks at some point over the 10-year  period in retirement. We found that from 2002 to 2004 the stock  ownership for most of these retirees either increased or remained at the  same level. Among those who owned stock, almost 31 percent reported  buying stocks during this 2-year period, while just fewer than 26 percent  reported selling. For the retirees who both bought and sold stocks,  approximately 77 percent purchased at least as much value in stock as  they sold.
Additionally, although retirees might be expected to have a low tolerance  for market risk and will therefore divest themselves of equities in favor of  bonds, the SCF data does not suggest such a major reallocation.  Comparing households’ holdings in stocks and bonds by age, we found  only a small difference in aggregate stock and bond allocation across  portfolios. Specifically, data from the 2004 SCF shows that of total wealth  among households headed by people over age 70, more is invested in  stocks than bonds. In 2004, households headed by those over age 70 had  roughly 60 percent of their investments in stocks and 40 percent invested  in bonds, while those households headed by someone aged 40 to 48 held  68 percent of their portfolios in stocks and 32 percent in bonds.
Our finding that retirees slowly spend down assets is consistent with the  results of several academic studies. One recent study that examined asset  holdings of elderly households suggests there is a limited decline in  financial assets as households age. Prior work also finds evidence that  retirees spend down at rates that would leave a considerable portion of  their wealth remaining at the end of average life expectancy and a  significant number of retirees continue to accumulate wealth at old ages.  For example, a 1990 study estimated that most single women would have  approximately 44 percent of their initial wealth (at age 65) remaining if  they died at the average age of life expectancy. Other studies have shown  that over the last several decades the elderly have drawn down their lump- sum wealth at relatively conservative rates of 1 to 5 percent per year.
Retirees may spend down assets cautiously as a hedge against longevity  risk. Private annuities, which minimize longevity risk, are not widely held  by older Americans. As life expectancy increases and people spend more  years in retirement, retirees will need their assets to last a longer period of  time and, thus, should spend them down more slowly. The average  number of years that men who reach age 65 are expected to live has  increased from 13 in 1970 to 16 in 2005, and is projected to increase to 17  by 2020. Women have experienced a similar rise—from 17 years in 1970 to  over 19 years in 2005. By 2020, women who reach age 65 will be expected  to live another 20 years.
Another factor that may explain the observed slow spending down of  assets among retirees is the bequest motive. National survey data show  that many retirees intend to leave a sizeable bequest, which may explain  their reluctance to spend down their wealth. Because more than three- quarters of retirees have a bequest motive, many may never sell all of their  assets. To the extent that retirees bequeath their assets instead of selling  them for consumption, the result could be an intergenerational transfer  rather than a mass sell-off that would negatively affect asset markets. In  addition to current retirees, data from the HRS indicates that the majority  of older baby boomers (those born between 1946 and 1955) expect to  leave a bequest. Approximately 84 percent of these baby boomers expect  to leave a bequest, while 49 percent expect the bequest to be at least  $100,000.
It is important to note that the baby boom generation’s asset sale behavior  in retirement might differ from that of recent generations of retirees. First,  fewer baby boomers are covered by DB plans that typically pay a regular  income in retirement and increasingly have DC plans that build up benefits  as an account balance. To the extent that this shift means that boomers  have an increased share of retirement wealth held as savings instead of as  income, this may require boomers to sell more assets to produce  retirement income than did previous generations. Second, unanticipated  expenses, such as long-term care and other health care costs, may make  actual bequests smaller than expected. Although 2002 HRS data indicates  that only 8 percent of the leading edge of baby boomers have long-term  care insurance, recent projections show that 35 percent of people  currently age 65 will use nursing home care. If boomers are confronted  with higher than expected health care costs in retirement, they would have  a greater need to spend down their assets.
section_title: Defined Benefit Pension Plans Unlikely to Sell Off Large Amounts of Stocks Solely as a Response to Boomer Retirement
paragraphs: Households are not the only holders of financial assets that might shift or  draw down their holdings as the baby boomers age. DB pension plans,  which promise to provide a benefit that is generally based on an  employee’s salary and years of service, hold assets to pay current and  future benefits promised to plan participants, which are either current  employees or separated or retired former employees. According to Federal  Reserve Flow of Funds Accounts data, private-sector plans as a whole  owned $1.8 trillion in assets in 2005. Of this amount, plans held  approximately half in stocks. According to the Employee Benefit  Research Institute (EBRI), federal government DB plans contained an  additional $815 billion in assets as of 2004.  However, most of these DB  plans invest in special Treasury securities that are non-marketable. State  and local plans held an additional $2.6 trillion in assets; however, the data  do not separate DB and DC assets for these plans. If DB plans hold  approximately 85 percent of state and local plan assets, as is the case for  federal government plans, and if DB plans held approximately half of their  assets as equities, this would mean state and local plans held an estimated  $1.1 trillion in equities. Thus, public and private DB plans held an  estimated approximate value of $2 trillion in stocks. Because of the  number of boomers, we would expect that, as they retire, DB plans would  pay out an increasing amount of benefits. This demographic shift could  cause plans to sell some of their holdings to provide current benefits.  Indeed, a 1994 study projected that the pension system would cease to be  a source of saving for the economy roughly in 2024.  We would also  expect plans to convert some stocks to less volatile assets, such as cash  and bonds, to better ensure that plans have sufficient money to pay  current benefits.
While DB plans may shift their assets in response to demographic changes,  it is unclear whether they would cause major variations in stock and bond  prices. First, even though DB plans hold about $2 trillion in stocks, this  sum still represents a relatively small fraction of total U.S. stock wealth  ($16.1 trillion, as of 2004). Further, there are reasons why DB plans may  not appreciably shift their investments away from stocks. While the baby  boom retirement may increase the number of persons receiving benefits,  the DB participant pool has been aging long before the baby boom  approached retirement. The percentage of private-sector DB participants  made up of retirees has climbed steadily for the past 2 decades, from 16  percent in 1980 to over 25 percent in 2002. Over this time, we have  observed little evidence of a shift in investments by private DB plans away  from stocks and toward fixed-income assets. In 1993, private DB plans  held just below half of their assets in stocks, about the same proportion as  today; in 1999, at the recent stock market’s peak, plans held about 58  percent of assets in stocks.
section_title: Gradual Entry into Retirement and Subsequent Employment Plans Suggest a Cumulative Rather Than Sudden Effect on Markets
paragraphs: The gradual transition of the baby boomers into retirement suggests that  the sale of their financial assets will be spread out over a long period of  time, which mitigates the risk of a shock to financial markets. The baby  boom generation spans a 19-year time period—the oldest baby boomers  will turn age 62 in 2008, becoming eligible for Social Security benefits, but  the youngest baby boomers will not reach age 62 until 2026. Among  boomers in the U.S. population in 2004, the peak birth year was 1960, as  seen in figure 5, and these boomers will turn age 62 in 2022.
