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The ageing problem: its impact on financial markets and possible policy responses

Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB
Workshop: 'Funding social security systems – international experiences'
Würzburg, 1 December 2006

1 Introduction

[Slide 1: Population ageing]

Ladies and Gentlemen,

I am delighted to be here today to talk about a topic that interests us all very much, not least because we are all getting older. Longevity has increased spectacularly over the past two centuries. Scientists are even starting to consider the question of “how to live for ever”.[1] I wish this could really be achieved one day, but the truth of the matter is that we are already living longer – which is certainly a great achievement in itself – and on average we are having fewer children. The result is that the world population is ageing. The pace of ageing is different across countries: it is faster in more developed economies and particularly pronounced in continental Europe. Nevertheless, the rapid decline in fertility rates in some emerging countries, which, in some cases, is also due to deliberate policies to control population growth, make the problem of ageing relevant – if not urgent – also in these countries[2].

[Slide 2: Challenges and reforms]

Of course, as policy-makers, we are interested primarily in the challenges that these developments pose for public finances. The consequences for age-related public expenditure could be severe, as many studies have indicated. The ECB has repeatedly called on governments to implement comprehensive reforms. These reforms need to address specific problems in public pension and health care systems, maintain fiscal discipline, and, at the same time, they need to support an increase in labour utilisation and strengthen the forces driving productivity, to countervail the impact of population ageing on economic growth.[3]

Public pension reforms are on the agenda of most governments in the euro area, some of which have already introduced extensive changes to their public pension systems. Given the objectives of maintaining public pension systems on a financially sustainable path and public debt sustainability, pension reforms have generally moved in three directions: i) an increase in contribution rates, ii) a reduction in replacement rates and iii) a higher retirement age (although in some countries the effective retirement age remains well below the statutory retirement age). This implies that benefits have generally been reduced and that retirement income relative to wage has declined.

Projected changes in life expectancy are surrounded by considerable uncertainty, longevity risk. Governments, through their public social security systems, bear a collective longevity risk, due to unexpected changes in mortality trends. By definition, this risk cannot be diversified within the members of the same cohort, as it affects all individuals in the same way. Public pension reforms are, at least partially, transferring this risk to the individuals, promoting a move towards systems where benefits depend on the accumulated value of contributions (both public and private). Individual longevity risk can be diversified to some extent, insofar as financial markets can provide us with instruments that can help to manage longevity risk, as well as other kinds of risks.

[Slide 3: Outline of my presentation]

In the rest of my intervention today, I will talk about the relationship between demographic changes and financial markets. I will start with the consequences we may observe in the future – when the current baby boom generation retires – and will continue with the changes in financial structures that we are already witnessing today. I will describe how population ageing can directly affect financial markets and, in particular, the prices of certain assets. I will then look at the current and foreseen changes in the retirement savings industry and how these changes may exert pressure on asset prices. In this regard, policy-makers can play an important role to smooth the transition. Finally, I will look at the issue from the individual’s perspective and discuss how the development of certain financial instruments could help individuals to properly prepare for their later years.

2 The impact of demographic changes on financial markets

[Slide 4: Impact on asset prices]

First, I would like to turn your attention towards the impact of demographic changes on asset prices. I should say upfront that, although this issue is currently being debated by academics and practitioners, available projections are still surrounded by a large degree of uncertainty. Some people anticipate a “doom” scenario. When the current generation of baby boomers retires and starts cashing in investments in order to finance consumption, asset prices will fall, simply because there will be not enough “young people” willing to buy their assets. Jeremy Siegel, an eminent American academic, describes a situation in which future retirees may be haunted by the words “Sell? Sell to whom?”[4] This “asset prices meltdown” will leave people with a smaller nest egg than they had anticipated. Some other people, instead, argue that forward-looking financial markets are already setting asset prices to reflect current and future demographic trends; thus, asset prices today already reflect the fact that returns are projected to decline when a large share of the population retires.[5]

I will argue that, on the basis of our knowledge today, the likelihood of a meltdown is quite low – at least in the way it is commonly referred to in the literature. Nevertheless, the possibility should not be dismissed altogether, for at least two reasons. First, theoretical models studying the potential impact of population ageing on financial markets generally predict a decline in the prices of financial assets (particularly stocks and bonds) when the baby boom generation retires. Estimates of the magnitude of this decline vary greatly and are surrounded by a high level of uncertainty. These models assume a pattern for the life-cycle investments of individuals. One commonly assumed pattern is that savings are accumulated mainly during working years and then liquidated gradually to fund retirement years.

