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8
Capital Markets and Rates of Return
Population aging may affect the aggregate saving rate by raising the
fraction of the population in age groups traditionally associated with the
drawdown rather than the accumulation of savings. It may also affect the
economy's average level of savings per capita, since individuals approach-
ing, and shortly after, retirement age tend to have higher levels of savings
than those at the start of their working career. The preceding chapter de-
scribed both of these effects, which may affect the productive capacity of
the economy. These effects may also, in turn, affect the rate of return that
investors earn on their savings.
The average return on investments is a key determinant of the perfor-
mance of funded retirement plans in both the private and public sectors.
High rates of return enhance the power of private saving to provide for
consumption and health needs in retirement. If investors can earn a real,
net-of-tax return of 6 percent each year, for example, a dollar saved at age
53 will grow to 2 dollars at age 65. If the rate of return is 4 percent, how-
ever, a dollar must be saved at age 47 to double in value by age 65. With a
return of only 2 percent, a dollar must be saved at age 30 to double by 65.
For many households, the ongoing shift from defined benefit (DB) to
defined contribution (DC) plans has tightened the link between investment
returns and retirement security. As discussed in Chapters 5 and 7, the re-
turns earned by participants in DC plans, along with their contributions,
determine their asset balances at retirement and directly affect postretire-
ment living standards. In DB plans, the links between asset returns and
participant benefits are weaker, since the firm or government offering the
pension plan bears the risk of asset value fluctuations. When the assets in a
153
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154 AGING AND THE MACROECONOMY
private DB plan perform poorly, shareholders in the sponsoring firm earn
lower returns because the firm must make compensatory contributions to
fund the plan. Taxpayers play the role of shareholders in public sector DB
plans. Past and projected rates of return are likely to affect the willingness
of firms and government to continue DB plans, or at least continue them
at the same level.
Private wealth accumulation supports a substantial share of retire-
ment spending for some older households in the United States. For those
households with substantial wealth, the rate of return can be an important
determinant of retirement income. However, not all households have much
exposure to financial markets, and many retirees have low levels of both
financial and physical assets. For these households, rates of return are likely
to be relatively unimportant influences on their financial circumstances.
Poterba, Venti, and Wise (2011) report that in 2008, the median hold-
ing of all financial assets, including those in individual retirement accounts
and other similar vehicles, among households headed by someone aged
65-69 was $52,000. The analogous statistic was $112,000 for married
couples. Because the ownership of assets is concentrated, average assets per
capita are substantially greater than the assets of the median household. For
households near the median as well as for those with fewer financial assets,
their financial asset holdings are smaller than the value of prospective Social
Security benefits. Financial assets are also smaller than accumulated home
equity for those who own a home and smaller than DB pensions for those
who are eligible for such benefits. Because the wealth distribution is highly
skewed, however, there are also many households with substantial asset
holdings for whom changes in rates of return are consequential.
Many factors affect capital market returns, including global demo-
graphic trends, long-run trajectories of productivity growth, investors'
attitudes toward risk, and government tax and spending policies. Some
analysts have suggested that population aging during the next few decades
will drive down the general level of investment returns (Arnott and Chaves,
2011; Liu and Spiegel, 2011). They reason that as baby boomers approach
the traditional age at which asset holdings peak, assets will be in plentiful
supply and the equilibrium return on assets will decline. As The Economist
reported (2006), some have even suggested that when baby boomers draw
down their financial assets to pay for their retirement consumption, selling
pressure may generate an asset market meltdown, a sharp decline in asset
values. However, that scenario seems unlikely because it is inconsistent with
forward-looking behavior on the part of financial market participants; it
would require a sharp fall in asset prices in response to a predictable de-
mographic event.
This chapter examines the ways in which prospective changes in the
age structure of both the United States and the global population may af-
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CAPITAL MARKETS AND RATES OF RETURN 155
fect rates of return. The increasing globalization of world capital markets
requires a focus on how global population aging will affect the global
supply and demand for savings and the rate of return available to savers
(see Box 8-1 for basic terminology used in this chapter). The committee
begins by presenting a general framework that highlights the various ways
by which global population aging may affect rates of return. Because other
factor inputs, notably labor input, also affect asset returns, the committee
also explores how changing population age structure may affect labor sup-
ply and the decisions of young households with regard to human capital
acquisition. Rising investment in human capital by younger workers can
potentially offset some of the rate of return consequences associated with
population aging, since the effective labor supply from a small cohort of
highly skilled workers can be comparable to that from a larger cohort of
less-skilled workers. In evaluating how population aging may affect rates
of return, the committee draws on empirical studies that have compared
rates of return in the United States and other nations to various measures
of demographic structure as well as on findings from simulation models
that have been calibrated to reflect central attributes of the U.S. and the
global economy.