As boomers gradually enter retirement, the share of the population age 65  and older is projected to continue increasing until about 2040, at which  point it is expected to plateau, as seen in figure 6. Thus, the aging of the  baby boom generation, in conjunction with the aging of the overall U.S.  population, is a cumulative development rather than a sudden change.
In addition, the expected increase in the number of baby boomers working  past age 62 may also reduce the likelihood of a dramatic decline in  financial asset prices. An increase in employment at older ages could  facilitate the accumulation of financial assets over a longer period of time  than was typical for earlier generations (albeit also needing to cover  consumption over a longer life expectancy). Furthermore, continuing to  work for pay in retirement, often called partial or phased retirement,  would reduce the need to sell assets to provide income. In fact, some  degree of extended employment has already been evident since the late  1990s, as seen in figure 7. From 1998 to 2005, the labor force participation  rate of men and women age 65 and older increased by 20 percent and 34  percent, respectively. Survey data show that such a trend is expected to  continue: Data from the 2004 SCF indicate that the majority of boomers  intend to work past age 62, with boomers most commonly reporting they  expect to work full time until age 65. Almost 32 percent of boomers said  they never intend to stop working for pay. Another study by the AARP in  2004 found that many baby boomers expect to go back to work after they  formally retire—approximately 79 percent of boomers said they intend to  work for pay in retirement. Other research has shown that about one- third of those who return to work from retirement do so out of financial  necessity. These developments suggest that baby boomers may be less  inclined to take retirement at age 62. However, some boomers may not be  able to work as long as they expect because of health problems or limited  employment opportunities. To the extent that these boomers follow  through on their expressed plans to continue paid work, their income from  earnings would offset some of their need to spend down assets.
section_title: The Role of Housing, a Key Asset for Baby Boomers in Retirement Security, Continues to Evolve
paragraphs: Housing represents a large portion of most baby boomers’ wealth and their  management and use of this asset may have some effect on their decisions  to sell assets in the financial markets. For a majority of boomers, the  primary residence accounts for their largest source of wealth— outstripping DC pensions, personal savings, vehicles, and other  nonfinancial assets. Home ownership rates among boomers exceed 75  percent, and recent years of appreciation in many housing markets have  increased the net wealth of many boomers. This suggests that a price  decline in housing, a prospect that many analysts appear to be concerned  about, could have a much greater impact on the overall wealth of boomers  than a financial market meltdown.  While research has suggested that baby  boomers have influenced housing demand and, in turn, prices, assessing  the potential impact of the baby boom retirement on the housing market is  beyond the scope of our work.
Interestingly, according to experts we interviewed, equity in the primary  residence has not historically been viewed by retirees as a source of  consumable wealth, except in the case of financial emergencies.  Reverse  mortgages, which do not require repayment until the owner moves from  the residence or dies, could grow more attractive for financing portions of  retirement spending, particularly for those baby boomers who are “house  rich but cash poor” and have few other assets or sources of income.  For  boomers who do own financial assets, an expansion of the reverse  mortgage market might reduce their need to sell financial assets rapidly.   However, boomers also appear to be carrying more debt than did previous  generations.  Our analysis of the SCF data shows that the mean debt-to- asset ratio for people aged 52 to 58 rose from 24.5 percent in 1992 to 70.9  percent in 2004.  To the extent that baby boomers continue to be willing  to carry debt into retirement, they may require more income in retirement  to make payments on this debt.
section_title: Researchers and Financial Industry Representatives Largely Foresee Little to No Impact on Financial Markets as the Baby Boomers Retire
paragraphs: Researchers and financial industry representatives largely expect the U.S.  baby boom’s retirement to have little or no impact on the stock and bond  markets. A wide range of studies, both simulation-based and empirical,  either predicted a small, negative impact or found little to no association  between the population’s age structure and the performance of financial  markets. Financial industry representatives whom we interviewed also  generally expect the baby boom retirement not to have a significant  impact on financial asset returns because of the concentration of assets  among a minority of boomers, the possibility of increased global demand  for U.S. assets, and other reasons. Broadly consistent with the literature  and views of financial industry representatives, our statistical analysis  indicates that past changes in macroeconomic and financial factors have  explained more of the variation in historical stock returns than  demographic changes. Variables such as industrial production and  dividends explained close to half of the variation in stock returns, but  changes in the population’s age structure explained on average less than 6  percent. If the pattern holds, our findings indicate that such factors could  outweigh any future demographic effect on stock returns.
subsections: section_title: Academic Studies Largely Foresee Little to No Baby Boom Retirement Effect on the Financial Markets
paragraphs: With few exceptions, the academic studies we reviewed indicated that the  retirement of U.S. baby boomers will have little to no effect on the  financial markets. Studies that used models to simulate the market effects  of a baby boom followed by a decline in the birth rate generally showed a  small, negative effect on financial asset returns. Similarly, most of the  empirical studies, which statistically examined the impact of past changes  in the U.S. population’s age structure on rates of return, suggested that the  baby boom retirement will have a minimal, if any, effect on financial asset  returns.
subsections: section_title: Simulation-Based Studies
paragraphs: Thirteen studies that we reviewed used models of the economy to simulate  how a hypothetical baby boom followed by a baby bust would affect  financial asset returns. The simulation models generally found that such  demographic shifts can affect returns through changes in the saving,  investment, and workforce decisions made by the different generations  over their lifetime. For example, baby boomers cause changes in the labor  supply and aggregate saving as they progress through life, influencing the  demand for assets and productivity of capital and, thus, the rates of return.  Specifically, the models predicted that baby boomers cause financial asset  returns to increase as they enter the labor force and save for retirement  and then cause returns to decline as they enter retirement and spend their  savings. According to a recent study surveying the literature, such  simulation models suggest, on the whole, that U.S. baby boomers can  expect to earn on their financial assets around half a percentage point less  each year over their lifetime than the generation would have earned absent  a baby boom. In effect, for two investors—one of whom earns 7 percent  and the other earns 6.5 percent annually over a 30-year period—the former  investor would earn $6.61 for every dollar saved at the beginning of the  period and latter investor would earn $5.61 for every dollar saved.
