The investment impact of an ageing population

By LARRY SWEDROE

As chief research officer for the Buckingham Family of Financial Services, I get lots of questions from investors based on what they are reading or hearing in the financial media. A significant part of my time is spent calming investors down, assuring them that what they are concerned about is nothing more than what Jane Bryant Quinn called investment porn — advice on markets that is designed to titillate, stimulate and excite you into action, but has no basis in reality.

Over the last few years I’ve been getting lots of questions about the ageing population and its impact on financial markets. The questions arise because the number of Americans ages 65 and older is projected to nearly double from 52 million in 2018 to 95 million by 2060, and the 65-and-older age group’s share of the total population will rise from 16 percent to 23 percent. Globally, the percentage of those age 65 and older is estimated to nearly double, from 8 percent in 2015 to 15 percent in 2045.

The concerns go something like this: How will the ageing population impact economic growth? As investors age, are they likely to invest or begin to liquidate their holdings in the stock market and, at a minimum, shift more into bonds? Ageing populations consume less, what impact will that have on economic growth?

In addressing these concerns, the first thing I point out is that you should not confuse information with value-relevant information (information you can use to outperform appropriate benchmark returns). It is only unanticipated events that move markets, not those that are fully anticipated. Think of it this way, if you know something (like a large segment of the population is nearing retirement), it’s a virtual certainty that other investors (especially the sophisticated institutional investors that now account for as much as 90 percent of the trading) also have this knowledge and have acted on it.

If anything is well known and predictable well in advance, it’s demographic trends. Thus, any expected impact of equity sales by retirees should already be reflected in today’s prices. It’s only if the level of equity sales is greater than expected should there be a negative impact on future equity prices. And, it is certainly possible that sales will be less than expected. It’s also possible that there will be an unexpected offsetting increase in demand for equities from other sources. If either is true, all else equal, equity valuations could increase.

A second point I raise is that often what one reads, even if it sounds logical and the arguments are persuasive, may still be wrong—as conventional wisdom often is. One of my favourite sayings is “It ain’t what a man doesn’t know that gets him in trouble, but what he knows for sure, but ain’t so.” The conventional wisdom about the relationship between age and investment allocations is actually wrong. There is no evidence that investors dramatically reduce equity exposure as they age. As Jim Davis of Dimensional pointed out in a 2005 article, the evidence actually suggests that investors “accumulate equity positions during years of their greatest earning power and do not dramatically reduce those positions as they enter retirement.” In addition, the evidence is that consumption as a percentage of peak income remains relatively smooth throughout life.

Another important point is that it is certainly possible that people will not retire as expected. Many people are now working well into what was considered the retirement years. For example, in Japan, with the oldest population in the world, workers are staying in the workforce until an effective retirement age of almost 71. This may become a common feature of other ageing countries. Thus, it’s possible that labour participation rates could increase. In addition, we continue to see rising levels of female participation in the labour force. Higher labour participation rates are positively correlated with economic growth. We are also seeing an increase in part-time employment. And the increase in the percentage of jobs which do not require hard manual labour is allowing more workers to extend their years in the work force, as well as allowing more women to participate in the labour force. Extending working years reduces the need to draw on portfolio assets.

Another issue to consider is that the U.S. equity market is not solely dependent on U.S. investors. The rapid growth of sovereign wealth funds and rapidly increasing per capita GNP in developing markets could lead to increased demand for U.S. equities from non-U.S. investors. Thus, it’s quite possible that when a U.S. retiree is selling shares the buyer will be a young software engineer from India or China. Thus, even if U.S. retirees become large net sellers of equities, it does not mean U.S. valuations will be negatively impacted. There might be offsetting increases in demand from other sources.