This hump-shaped pattern of life-cycle investment, which was first proposed by Modigliani in the 1980s[6] as a follow-up to some of his earlier studies in the 1950s[7], does not always provide an accurate description of the way individuals behave. People simply do not sell all their assets when they are old, which could be partly explained by a desire to leave a bequest and by the uncertainty surrounding the length of their life. Another more important reason, however, seems to be that in countries where public social security systems are in place, and often still very generous, people just do not need to sell the assets accumulated during their working years in order to fund their retirement years. The natural implication of this is that people’s behaviour might change if the benefits of public pension systems are significantly reduced. Indeed, there is evidence suggesting that in countries where retirement income is more heavily dependant on the accumulation of savings, individuals tend to behave more in line with what theory would suggest.[8]

My second argument as to why I think the hypothesis of an asset meltdown should not be dismissed at once concerns international capital flows. Several researchers have argued that free capital mobility, coupled with non-contemporaneous demographic patterns across countries, will help to smooth out a fall in asset prices. In developed economies, low internal demand for assets stemming from the ongoing demographic trends may be replaced by foreign demand originating in those countries where the working-age population is still growing and savings are higher. This argument may definitely hold true when dealing with assets which are easily tradable, but what happens, for example, if the majority of retirees want to sell their real estate property at once? How can we be sure that foreign investors from emerging economies, say young Asian investors, will be willing to buy property in southern Europe?[9]. I will return to this issue later, and illustrate how financial instruments can help in dealing with households’ wealth locked in property.

The first lesson to be learnt is that the possibility of an asset meltdown should not be ruled out, at least not ruled out for those assets whose value depends on local investment and consumption behaviour. The second lesson (to be kept in mind) is that investors (or the institutions investing money on their behalf) should hold diversified portfolios and, as much as possible, assets demanded by heterogeneous investors. Clearly, international capital mobility can increase the variety of investors buying certain assets, but, as I mentioned earlier, this may not be enough.

[Slide 5: International capital flows]

Now, let me expand a little on the international dimension. Economic analysis suggests that countries where the working-age population is increasing and savings are relatively more abundant than investment opportunities should be exporting capital. Similarly, countries where the working-age population is decreasing and the number of retirees is rising should be liquidating assets and importing capital. Thus, at the current juncture, we would expect capitals flows to be going “downhill”, flowing from developed economies (which are relatively rich in capital but limited in investment opportunities) towards emerging market economies (where capital is scarcer and investment opportunities are more abundant), so that investors can enjoy higher returns on their investment. By contrast, in the future, when emerging market economies have reached a level of development comparable with that of more developed economies, one would expect capital flows to move “uphill” in order to finance the needs of “older” countries.

However, there are at least two factors working against these well-known predictions of conventional economic theory. The first is that some of the emerging market economies that are growing more rapidly are also ageing more quickly. This is particularly the case in China, where it is estimated that the population will be older than that of the United States by 2030.[10] Taking China as an example, the pattern of capital flows that we have observed over the past few years could be explained partly by demographic changes, although specific exchange rate and trade policies may have emphasised the strength of these flows. Recent analysis suggests that, if Chinese households continue to save at the current rate and growth in public expenditures is kept under control, significant amounts of capital will flow to more industrialised countries.[11] A second important factor is that emerging market economies very often have underdeveloped financial systems, which are likely to deter capital flows from developed economies and could therefore explain why currently there is so little capital flowing towards developing economies. From a policy point of view, these considerations highlight the importance of promoting the development of more sophisticated financial structures, payment and settlement systems and – of course – efficient systems of corporate governance in these economies.

3. Hedging longevity risk, the retirement savings industry and financial markets

[Slide 6: The retirement savings industry]

Let me now turn to the current situation in the retirement savings industry and how certain developments may affect financial markets. As I have already mentioned at the beginning of my intervention, current public pension reforms are moving in the direction of shifting longevity risk more and more towards individual households. Consequently, individuals have to take responsibility for providing for their retirement through alternative means. Over the next few decades, we can therefore expect a substantial increase in the size of assets managed by the retirement savings industry, at least in those countries where this industry is comparatively less developed. One of the main consequences of this will be that this industry, and primarily pension funds, will assume a more important role and have a greater impact on financial markets. Pension funds all over the world already represent one of the largest class of investors. Their long-term investment strategies, as well as their choices of portfolio allocation, may already largely influence the prices we observe in the market. In addition, one could envisage that pension funds will become increasingly important shareholders in many corporations, with possible implications for corporate structures, investment choices, dividend policies and more broadly for corporate governance and the way firms are run.[12]