None of the simulation-based studies concluded that the U.S. baby boom  retirement will precipitate a sudden and sharp decline in asset prices, and  some studies presented their results in quantitative terms. One of the  studies, for example, predicted that the baby boom’s retirement would at  worst lower stock prices below what they would otherwise be by roughly  16 percent over a 20-year period starting around 2012. This decline,  however, is equivalent to around 0.87 percent each year—somewhat small  in comparison to real annual U.S. stock returns, which have averaged  about 8.7 percent annually since 1948. The study therefore concluded that  the size of the decline is much too small to justify the term “meltdown.”  Moreover, another study predicted that baby boomers can expect the  returns on their retirement savings to be about 1 percentage point below  their current annual returns. The study’s lower returns reflect the decline  in the productivity of capital that results from fewer workers being  available (due to the baby boom retirement) to put the capital to  productive use. A third study’s results suggest that fluctuations in the size  of the different generations induce substantial changes in equity prices,  but the study does not conclude that the baby boom’s retirement will lead  to a sharp and sudden decline in asset prices.
The simulation models we reviewed, by design, excluded or simplified  some factors that were difficult to quantify or involved uncertainty that  may cause the models to overstate the baby boom’s impact on the  markets. For example, some models assumed that baby boomers will sell  their assets solely to a relatively smaller generation of U.S. investors when  they retire. Some researchers have noted that if China and India were to  continue their rapid economic growth, they may spur demand for the  assets that baby boomers will sell in retirement. Supporting this view,  other research suggests that global factors may be more important than  domestic factors in explaining stock returns in developed countries.  Some models assumed that individuals in the same generation enter the  labor force at the same time, work a fixed amount, and retire at the same  time. In reality, some may work full or part-time after reaching retirement  age. Likewise, the baby boomers’ children, rather than working a fixed  amount, may delay their entry into the labor force and take advantage of  job opportunities created by retiring baby boomers. These factors could  dampen the effect of the baby boomer retirement on the markets. A few  of the models neglect that some investors may be forward-looking and  anticipate the potential effect of the aging baby boomers on the markets.  To the extent that such investors do so, current financial asset prices  would reflect, at least partially, the future effect of the baby boom’s  retirement and thus dampen the event’s effect on asset prices when it  actually occurs. Finally, the models typically do not include a significant  increase in immigration, but such an outcome would increase the labor  force and be expected to raise the productivity of capital and, thus, the  return on financial assets.
section_title: Empirical Studies
paragraphs: Seven empirical studies of the U.S. financial markets we reviewed  suggested, on average, that the retirement of U.S. baby boomers will have  a minimal, if any, impact on financial asset returns. These studies  specifically tested whether changes in the U.S. population’s age structure  have affected stock returns or bond yields or both over different periods,  ranging from 1910 to 2003. These studies focused primarily on changes in  the size of the U.S. middle age population (roughly age 40 to 64) or its  proportion to other age segments of the population. People in this age  group are presumably in their peak earning and saving years and, thus,  expected to have the most significant impact on financial asset returns.
These empirical studies are inherently retrospective. Therefore, care must  be taken in drawing conclusions about a future relationship between  demographics and asset performance, especially given that the historical  data do not feature an increase in the retired population of the magnitude  that will occur when the U.S. baby boomers retire. However, the  significant shift in the structure of the population that occurred as the  boomers entered the labor force and later their peak earning years should  provide an indication of how demographic change influences financial  asset returns.
For stocks, four of the seven studies found statistical evidence implying  that the past increases in the relative size of the U.S. middle age  population have increased stock returns. This finding supports the  simulation-model predictions that a relative decrease in the middle age  population—as is expected to occur when baby boomers begin to retire— will lower stock returns. In contrast, two of the studies found little  evidence that past changes in the U.S. middle age population have had any  measurable effect on stock returns. Finally, the remaining study found  evidence implying that a relative decrease in the U.S. middle age  population in the future would increase, rather than decrease, stock  returns.
For the four studies whose statistical results implied that the baby boom  retirement will cause stock returns to decline, we determined that the  magnitude of their demographic effect, on balance, was relatively small.  Using U.S. Census Bureau data, we extrapolated from three of the four  studies’ results to estimate the average annual change in returns of the  Standard and Poor’s (S&P) 500 Index that the studies would have  attributed to demographic changes from 1986 to 2004. During this period,  baby boomers first began to turn age 40 and the proportion of individuals  age 40 to 64 went from about 24.5 percent of the population to about 32  percent. We found two of the studies’ results show that the increase in  the middle age population from 1986 to 2004 led stock returns, on average,  to increase by 0.19 and 0.10 percentage points each year, respectively. We  found that the third study’s results showed a much larger average annual  increase of about 6.7 percentage points from 1986 to 2004. To put these  three estimates into context, the average annual real return of the S&P 500  Index during this period was around 10 percent. The last estimate,  however, may exaggerate the probable impact of the baby boom  retirement on stock returns. The fourth study’s methodology did not  allow us to use U.S. census data to estimate the effect of its results on  stock returns from 1986 to 2004. Nonetheless, the study estimated that  demographically driven changes in the demand for stocks can account for  about 77 percent of the annual increase in real stock prices between 1986  and 1997 and predicted that stock prices will begin to fall around 2015 as a  result of falling demographic demand.
Besides testing for the effect of demographic shifts on stock returns, five  of the seven studies included bonds in their analyses and largely found  that the baby boom retirement will have a small effect or no effect on bond  yields. Three studies found statistical evidence indicating that the past  increase in the relative size of the U.S. middle age population reduced  long-term bond yields. In turn, the finding suggests that the projected  decrease in the middle age population in the future would raise yields.  Extrapolating the results of one study, we find its estimates imply that the  increase in the U.S. middle age population from 1986 to 2004 reduced long- term bond yields by about 0.42 percentage points each year, compared to  actual real yields that averaged 3.41 percent over the same time period.  The other two studies tested how the demographic shift affected long-term  bond prices rather than yields, but an increase in prices would, in effect,  reduce yields. We found that the results of one of the studies showed that  the demographic shift from 1986 to 2004 raised bond prices by only about  0.05 percentage points each year. The other study’s methodology did not  allow us to estimate the effect, but the study estimated that  demographically driven changes in the demand for bonds can account for  at least 81 percent of the annual increase in real bond prices between 1986  and 1997 and predicted that bond prices will begin to fall around 2015 as a  result of falling demographic demand. In contrast to these studies, two  studies found little statistical evidence to indicate that past changes in the  middle age population have had any measurable effect on long-term bond  returns.
section_title: Financial Industry Representatives Do Not Expect Baby Boom Retirement to Have a Significant Financial Market Impact
paragraphs: The financial industry representatives with whom we met generally told us  that they do not expect U.S. baby boomers to have a significant impact on  the financial markets when they retire. They cited a number of factors that  could mitigate a baby boom induced market decline, many of which we  discussed earlier. For example, some mentioned the concentration of  assets among a minority of households, the long time span over which  boomers will be retiring, and the possibility for many boomers to continue  working past traditional retirement ages. Some also noted that baby  boomers will continue to need to hold stocks well into retirement to hedge  inflation and to earn a higher rate of return to hedge the risk of outliving  their savings, reducing the likelihood of a sharp sell-off of stock. A number  of representatives cited developments that could increase the demand for  U.S. assets in the future, such as the continued economic growth of  developing countries and an increase in immigration. Finally, several  commented that interest rates, business cycles, and other factors that have  played the primary role in influencing financial asset returns are likely to  overwhelm any future demographic effect from changes in the labor force  or life cycle savings behavior.