Demographic structure is only one of many influences on prospective
rates of return. While the committee does not attempt to evaluate all the
other forces that may affect such returns, it does note that the large fis-
BOX 8-1
Terminology
Throughout this chapter, a standard practice is followed and "savings" is used
to denote a stock and "saving" to denote a flow. The stock of savings refers to
the total amount of accumulated net assets that households, companies, and
governments hold. The amount of saving in a given period, a flow, denotes the
difference between income and consumption; the saving rate is the ratio of the
flow of saving to the flow of income. An increase in the saving rate increases the
supply of savings; an increase in desired consumption or investment increases the
demand for savings. "Assets" can refer to any store of value, including physical
assets such as land or plant and equipment, intangible assets such as patents,
and financial assets that represent claims on the cash flows paid by companies,
governments, or households. "Capital" here is used to denote the subset of assets
that are used to produce goods and services. The capital-labor ratio, a common
measure of the factor intensity of an economy, equals the ratio of the capital that is
used in production to the amount of labor used in production. Labor in this context
is a weighted sum, with the number of hours of labor input from different workers
weighted by the workers' skill level.
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156 AGING AND THE MACROECONOMY
cal deficits projected for the United States and other developed countries,
which in turn are substantially affected by population aging, could play a
significant role. These deficits will raise government liabilities and absorb
savings that would otherwise be invested in productive capacity, leaving
the economy with slower growth and fewer resources to support an older
population. One consequence of the government-induced increase in the
demand for savings could be higher rates of return. As is noted elsewhere,
the lack of a credible strategy and its timely implementation for reducing
projected deficits raises the risk of investors losing confidence in U.S. Trea-
sury debt, which could lead to a rise in interest rates and a decline in the
value of Treasury bonds.
HOW DEMOGRAPHIC CHANGE AFFECTS EXPECTED
RATES OF RETURN: A FRAMEWORK
The balance between the supply of savings and the demand for savings
determines the rate of return earned by investors. Households, businesses,
and governments that accumulate savings hold financial claims such as
bank deposits, corporate and government bonds, stocks, and deeds to
houses and other real estate. Other households, businesses, and govern-
ments may demand savings to deploy in financing investment, personal
consumption, or government consumption. They may issue financial claims,
such as corporate bonds, to the suppliers of savers when they deploy these
savings. An increase in the supply of savings lowers the expected rate of
return to savers, whereas an increase in the demand for savings increases
the return that savers can expect to earn. The decisions of savers about
what share of current output to save each year, together with the value of
savings that have been accumulated in past years, determine the aggregate
supply of savings. The demand for savings, in turn, is determined by com-
pany decisions about how much capital to use in the production process, by
government borrowing needs, and by household demand for credit.
An aging population can affect both the supply of and the demand for
savings, and there are potentially countervailing effects. This makes it dif-
ficult to provide a clear-cut answer to the question, Are asset returns more
likely to rise or to fall as a consequence of population aging? The commit-
tee concludes that the net effects of population aging on rates of return are
likely to be modest.
This analysis is generally set in a framework in which global asset mar-
kets operate as an integrated whole, which means that assets can migrate
freely to wherever they are expected to earn the highest rate of return.
Migration of assets tends to equalize expected returns internationally: The
global supply and demand for assets determines expected returns. This is
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CAPITAL MARKETS AND RATES OF RETURN 157
why the aging of the global population, weighted by the amount of assets
that residents of various nations hold, rather than the aging of the U.S.
population, is most relevant for predicting how aging will affect rates of
return. While the committee focuses on the mobile assets case, if asset mo-
bility is limited, then while global population dynamics may affect rates of
return, domestic demographic factors may also matter.
Table 8-1 shows the evolution of the U.S. old age dependency ratio,
the global old age dependency ratio in which population aggregates are
simply added up across nations, and a weighted old age dependency ratio in
which each country's dependency ratio is weighted by its current and pro-
jected per capita gross domestic product (GDP) rather than its population
in computing the global measure. The committee reports GDP-weighted
values because it does not have detailed information on the aggregate asset
holdings in each nation. The table shows that the global population today
is older on a GDP-weighted basis than on an equal-weighted basis. It also
shows that GDP weighting tends to reduce the disparity between the aging
of the U.S. and the global population. The per capita GDP-weighted old age
dependency ratio for the global economy rises more slowly than that for
the United States for the next 20 years, but it catches up in the subsequent
two decades.