[Slide 7: Structural changes in the industry]

It is important to monitor not only the quantity of assets involved but also the structural changes taking place in this industry. Over recent years, there has been a shift away from defined benefit plans towards defined contribution plans. The main reason for this shift has been the underfunding of defined benefit plans which partly reflected unexpected demographic developments, but also reflected the impact of low interest rates coupled with heavy losses in equity portfolios. This shift implies that the choices made by these institutional investors in terms of portfolio allocation will tend to be more in line with individual preferences. For example, we can expect that, as a larger share of the population gets closer to retirement, the portfolio allocation of defined contribution funds will move more towards less risky assets. Incidentally, such investment patterns would increase the likelihood of an asset meltdown.

The regulations of the retirement savings industry are also an important factor that influences the portfolio allocation decisions of these financial intermediaries. Traditionally, pension regulations tended to focus more on pensioner and employee rights than on risk management. The requirements included minimum funding rules, restrictions on certain types of investment and “prudent person” rules. They did not look specifically at pension funds’ balance sheets or the risks involved. Recent regulatory (and accounting) reforms, however, have placed more emphasis on risk management. Proposed measures require pension fund managers to focus more on asset-liability considerations. What are the consequences of this in terms of financial instruments?

Pension fund managers and market observers claim that a greater supply of certain instruments is needed to properly hedge against interest rate, inflation and longevity risk. Since pension liabilities are long-term in nature, hedging against interest rate risk means increasing the duration of assets. The current supply of long-dated and index-linked instruments – which protect against inflation – is thought to be largely below the potential demand, although forecasts of this demand over the years to come vary greatly and depend on the baseline assumptions. Financial innovations could help to close this gap, as pension funds would be able to transfer the interest rate and inflation risk to other market players.

Unfortunately, the problem is more complex when it comes to longevity risk, which is much harder to hedge since it has no natural counterpart. Professionals working in the insurance industry claim that, at the moment, they are unable to satisfactorily forecast the increase in longevity over the years to come and are therefore unable to fairly price longevity risk. This means that for those market players wanting to hedge against longevity risk (pension funds and annuity providers), it is difficult to find a counterpart willing to assume this risk; and in this case, financial innovation will not help as there are almost no institutions willing to bear the risk. It could be argued that long-term care providers, as well as pharmaceutical companies specialising in products for old people, constitute a natural counterpart for bearing longevity risk, as these industries would benefit from greater longevity. The need for care is essentially age-dependent and the probability of requiring care rises significantly as people get older, doubling around every five years after the age of 65.[13] However, this industry seems to be far too small to be able to satisfy the projected demand.

Policy-makers should consider how to promote the development of markets to pool and transfer interest rate and inflation risk, as well as longevity risk. Governments could manage the maturity of their debt by promoting the issuance of long-dated and inflation-linked assets. For example, some countries recently issued very long-dated bonds in order to meet the rising demand[14]. However, the development of a market for longevity or mortality bonds may prove to be more challenging, since, as I outlined earlier, it is difficult to find issuers of such instruments.

4. Hedging longevity risk with financial instruments

[Slide 8: Individual longevity risk (I)]

Finally, I would like to look at the issue from the individual’s perspective and at how financial markets could provide instruments to help people manage the uncertainty surrounding longevity. The amount of risk borne by individual households depends on the design of the pension scheme. Households that do not rely, or rely only partially, on public pension schemes – with defined benefits – to fund their retirement years are directly exposed to longevity risk.

So far, I have talked about the financial instruments that financial institutions need to manage risks posed by ageing. Now, I would like to look at the financial products aimed at the individual. The natural product for households to insure against longevity risk is the annuity, a financial product that was designed centuries ago. As you all know very well, an annuity is a financial contract that converts long-term savings into a life stream of income after retirement. Theoretically, annuities are the perfect product for funding retirement (public pension schemes de facto provide an annuity). In practice, however, annuities are not as widespread as one might expect. Annuity markets for individuals are generally underdeveloped (or at least underutilised). In many countries, the market for annuity providers is highly concentrated, with the number of market participants having declined over recent years.[15]

There could be several reasons for this – taxation models, bequest motives, potential adverse selection motives, and lack of understanding of investors– but one further possibility is that the annuities market, at least in some countries, is being crowded out by the benefits provided by public pension schemes. It could therefore happen that, in countries where the benefits have been cut following social security reforms, there will be a rise in demand for such instruments, which, in turn, will trigger a rise in supply.