section_title: Broad Economic Factors Will Likely Have a Greater Impact on Financial Markets Than Will Demographics
paragraphs: Our statistical analysis indicates that macroeconomic and financial factors  explain more of the variation in historical stock returns than population  shifts and suggests that such factors could outweigh any future  demographic effect on stock returns. In addition, factors not captured by  our model were also larger sources of stock return variation than the  demographic variables we selected. We undertook our own statistical  analysis, because many of the empirical studies we reviewed either did not  include relevant variables that influence stock returns in their models or  included them but did not discuss the importance of these variables  relative to the demographic variables. To broaden the analysis, we  developed a statistical model of stock returns based on the S&P 500 Index  to compare the effects of changes in demographic, macroeconomic, and  financial variables on returns from 1948 to 2004. As shown in figure 8,  fluctuations in the macroeconomic and financial variables that we selected  collectively explain about 47 percent of the variation in stock returns over  the period. These variables are the growth rate of industrial production,  the dividend yield, the difference between interest rates on long- and  short-term bonds, and the difference between interest rates on risky and  safe corporate bonds—all found in previous studies to be significant  determinants of stock returns. These variables are likely to contain  information about current or future corporate profits. In contrast, our four  demographic variables explained only between 1 percent and 8 percent of  the variation in the annual stock returns over the period. These variables  were based on population measures found to be statistically significant in  the empirical studies we reviewed: the proportion of the U.S. population  age 40 to 64, the ratio of the population age 40 to 49 to the population age  20 to 29, and annual changes in the two. Note, however, that almost half of  the variation in stock returns was explained by neither the  macroeconomic and financial variables nor the demographic factors we  tested, a finding that is comparable to similar studies. Hence, some  determinants of stock returns remain unknown or difficult to quantify.
Not explained by selected   variables (average)
The statistical model shows that financial markets are subject to a  considerable amount of uncertainty and are affected by a multitude of  known and unknown factors. However, of those known factors, the  majority of the explanatory power stems from developments other than  domestic demographic change. Simply put, demographic variables do not  vary enough from year to year to explain the stock market ups and downs  seen in the data. This makes it unlikely that demographic changes, alone,  could induce a sudden and sharp change in stock prices, but leaves open  the possibility for such changes to lead to a sustained reduction in returns.  At the same time, fluctuations in dividends and industrial production,  which are much more variable than demographic changes, may obscure  any demographic effect in future stock market performance. For example,  a large recession or a significant reduction in dividends would have a  negative effect on annual returns that would likely overwhelm any  reduction in returns resulting from the baby boom retirement. Conversely,  an unanticipated increase in productivity or economic growth would be  expected to increase returns substantially and likely dwarf the effect of  year-over-year changes in the relative size of the retired population.
section_title: Baby Boomers and Future Generations Likely to Increasingly Rely on Their Own Savings, Placing Greater Importance on Rates of Return and Financial Management Skills
paragraphs: While the baby boom retirement is not likely to cause a sharp decline in  asset prices or returns, the retirement security of boomers and future  generations will likely depend increasingly on individual saving and rates  of return as guaranteed sources of income become less available. This  reflects the decline of coverage by traditional DB pension plans, which  typically pay a regular income throughout retirement, and the rise of  account-based DC plans. Uncertainties about the future level of Social  Security benefits, including the possible replacement of some defined  benefits by private accounts, and the projected increases in medical and  long-term care costs add to the trend toward individuals taking on more  responsibility and risk for their retirement. All of these developments  magnify the importance of achieving rates of return on savings high  enough to produce sufficient income for a secure retirement. In this  environment, individuals will need to become more educated about  financial issues, both in accumulating sufficient assets as well as learning  to draw them down effectively during a potentially long retirement.
subsections: section_title: As Baby Boomers Retire, Fewer May Receive Income from Traditional Pensions
paragraphs: Changes in pension design will require many baby boomers and others to  take greater responsibility in providing for their retirement income,  increasing the importance of rates of return for them. The past few  decades have witnessed a dramatic shift from DB plans to DC plans. From  1985 to 2004, the number of private sector DB plans has shrunk from about  114,000 to 31,000. From 1985 to 2002 (the latest year for which complete  data are available), the number of DC plans almost doubled, increasing  from 346,000 to 686,000. Furthermore, the percentage of full-time  employees participating in a DB plan (at medium and large firms) declined  from 80 to 33 percent from 1985 to 2003, while DC coverage increased  from 41 to 51 percent over the period. The shift in pension design has  affected many boomers. According to the 2004 SCF, about 50 percent of  people older than the baby boomers reported receiving benefits from a DB  plan, but fewer than 44 percent of baby boomers have such coverage.  However, within the baby boom generation, there is a noticeable  difference: 46 percent of older boomers (born between 1946 and 1955)  reported having a DB plan, while only 39 percent of young boomers (born  between 1956 and 1964) had a DB plan (see table 1). According to the  SCF, the percentage of households age 35 to 44 with a DC plan increased  from 18 percent in 1992 to 42 percent in 2001.
The shift from DB to DC plans places greater financial management  responsibility on a growing number of baby boomers and makes their  retirement savings more dependent on financial market performance.  Unlike DB plans, DC plans do not promise a specified benefit for life.  Rather, DC plan benefits depend on the amount of contributions, if any,  made to the DC plan by the employee and the employer, and the returns  earned on assets held in the plan. Because there is no guaranteed benefit,  the responsibility to manage these assets and the risk of having  insufficient pension benefits at retirement falls on the individual. Similar  to DB plans, some DC plans offer their participants the option of  converting their balance into an annuity upon retirement, but DC plan  participants typically take or keep their benefits in lump-sum format.
Small changes in average rates of return can affect the amount  accumulated by retirement and income generated during retirement. For  example, if a boomer saved $500 each year from 1964 until retirement in  2008 and earned 8 percent each year, he or she would accumulate almost  $209,000 at retirement. The same worker earning 7 percent each year over  the same period would accumulate only $153,000 at retirement, a  difference in total saving of 27 percent. Moreover, rates of return can have  a similar affect on retirement income. With $209,000 at retirement, the  retiree could spend $19,683 each year for 20 years if he or she continued to  earn 8 percent each year in retirement. If the annual rate of return dropped  one percentage point to 7 percent, the same amount of retirement savings  would generate only about $18,412 each year for 20 years, a difference of  6.5 percent in annual retirement income. Retirees depending on converting  savings to income are particularly dependent on rates of return, since they  may have limited employment options. Similarly, workers nearing  retirement may be more affected by fluctuations in rates of return than  younger workers, who would have more working years to make up any  declines or losses.