Each year households decide how much to consume. When consump-
tion exceeds their income, they must draw down savings to finance con-
sumption, and vice versa. Companies decide whether to retain or distribute
their earnings and how much to invest; and governments decide whether
or not to save by collecting taxes in excess of current spending. Companies
that seek resources to deploy plant or equipment in their business or to
invest in new technology, households that wish to borrow because their
desired consumption exceeds their current income, and governments that
issue bonds because their tax revenues fall below their outlays determine
the demand for savings.
TABLE 8-1 U.S. and Global Old-Age Dependency Ratios, 2010-2050
U.S. Dependency Global Dependency Global Dependency Ratio
Year Ratio Ratio (Unweighted) (Per Capita GDP Weighted)
2010 21.6 13.4 19.5
2020 28.3 16.1 22.7
2030 36.8 20.1 27.5
2040 39.0 24.5 33.9
2050 39.3 28.3 37.8
SOURCE: Donehower and Boe (2012).
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158 AGING AND THE MACROECONOMY
Household Savings
The standard theory of consumer behavior has clear implications for
the amount of savings that households will choose to hold. The theory
posits that, all else equal, households prefer more consumption to less,
smoother consumption to a more volatile consumption profile, consuming
sooner to consuming later, and greater certainty about their consumption
path. For a given level of expected returns, the desire to smooth consump-
tion over time causes households to hold higher levels of savings when
they expect consumption growth to be relatively slow; conversely they save
less or try to borrow against future income when expected consumption
growth is more rapid. Impatient households postpone the accumulation of
savings until they near retirement age. Risk aversion motivates higher levels
of savings as a buffer against adverse economic shocks. While the effect of
higher expected rates of return on the household saving rate is theoretically
ambiguous, under many reasonable modeling assumptions it seems that
higher returns draw forth higher saving.
An aging population can affect aggregate savings in a variety of ways.
Because older households on average hold more savings than younger
households, an aging population will tend to display rising savings per
capita. The desire to smooth consumption leads households to save while
working so that they can draw down their assets to finance their retirement
years. Higher aggregate savings per worker can affect the marginal prod-
uct of capital--the amount of additional output that is produced from an
incremental deployment of capital investment--if it translates into a higher
level of capital per worker. Economic models of production imply that
when the number of workers per unit of productive capital declines, the
marginal product of capital will decline. A lower marginal product of capi-
tal would translate into a lower rate of return on incremental investments,
which could reduce the incentive to save and partly offset the aging-related
increase in savings per capita.
Population aging may also affect household savings by affecting the
expected path of productivity growth and thereby consumption growth.
Productivity growth is the most important determinant of consumption
growth over long horizons. The rates of output and consumption growth
over substantial periods of time are roughly proportional to the growth
rate of output per unit of labor used in production. Chapter 6 reviews the
evidence of the effects of an aging population on productivity and concludes
that there is likely to be a negligible effect of the age composition of the
labor force on the level of aggregate productivity over the next two decades.
Another way by which population aging may affect savings is its effect
on economic uncertainty. For example, households may increase their sav-
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CAPITAL MARKETS AND RATES OF RETURN 159
ings if the imbalances between promised social insurance benefits and the
tax revenues available to pay them create doubts about whether benefits
will be fully paid or whether taxes will be sharply raised. Aggregate savings
could fall, however, if developing countries introduce more extensive social
insurance programs for their older citizens that reduce their incentives for
private saving. China is currently pursuing policies of this type.
Savings by Companies and Governments
Companies and governments also make decisions that affect the aggre-
gate supply of savings. Companies save when they retain earnings instead of
paying them out to shareholders. Retained earnings generally are invested
in a firm's own operations or in securities issued by other entities. Compa-
nies have a greater incentive to save when expected returns are higher and
when there is more uncertainty about the availability of bank or investor
financing. Because companies operate on behalf of the households that own
them, household preferences are generally taken to be the fundamental de-
terminants of company saving and investment decisions. The foregoing dis-
cussion of the effect of population aging on household savings therefore is
suggestive of the forces that will indirectly affect corporate savings as well.