[Slide 9: Individual longevity risk (II)]

However, there are other products on the market that could be of more use to the individual. One of the main problems with annuities is that they are only beneficial to people “rich” in cash, people who can afford to buy a significant income. A household’s wealth, however, is often accumulated in forms other than just cash. In several countries, a significant portion of a household’s wealth is invested in real estate.

[Slide 10: Individual longevity risk (III)]

Thus, if we could “extract” this wealth and annuitise it, it could indeed become a major source of income for retired people. “Reverse mortgages” are financial instruments that allow retirees to draw on the equity of their home without having to move out. In practice, retirees receive a monthly payment from a bank which gains the rights to ownership of the house. In most countries, these arrangements are still rare, although they were initially designed decades ago. One reason could be that the costs of reverse mortgage loans are still perceived to be relatively high. Policies should be put in place to help develop a market for reverse mortgages, eliminating any regulatory and tax impediments/disincentives that are making these products so undesirable. These instruments could be repackaged as securities and sold in global markets; it might then be easier for young Asian investors to buy “property” in southern Europe after all.

[Slide 11: Financial literacy and financial education]

Finally, I would like to stress that it is important to improve financial literacy and promote financial education programmes for households. Surveys carried out in some countries show that households are behaving myopically and largely underestimate the magnitude of the risks they will face. In both the United States and the United Kingdom, evidence suggests that the level of undersaving is significant and that households lack the knowledge of basic financial concepts. Studies show that individuals overestimate their knowledge of concepts, such as inflation, compound interest and risk diversification.[16] Households should also become more financially sophisticated so that they can take advantage of the opportunities offered by financial markets.

5. Concluding remarks

[Slide 12: Conclusions]

In conclusion, the relationship between demographic changes and asset prices can be analysed from several points of view. In my opinion, it should be noted that although demographics may alter the existing equilibria in the prices of financial assets, financial markets can also give us the instruments we need to manage the risks we are facing. I believe that in this matter, more so than in any others, a lack of planning would be inexcusable.

Thank you for your attention.



[1] See “How to live for ever,” in The Economist, 23 February 2006.

[2] Primarily China, India and Brazil

[3] See the article entitled “Demographic change in the euro area: projections and consequences,” in the October 2006 issue of the ECB’s Monthly Bulletin.

[4] Siegel, J., “Stocks for the Long Run”, McGraw-Hill, New York, 1998.

[5] In this case it is assumed that investors are able to factor events far in the future into their current set of information. However, in Della Vigna, S. and Pollet J., “Attention, demographics, and the stock market”, NBER Working Paper No. 11211, 2005, it is argued that market participants are not able to take into account demographic changes beyond a five to six-year horizon when pricing assets.

[6] See Modigliani, F., “Life-cycle, individual thrift, and the wealth of nations”, in American Economic Review, Vol. 76, 1986, pp. 297-312.

[7] See Modigliani, F. and Brumberg R., “Utility analysis and the consumption function: an interpretation of cross-section data”, in Post-Keynesian Economics, Kurihara K. (ed.), Rutgers University Press, New Brunswick: New Jersey, 1954 and Ando, A. and Modigliani F., “The “life-cycle” hypothesis of saving: aggregate implications and tests”, in American Economic Review, Vol.53, 1963, pp. 55-84.

[8] See, for example, Boersch-Supan, A. and Winter J. K., “Population aging, savings behaviour and capital markets”, NBER Working Paper No. 8561, 2001.

[9] Spain and Italy are the euro area countries which are ageing the fastest.

[10] See Jackson, R. and Howe N., “The graying of the Middle Kingdom: the demographics and economics of retirement policy in China”, CSIS and Prudential Foundation, 2004.

[11] See Fehr H., Jokish S. and Kotlikoff L., “Will China eat our lunch or take us to dinner? Simulating the transition paths of the US, EU, Japan and China”, 2006, mimeo.

[12] See, for example, a recent paper by Qiu, L., “Selection or influence? Institutional investors and corporate acquisitions”, mimeo, 2006.

[13] See Just T., “More long-term care property for an ageing society”, Deutsche Bank Research, September 2006.

[14] 50-year bonds were issued by the French and the British Treasuries in February and May 2005 respectively.

[15] See G10 report “Ageing and pension system reform: implications for financial markets and economic policies”, September 2005.

[16] See “Caveat investor”, in The Economist, 12 January 2006.

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