Although DC plans place greater responsibility on individuals for their  retirement security, statistics indicate that so far at least some have yet to  fully accept it. First, many workers who are covered by a DC plan do not  participate in the plan. Recent data indicate that only about 78 percent of  workers covered by a DC plan actually participate in the plan. Second,  even among baby boom participants, many have not saved much in these  accounts. Figure 9 shows the percentage of boomers with account  balances in their DC pensions and IRAs, which are personal accounts  where individuals can accumulate retirement savings. Over one-half of  households headed by someone born from 1946 to 1955 did not have a DC  pension; for those that did have a DC pension, their median balance was  $58,490, an amount that would generate just a $438 monthly annuity  starting at age 65. Similarly, only 38 percent reported having an IRA, and  the median IRA balance among those participating was only $37,000, an  amount that would generate a monthly annuity of only $277.
These statistics may not provide a complete picture for some individuals  and households, since those with a small DC plan account balance also  may have a DB plan and thus may not have the same need to contribute to  their account. However, EBRI found that, as of 2004, median savings in  401(k) accounts, a type of DC plan, were higher for every age group up to  age 64 for those with a DB plan than those with only a 401(k). Also, the  median balances for those with only 401(k) plans may not be enough to  support them in retirement. For families with the head of family age 55 to  64 in 2004 with only a 401(k), EBRI estimated that their median balance  was $50,000; for those age 45 to 54, the median was $40,000. While many in  these age groups could continue to work for several years before reaching  retirement age, without substantially higher savings, these households may  be primarily dependent on income from Social Security during retirement.
Extending our analysis of the allocation of baby boomer assets generally  reveals that financial assets are, in general, a small portion of boomers’  asset portfolios.  Among all boomers, housing is the largest asset for the  majority of households, with vehicles making up the second largest  portion of wealth.  Figure 10 shows the allocation of baby boomer assets  among housing, cash, savings, pensions, vehicles, and other assets.  Not  including the top quartile by wealth, savings and pensions, the portions of  wealth that are invested in stocks and bonds are a small portion of overall  wealth, constituting no more than 20 percent of total gross assets per  household.  Among the bottom two quartiles by wealth, on average  boomers have more of their wealth invested in their personal vehicle  (automobile or truck), which depreciates over time, than in either savings  or pensions, assets that generally appreciate over time.  Overall, the  finding that most boomers do not hold a significant amount of financial  assets, measured both by account balance and by percentage of total  assets, mitigates this generation’s potential effect on the asset markets as  boomers retire and highlights the fact that many boomers may enter  retirement without adequate personal savings.
section_title: Financial Stress on Social Security, Medicare, and Health Expenditures May Create Uncertainties for Some Baby Boomers and Future Generations
paragraphs: The uncertainties surrounding the future financial status of Social  Security, the program which provides the foundation of retirement income  for most retirees, also presents risks to baby boomers’ retirement  security. These benefits are particularly valuable because they provide a  regular monthly income, adjusted each year for inflation, to the recipient  and his survivors until death. Thus, Social Security benefits provide some  insurance against outliving one’s savings and against inflation eroding the  purchasing power of a retiree’s income and savings. Such benefits provide  a unique retirement income source for many American households.
Social Security, however, faces long-term structural financing challenges  that, if unaddressed, could lead to the exhaustion of its trust funds.  According to the intermediate assumption projections of Social Security’s  2006 Board of Trustees’ Report, annual Social Security payouts will begin  to exceed payroll taxes by 2017, and the Social Security trust fund is  projected to be exhausted in 2040. Under these projections, without  counterbalancing changes to benefits or taxes, tax income would be  enough to pay only 74 percent of currently scheduled benefits as of 2040,  with additional, smaller benefit reductions in subsequent years.
These uncertainties are paralleled, if not more pronounced, with Medicare,  the primary social insurance program that provides health insurance to  Americans over age 65. Medicare also faces very large long-term financial  deficits. According to the 2006 Trustees report, the Hospital Insurance  Trust Fund is projected to exhaust itself by 2018. The challenges stem  from concurrent demographic trends—people are living longer, spending  more years in retirement, and have had fewer children—and from costs for  health care rising faster than growth in the gross domestic product. These  changes increase benefits paid to retirees and reduce the number of  people, relative to previous generations, available to pay to support these  benefits.
These financial imbalances have important implications for future retirees’  retirement security. While future changes to either program are uncertain,  addressing the financial challenges facing Social Security and Medicare  may require retirees to receive reduced benefits, relative to scheduled  future benefits, while workers might face higher taxes to finance current  benefits. In addition, some proposals to reform Social Security incorporate  a system of individual accounts into the current program that would  reduce scheduled benefits under the current system, perhaps with  protections for retirees, older workers, and low-wage workers, and make  up for those reductions to some degree with income from the individual  accounts. Like DC plans generally, these accounts would give the  individual not only the prospect for higher rates of return but also the risk  of loss, placing additional responsibility and risk on individuals to provide  for their own retirement security. Similarly, tax-preferred health savings  accounts are a type of personal account to allow enrollees to pay for  certain health-related expenditures.
The worsening budget deficits that are expected to result if fiscal  imbalances in Social Security and Medicare are not addressed could have  important effects on the macroeconomy. By increasing the demand for  credit, federal deficits tend to raise interest rates, which are mitigated to  the extent that foreign savings flow into the United States to supplement  scarce domestic savings. If foreigners do not fully finance growing budget  deficits, upward pressure on interest rates can reduce domestic  investment in productive capacity. All else equal, these higher borrowing  costs could discourage new investment and reduce the value of capital  already owned by firms, which should be reflected in reduced stock prices  as well.
