LONDON, England / The Financial Times / October 16, 2010
Plot thickens in the scary world of pensions
By John Authers
When PD James, the English whodunit writer, turned her hand to predicting the future, she produced a terrifying read. In The Children of Men, she portrayed a future world in which humans have stopped reproducing. Ageing populations rail at the pointlessness of their existence. Frustrated gangs roam the countryside indulging in mindless violence. England falls into the clutches of a dictator who organises mass suicides.
That book was published some 15 years ago, and its viewpoint was extreme. But in finance the vision sometimes does not seem so far-fetched. In the past week, strikers have brought France to a halt over plans to raise the retirement age from 60 to 62, while scare headlines greeted an effort to change the taxation of UK pensions.
Even if governments somehow get through the acute problems caused by the bursting of the credit bubble, the chronic problem of tending to an increasing elderly population will soon take over. How exactly will this affect our finances?
Standard & Poor’s this month produced a report measuring the proportion of gross domestic product that “age-related expenses” – on healthcare, pensions and so on – could be projected to take as populations aged. Assuming no actions in the interim to reduce deficits, it found that the size of the state would increase significantly, with government spending rising to 60 per cent of global domestic product, from 44 per cent today.
The debt burdens would be unsustainable. In the UK, government debt would rise to more than 430 per cent of GDP by 2050 (up from 162 per cent of GDP in the previous projection S&P made for this figure in 2007).
This sounds like PD James territory. But S&P emphasises that these are not predictions. Its analysts believe that the scale of the problem – and the attitude of bond investors – will force governments to take action before they grow this indebted. They also point out that the window to tighten budgets remains open, although “it will not be for long with the expected acceleration in spending starting in 2020”.
Stepping back from dystopian scare stories, it seems inevitable that ageing populations will put a brake on the world economy. Governments must either tax more or push up interest rates by borrowing more.
But how bad does it need to be, and what effect will it have on asset prices? Could the large group of the aged help push down share prices and thereby dent the pensions that the elderly will receive? Quite possibly. Earlier this year, this column featured research by Barclays Capital. It compared cyclical price/earnings ratios on stocks (as good a measure of equity valuation that exists) since 1950 with the ratio of 35-54-year-olds in the population. The fit was excellent; the more people were in the peak demographic for investing, the higher stock multiples went. The peak of the Nasdaq bubble in 2000 came just as baby boomers were saving and producing the most.
The corollary is disturbing. As people of peak investing age begin to be outnumbered by the elderly, logic suggests that share valuations will fall.
But there are balancing mechanisms. Traditionally, pension funds invest more in bonds, as retirement approaches. Regulations are forcing them in that direction any way.
Thus the greater supply of bonds from governments may meet a greater demand for them from pension fund managers. The net result need not be catastrophic.
George Magnus, consultant at UBS who last year published a book called the Age of Aging, is sceptical whether ageing will damage our wealth. He reasons that if retirement ages are raised to the late 60s (which is probable, even if many in France man the barricades), phased retirement plans become more prevalent (which he considers likely), and there are large changes in pension financing and funding (which is inevitable), then the impact of aging on the savings flows going into equities might well help to offset the economic effects of the shrinking of the labour force.
Another balancing mechanism is geographic. As the chart shows, the developed world is ageing more quickly than the emerging markets, which have much less expensive social safety nets. The emerging world may yet pick up the slack and produce the growth needed to keep asset prices buoyant.
Jeremy Siegel, professor of economics at the Wharton School in Philadelphia, produced a model, in his The Future for Investors, that suggested that westerners’ comfort in retirement was almost wholly dependent on productivity growth in the developing world. If the developing world keeps raising productivity at 6 per cent per year, then the US could meet the needs of its ageing population while barely raising the retirement age from 62. If, however, developing world productivity growth stalls completely, then the US retirement age by 2050 will have to rise to 77.
This helps explain why so much ink is spilt over China’s economic prospects. If it stalls, then the prospects are almost as scary as a PD James novel.
Copyright The Financial Times Limited 2010