Vanguard’s research team examined the issues of an ageing population in their paper “The Economics of a Graying World.” Following is a summary of their key conclusions:

Demographics are only one factor affecting economic growth. Others are labour participation rates and productivity.
The developed markets that will have rising dependency ratios also have more service-oriented economies, which have jobs that are more accommodative than physically intensive manufacturing-oriented economies. That could raise the labour participation rate. Another positive contributor to labour participation rates could be concerns about the ability of government funded programs to meet their obligations.
Demographic trends will have a neutral to negative impact on long-term GDP growth through lower population growth and lower participation in the labour force. These downward pressures may be offset by the higher productivity growth that is needed for a shrinking number of workers to support a growing number of retirees. On balance, the overall impact will be muted, as demographic changes have only an indirect and minor effect on productivity growth, the main driver of economic growth.
Consumption as a percentage of peak income remains relatively smooth throughout life.
Shortfalls in retirement savings and increasing retirement ages may prompt those over 65 to continue saving well into traditional net spending years.
Although demographics may exert downward pressure on the risk-free interest rate, risk premia are not clearly linked to demographic changes. This is consistent with the conclusions reached by Carlos Carvalho, Andrea Ferrero, and Fernanda Nechio, authors of the April 2016 paper “Demographics and Real Interest Rates: Inspecting the Mechanism.” They found that main channel through which demographics affect real interest rate is the increase in life expectancy. The reason is that at all stages of their life cycle, individuals save more to finance consumption over a longer time horizon. However, that is offset to some degree by the raising of retirement ages in pension programs and working longer past retirement age. They concluded that a drop in the growth rate of the population produces two opposite effects on real interest rates. On the one hand, lower population growth leads to a higher capital-labour ratio, which depresses the marginal product of capital. This “supply effect” is very much akin to a permanent slowdown in productivity growth, pushing down real interest rates. On the other hand, however, lower population growth eventually drives up the dependency ratio. Because retirees have a lower marginal propensity to save, this change in the composition of the population is akin to a “demand effect” that pushes up aggregate consumption, and puts upward pressure on equilibrium real interest rates.
A declining ratio of dependents to workers, as occurs when populations age, leads to increased competition for qualified workers. Workers still in the labour force realise more bargaining power with respect to pay and policy. As the cost of labour rises, businesses will be incentivised to invest in productivity-enhancing projects to realise more output per worker. Recent research has found this to be the case in countries with rising dependency ratios, noting a more rapid adoption of automation that more than offset negative impacts from demographics.
Faced with lower fertility rates, developed markets could implement policy changes to increase migration and bolster economic growth via higher population growth.
There is no statistical relationship between the percentage of the population age 65 and older and real stock returns.
Diversification is investors’ best response to changing demographics. Unfortunately, many investors still demonstrate significant home bias in their portfolio allocation.
A low-cost, globally diversified portfolio provides the best chance of investment success through exposure to a variety of growth and demographic outlooks. The globalisation of financial markets that has occurred over the past 40 years has reduced potential risk posed by an individual country’s demographic trends. A region’s equity and fixed income assets are now affected by global supply-and-demand factors, mitigating the effects of local changes in demographics.

The research team at Vanguard also reached an interesting conclusion. “Widespread adoption of technology and robotics has significantly reduced the physical demands of labour, while providing flexibility for older citizens to continue working in later years. A recently published Vanguard research piece, Megatrends: The Future of Work, found that the U.S. labour force spends nearly 50% of its time on uniquely human tasks, up from just 30% in 2000. The pace of these trends is expected to accelerate and will result in the labour market competing to entice older workers to remain in the labour force longer. The changing nature of work, the incentives of working longer, and structural reforms to social programs will help ease the financial burden of ageing populations.”

Summary

The bottom line is this. Because today’s market valuations are based on all that is knowable about the future, it is likely that events that are currently unforeseeable will have a far greater impact on prices than demographic shifts. And because what we don’t know, by definition, cannot be forecasted, the biggest impact on equity markets will likely come from events that few if any even have on their radar screens.

Thus, investors are best served by ignoring market forecasts and instead should focus on the things they can actually control: The amount of risk they take, how well they diversify the risks they decide to accept (eliminating or minimising diversifiable/ idiosyncratic risks of single companies, sectors and countries), costs and tax efficiency.