The fiscal challenges facing Medicare underscore the issue of rising retiree  health costs generally. Rising health care costs have made health  insurance and anticipated medical expenses increasingly important issues  for older Americans. Although the long-term decline in the percentage of  employers offering retiree health coverage has appeared to have leveled  off in recent years, retirees continue to face an increasing share of costs,  eligibility restrictions, and benefit changes that contribute to an overall  erosion in the value and availability of coverage. A recent study estimated  that the percentage of after-tax income spent on health care will almost  double for older individuals by 2030 and that after taxes and health care  spending incomes may be no higher in 2030 than in 2000 for a typical older  married couple. People with lower incomes will be the most adversely  affected. The study projected that by 2030, those in the bottom 20 percent  of the income distribution would spend more than 50 percent of their  after-tax income on insurance premiums and out-of-pocket health care  expenses, an increase of 30 percentage points from 2000. The costs of  healthcare in retirement, especially long-term and end-of-life care, are a  large source of uncertainty for baby boomers in planning their retirement  financing, as typical private and public insurance generally does not cover  these services. Nursing home and long-term care are generally not covered  under Medicare but by Medicaid, which is the program that provides  health insurance for low-income Americans. Medicaid eligibility varies  from state to state, but generally requires that a patient expend most of  their financial assets before they can be deemed eligible for benefits. Most  private long-term care insurance policies pay for nursing home and at- home care services, but these benefits may be limited, and few elderly  actually purchase this type of coverage, with a little over 9 million policies  purchased in the United States by 2002. Thus, health care costs may cause  some baby boomers without long-term care insurance to rapidly spend  retirement savings.
section_title: Baby Boomers and Future Generations May Increasingly Rely on Their Own Investment Decisions, Highlighting Importance of Financial Literacy
paragraphs: With more individuals being asked to take responsibility for saving for  their own retirement in a DC pension plan or IRA, financial literacy and  skills are becoming increasingly important in helping to ensure that  retirees can enjoy a comfortable standard of living. However, studies have  found that many individuals have low financial literacy. A recent study of  HRS respondents over age 50 found that only half could answer two  simple questions regarding compound interest and inflation correctly, and  one-third could answer these two questions and another on risk  diversification correctly. Other research by AARP of consumers age 45 and  older found that they often lacked knowledge of basic financial and  investment terms. Similarly, a survey of high school students found that  they answered questions on basic personal finance correctly only about  half of the time.
Baby boomers approaching retirement and fortunate enough to have  savings may still face risks from failing to diversify their stock holdings. In  one recent survey, participants perceived a lower level of risk for their  company stock than for domestic, diversified stock funds. However,  investors are more likely to lose their principal when investing in a single  stock as opposed to a diversified portfolio of stocks, because below  average performance by one firm may be offset by above average  performance by the others in the portfolio. In addition, holding stock  issued by one’s employer in a pension account is even more risky because  if the company has poor financial performance, it could result in both the  stock losing value and the person losing his job. One consequence of this  poor financial literacy may be investors holding a substantial part of their  retirement portfolio in employer stock. EBRI reported that the average  401(k) investor age 40 to 49 had 15.4 percent of her portfolio in company  stock in 2004; the average investor in his 60’s still had 12.6 percent of her  assets in company stock. Perhaps of greater concern, the Vanguard  Group found that, among plans actively offering company stock, 15  percent of participants had more than 80 percent of their account balance  in company stock in 2004.
section_title: Concluding Observations
paragraphs: Our findings largely suggest that baby boomers’ retirement is unlikely to  have a dramatic impact on financial asset prices. However, there appear to  be other significant retirement risks facing the baby boom and future  generations. The long-term financial weaknesses of Social Security and  Medicare, coupled with the uncertain future policy changes to these  programs’ benefits, and the continued decline of the traditional DB  pension system indicate a shift toward individual responsibility for  retirement. These trends mean that rates of return will play an increasingly  important role in individuals’ retirement security. For those with sufficient  income streams, this new responsibility for retirement will entail a lifetime  of financial management decisions—from saving enough to managing such  savings to generate an adequate stream of income during retirement, the  success of which will directly or indirectly be dependent on rates of  return. Given the potential impact of even a modest decline in returns over  the long run on savings and income, market volatility, and uncertainties  about pensions, Social Security, and Medicare, the onset of the baby boom  retirement poses many questions for future retirement security.
The performance of financial and other asset markets provides just one  source of risk that will affect the retirement income security of baby  boomers and ensuing generations. For those with financial assets, choices  they make about investments play a critical role not just in having  adequate savings at retirement but also in making sure their wealth lasts  throughout retirement. That Americans are being asked to assume more  responsibility for their retirement security highlights the importance of  financial literacy, including basic financial concepts, investment  knowledge, retirement age determination, and asset management in  retirement. Government policy can help, policies that encourage  individuals to save more and work longer (for those who are able) and that  promote greater education about investing and retirement planning that  can help ensure higher and more stable retirement incomes in the future.
Although individual choices about saving and working will continue to  play a primary role in determining retirement security, the high percentage  of boomers who have virtually no savings, assets, or pensions will face  greater difficulties in responding to the new retirement challenges. For  this group, the federal government will play an especially key role in  retirement security through its retirement and fiscal policies. The  challenges facing Social Security and Medicare are large and will only  grow as our population ages. Legislative reforms to place Social Security  and Medicare on a path towards sustainable long-term solvency would not  only reduce uncertainty about retiree benefits, particularly for those  Americans who own few or no assets, but also help address the federal  government’s long-term budget imbalances that could affect the economy  and asset markets. Ultimately, retirement security depends on how much  society and workers are willing to set aside for savings and retirement  benefits and on the distribution of retirement risks and responsibilities  among government, employers, and individuals. One of Congress’s  greatest challenges will be to balance this distribution in a manner that  achieves a national consensus and helps Americans keep the promise of  adequate retirement security alive in the 21st century.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Department of Labor, the  Department of the Treasury, the Department of Housing and Urban  Development, and the Social Security Administration, as well as several  outside reviewers, including one from the Board of Governors of the  Federal Reserve System.  Labor, Treasury, and SSA and the outside  reviewers provided technical comments, which we incorporated as  appropriate. We are sending copies of this report to the Secretary of  Labor, the Secretary of the Treasury, the Secretary of the Housing and  Urban Development Department, and the Commissioner of the Social  Security Administration, appropriate congressional committees, and other  interested parties. We will also make copies available to others on request.  In addition, the report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you have any questions concerning this report, please contact Barbara  Bovbjerg at (202) 512-7215 or George Scott at (202) 512-5932. Contact  points for our Office of Congressional Relations and Public Affairs may be  found on the last page of this report. GAO staff who made contributions  are listed in appendix VI.
section_title: Appendix I: Scope and Methodology
paragraphs: To analyze whether the retirement of the baby boom generation is likely to  precipitate a dramatic drop in financial asset prices, we relied primarily on  information from two large survey data sets. We calculated the  distribution of assets and wealth among baby boomers and existing  retirees and bequest and work expectations of baby boomers from data  from various waves of the Federal Reserve’s Survey of Consumer Finances  (SCF). This triennial survey asks extensive questions about household  income and wealth components; we used the latest available survey from  2004 and previous surveys back to 1992. The SCF is widely used by the  research community, is continually vetted by the Federal Reserve, and is  considered to be a reliable data source. The SCF is believed by many to be  the best source of publicly available information on U.S. household  finances.
Some caveats about the data should be kept in mind. Because some assets  are held very disproportionately by relatively wealthy families, the SCF  uses a two part sample design, one of which is used to select a sample  with disproportionate representation of families more likely to be  relatively wealthy.  The two parts of the sample are adjusted for sample  nonresponse and combined using weights to provide a representation of  families overall.  In addition, the SCF excludes one small set of families by  design. People who are listed in the October issue of Forbes as being  among the 400 wealthiest in the United States are excluded. To enable the  calculation of statistical hypothesis tests, the SCF uses a replication  scheme. A set of replicate samples is selected by applying the key  dimensions of the original sample stratification to the actual set of  completed SCF cases and then applying the full weighting algorithm to  each of the replicate samples. To estimate the variability of an estimate  from the SCF, independent estimates are made with each replicate and  with each of the multiple imputations; a simple rule is used to combine the  two sources of variability into a single estimate of the standard error.
We also analyzed recent asset sales by retirees and work and bequest  expectations of baby boomers, as well as gathered further financial  information on baby boomers and older generations, from data from the  Health and Retirement Study (HRS) from 1994 to 2004. The University of  Michigan administers the HRS every 2 years as a panel data set, surveying  respondents every two years starting in 1992 about health, finances, family  situation, and many other topics. Like the SCF, the HRS is widely used by  academics and continually updated and improved by administrators. We  also received expert opinions on the likely impact of the baby boom  retirement on asset and housing markets from interviews with various  financial management companies, public policy organizations, and  government agencies, particularly those agencies dealing with housing.
To assess the conclusions of academics researchers and outside experts  on the financial impacts of the baby boom retirement, we read, analyzed,  and summarized theoretical and empirical academic studies on the  subject. Based on our selection criteria, we determined that these studies  were sufficient for our purposes but not that their results were necessarily  conclusive.  We also interviewed financial industry representatives from  mutual fund companies, pension funds, life insurance companies, broker- dealers, and financial industry trade associations. We also did our own  analysis of the historical importance of demographics and other variables  on stock returns by collecting demographic, financial, and macroeconomic  data and running a regression analysis. We performed data reliability  assessments on all data used in this analysis.
To assess the role rates of return will play in providing retirement income  in the future, we synthesized findings from the analysis of financial asset  holdings to draw conclusions about the risk implications for different  subpopulations of the baby boom and younger generations. We also used  facts and findings on pensions and Social Security (from past GAO reports  and the academic literature) and insights from interviews with outside  experts to extend and support our conclusions.
We conducted our work between August 2005 and June 2006 in  accordance with generally accepted government auditing standards.
section_title: Appendix II: Bibliography of Simulation- Based and Empirical Studies
paragraphs: Abel, Andrew B. “Will Bequests Attenuate the Predicted Meltdown in  Stock Prices When Baby Boomers Retire?” The Review of Economics and  Statistics, vol. 83, no. 4 (2001): 589-595.
Abel, Andrew B. “The Effects of a Baby Boom on Stock Prices and Capital  Accumulation in the Presence of Social Security.” Econometrica, vol. 71,  no. 2 (2003): 551-578.
Ang, Andrew and Angela Maddaloni. “Do Demographic Changes Affect  Risk Premiums? Evidence from International Data.” Journal of Business,  vol. 78, no. 1 (2005): 341-379.
Bakshi, Gurdip S. and Zhiwu Chen. “Baby Boom, Population Aging, and  Capital Markets.” Journal of Business, vol. 67, no. 2 (1994): 165-202.
Bergantino, Steven M. “Life Cycle Investment Behavior, Demographics,  and Asset Prices.” Ph.D diss., Massachusetts Institute of Technology, 1998.
Börsch-Supan, Axel. “Global Aging: Issues, Answers, More Questions.”  Working Paper WP 2004-084. University of Michigan Retirement Research  Center (2004).
Börsch-Supan, Axel, Alexander Ludwig, and Joachim Winter. “Aging,  Pension Reform, and Capital Flows: A Multi-Country Simulation Model.”  Working Paper No. 04-65. Mannheim Research Institute for the  Economics of Aging (2004).
Brooks, Robin J. “Asset Market and Savings Effects of Demographic  Transitions.” Ph.D diss., Yale University, 1998.
Brooks, Robin. “What Will Happen to Financial Markets When the Baby  Boomers Retire?” IMF Working Paper WP/00/18, International Monetary  Fund (2000).
Brooks, Robin. “Asset-Market Effects of the Baby Boom and Social- Security Reform.” American Economic Review, vol. 92, no. 2 (2002): 402- 406.
Brooks, Robin. “The Equity Premium and the Baby Boom.” Working  Paper, International Monetary Fund, 2003.
Bütler, Monika, and Philipp Harms. “Old Folks and Spoiled Brats: Why the  Baby-Boomers’ Savings Crisis Need Not Be That Bad.” Discussion Paper  No. 2001-42. CentER, 2001.
Davis, E. Phillip and Christine Li. “Demographics and Financial Asset  Prices in the Major Industrial Economies.” Working Paper. Brunel  University, West London: 2003.
Erb, Claude B., Campbell R. Harvey, and Tadas E. Viskanta.  “Demographics and International Investments.” Financial Analysis  Journal, vol. 53, no. 4 (1997): 14-28.
Geanakoplos, John, Michael Magill, and Martine Quinzii. “Demography and  the Long-Run Predictability of the Stock Market.” Cowles Foundation  Paper No. 1099. Cowles Foundation for Research in Economics, Yale  University: 2004.
Goyal, Amit. “Demographics, Stock Market Flows, and Stock Returns.”  Journal of Financial and Quantitative Analysis, vol. 39, no. 1 (2004):  115-142.
Helmenstein, Christian, Alexia Prskawetz, Yuri Yegorov. “Wealth and  Cohort Size: Stock Market Boom or Bust Ahead?” MPIDR Working Paper  WP 2002-051. Max-Planck Institute for Demographic Research, 2002.
Lim, Kyung-Mook and David N. Weil. “The Baby Boom and the Stock  Market Boom.” Scandinavian Journal of Economics, vol. 105, no. 3  (2003): 359-378.
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section_title: Appendix III: Summary of the Simulation- Based and Empirical Studies Assessing the Impact of a Baby Boom on Financial Markets
paragraphs: Demographic  variable(s)
Asset variable(s)
Demographic  changes predicted  future changes in the  equity premium in the  international data but  only weakly in the  U.S. data.
In the United States,  increases in the  average age of  persons older than  age 20 predicted a  higher risk premium.
Demographic  variable(s)
Asset variable(s)
In the United States,  the increase in the  demand for stocks  and bonds based on  demographic changes  increased stock and  bond prices but had  no effect on the equity  premium.
The increase in  people age 40 to 64  relative to the rest of  the population  increased stock and  bond prices,  particularly in the  United States. Also,  the increase in people  40 to 64 relative to  people over 65  increased the equity  premium.
The relative increase  in people age 40 to  64 increased stock  prices and decreased  long-term bond yields  in the United States  and other countries.
In the United States,  the relative increase  in the population age  40 to 49 increased  stock returns. The  results for the other  countries included in  the study were mixed.
Percentage change  and level of  population age 25 to  44, age 45 to 64, and  age 65 and over.
In the United States,  the relative increase  in persons age 45 to  64 increased the  equity premium.
Average age of  person over age 25  Demographic  variable(s)
Asset variable(s)
In the United States,  the increase in people  age 45 and 66  decreased stock  returns.
In the United States,  the relative increase  in people age 40 to  64 decreased short- term government  bond returns but had  no effect on long-term  government bond or  stock returns.
In the United States,  the relative increase  in people age 45 to  54 decreased annual  returns of short and  intermediate-term  government bonds  but had no effect on  the annual returns of  stock and long-term  government or  corporate bonds.
section_title: Appendix IV: Econometric Analysis of the Impact of Demographics on Stock Market Returns
paragraphs: This appendix discusses our analysis of the impact of demographics and  macroeconomic and financial factors on U.S. stock market returns from  1948 to 2004. In particular, we discuss (1) the development of our model  used to estimate the relative importance of demographics and other  factors in determining stock market returns, (2) the data sources, and (3)  the specifications of our econometric model, potential limitations, and  results.
subsections: section_title: GAO’s Econometric Model of the Effects of Demographic, Macroeconomic, and Financial Factors on Stock Market Returns
paragraphs: We developed an econometric model to determine the effects of changes  in demographic, macroeconomic, and financial variables on stock market  returns from 1948 to 2004. Our independent empirical analysis is meant to  address two separate but related questions:    Are the demographic effects on stock returns found in some of the  empirical literature still apparent when additional control variables— macroeconomic and financial indicators known to be associated with  stock returns—are present in the regression analysis?
How much of the variation in stock returns is explained by those  macroeconomic and financial indicators as compared to demographic  variables?
Answering the first question serves to address the possibility of omitted  variable bias in simpler regression specifications. For example, studies by  Poterba; Geanakoplos, Magill, and Quinzii (hereafter, GMQ); and Yoo use  only demographic variables as their independent variables. The omission  of relevant variables in regressions of this kind will result in biased  estimates of the size and significance of the effects under investigation.  Answering the second question serves to put the influence of  demographics on stock returns in perspective: How much of stock market  movements are explained by demographics as opposed to other variables?  To answer the questions we include a series of demographic variables  from the literature we reviewed in a multivariable regression model. We  relied primarily on information in a seminal study done by Eugene Fama  to develop our model.
Data and Sample Selection  We analyzed the determinants of real (adjusted for inflation) total  (including both price changes and dividends) returns of the Standard and  Poor’s (S&P) 500 Index from 1948 to 2004. We chose the S&P 500 Index as  our dependent variable not only because it is widely regarded as the best  single gauge of U.S. equities market and covers over 80 percent of the  value of U.S. equities but also because S&P 500 Index mutual funds are by  far the largest and most popular type of index fund. Due to changes in the  structure of financial markets over time, we chose a shorter time horizon  to minimize the likelihood of a structural break in the data. For our  independent variables, we selected macroeconomic and financial variables  that economic studies have found to be important in explaining stock  returns and were used in Fama’s analysis to determine how much of stock  market variation they explained. We selected two demographic variables,  the proportion of the population age 40-64 and the ratio of the population  age 40-49 to the population age 20-29 (the middle-young or “MY” ratio),  that had statistically significant coefficients in several of the empirical  studies that we reviewed. Table 1 presents the independent and  dependent variables in our model and their data sources. For consistency,  we estimate the equation four times using both levels and changes in the  two demographic variables.
section_title: Model Specification, Limitations, and Estimation
paragraphs: where r is real stock market returns during calendar year t, x are four  control variables (the dividend yield, the term spread, shocks to the  default spread, and growth of industrial production, respectively) adapted  from Fama’s study, y is the demographic variable, and ε is the error at  time t. The error structure is modeled assuming White’s  heteroskedasticity-consistent covariance matrix. We first estimate the  equation without a demographic variable to measure the proportion of  variation explained by macroeconomic and financial indicators, followed  by estimating the regression equation four separate times to include each  of the demographic measures. For the benchmark model, we find no  evidence of serial autocorrelation or deviations from normality.
Despite standard diagnostics and careful regression specification, some  limitations of our analysis remain. We cannot be certain that we have  chosen the best variables to represent the aspects of the economy that  move the stock market or the demographic variables that may influence  stock returns as well. We have attempted to choose appropriate variables  based on the existing empirical and theoretical literature on the economic  and demographic determinants of stock returns. Nevertheless, even these  variables may be measured with error. Generally, measurement errors  would cause us to underestimate the importance of those variables that  have been measured with error. This would be most problematic in the  case of our demographic variables, though measurement error in our  economic and financial control variables actually makes our estimates  conservative. Nevertheless, we assessed the reliability of all data used in  this analysis, and found all data series to be sufficiently reliable for our  purposes. As a result, we believe that the limitations mentioned here (and  related to the direction of causality in industrial production mentioned  above) do not have serious consequences for the interpretation of our  results.
The regression results are presented in tables 2 through 6 below. Our  results are consistent with the literature on the determinants of stock  market returns, especially Fama’s study, in that several of our  macroeconomic and financial variables are statistically significant, and  they account for a substantial proportion (roughly 47 percent) of the  variation in stock returns. The coefficient of determination in Fama’s  study could be higher due to the inclusion of more industrial production  leads.
The finding in Davis and Li’s study that the 40-64 population had a  statistically significant impact on stock returns is not robust to alternative  specifications, as demonstrated in Table 6. The proportion of the  population 40-64 is no longer a statistically significant determinant of  stock returns, and the inclusion of the variable improves the R-squared by  less than 1.5 percent. However, changes in the 40-64 population are  significant, and account for an additional 8 percent of the variation in  stock returns.
The MY ratio and changes in the MY ratio are statistically significant, as  seen in Tables 5 and 6, and the model with changes in the MY ratio  accounts for a higher proportion of the variation in stock returns than the  model estimated with the level of the ratio.
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts above, Kay Kuhlman, Charles A. Jeszeck,  Joseph A. Applebaum, Mark M. Glickman, Richard Tsuhara, Sharon  Hermes, Michael Hoffman, Danielle N. Novak, Susan Bernstein, and Marc  Molino made important contributions to this report.