Governments save when current-year tax revenues exceed current-year
spending, i.e., when they run budget surpluses. Often those surpluses are
used to pay down government debt, but they also can be invested in real or
financial assets. It is likely that increases in government saving are partially
but not fully offset by reductions in household saving, so that government
saving increases the overall supply of saving. The effect of government sav-
ing programs on household saving may depend on the nature of the tax and
spending changes that are adopted. Except for a few years in the late 1990s,
the U.S. federal government has been a dis-saver for most of the last three
decades. Federal budget deficits have been particularly large as a result of
the deep recession that began in 2007. Projections described elsewhere in
this report suggest growing future deficits resulting from increased demands
on social insurance programs.
Population Aging and the Demand for Savings
Companies use savings when they deploy various types of capital, such
as land, real estate, equipment, and research and development capital, as
inputs to production. They invest more when there are a greater number of
profitable investment opportunities. When the return demanded by savers
is low, a firm's discount rate will also be low, and the number of projects
that will generate returns in excess of this threshold, or that will meet a
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160 AGING AND THE MACROECONOMY
present discounted value test, will be high. Population aging may affect a
company's demand for savings in several ways. First, as per capita labor
supply declines and labor becomes relatively scarce, firms may wish to
substitute capital for labor; this would stimulate investment demand. More
capital-intensive production processes may also allow older workers to
extend their stay in the labor force. A mitigating effect is that raising the
capital:labor ratio will reduce both the marginal product of capital and the
return on capital investment, all else equal.
Households demand savings when they borrow to finance purchases
of homes or cars, to invest in education, or to finance consumption. The
aging of the population may affect household borrowing demand. Older
households on average borrow less than younger ones--they are less likely
to want to buy a bigger house or to attend college, and they have less future
earning capacity to borrow against. However, if financial product innova-
tions create new ways for older households to use their home equity to
finance consumption, it is possible that borrowing by older households in
the future may be higher than it is today.
Governments borrow not only to pay for current spending, but also to
invest in capital that is used in the production of government services such
as transportation, education, and health care. An aging population per se
is unlikely to have a significant impact on that aspect of savings demand.
A more important way in which aging may affect government demand for
savings is by its impact on social insurance programs and associated budget
deficits, as noted above.
Asset Market Equilibrium and Expected Returns
Expected rates of return shift over time so as to equalize the supply of
and demand for savings. The foregoing discussion underscores the many
factors that influence supply and demand and their interactions with an
aging population. The underlying determination of returns, however, is
straightforward. An increase in expected returns increases the reward to
saving. Whether this raises or lowers the supply of saving is theoretically
indeterminate and has proven difficult to measure empirically. At the same
time, higher expected returns reduce the demand for savings, because it
becomes more difficult to find investment opportunities that earn a suf-
ficient return.
To summarize this discussion, Table 8-2 indicates the main channels
through which an aging population can affect expected returns. Because the
various effects point in different directions, evaluating the net effect of pop-
ulation aging on expected returns requires using an economic model that
makes it possible to compare the quantitative effects of different influences.
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CAPITAL MARKETS AND RATES OF RETURN 161
TABLE 8-2 Some Effects of Aging on the Supply of and Demand for
Savings
Aging Phenomenon Effect
Link to supply of savings
Older households have higher savings Increases supply
Policy uncertainty raises precautionary savings Increases supply
Higher capital-to-labor ratio lowers return to savers Decreases supply
Productivity growth effects Uncertain
Link to demand for savings
Firms substitute capital for labor Increases demand
Higher government deficits Increases demand
Older households borrow less Decreases demand
Productivity growth effects Uncertain
RISK AND RETURN
The preceding discussion implicitly assumed a single rate of the return
to investors, but in practice, there are a variety of real and financial as-
sets with different risk attributes and correspondingly different expected
returns. For example, households can save by holding stocks or bonds,
or by accumulating equity in their homes. Earlier chapters of this volume
examine how the choice between such alternatives may be affected by
population aging.
From a macroeconomic perspective, a key question is to what extent
an aging population will affect the aggregate risk appetite of the capital
market. If older investors are more risk-averse than younger ones, then as
the population ages, the price of risky assets may decline, and the required
risk premium might rise, relative to historical experience. Several studies
(notably Bodie, Merton, and Samuelson, 1992; Jagannathan and Kocher-
lakota, 1996) have suggested that older households may be less tolerant of
investment risk because they cannot offset adverse shocks to the value of
their asset holdings by increasing their labor supply. The typical advice of
financial advisers to reduce exposure to investment risk with age is consis-
tent with that reasoning.
Several recent analyses suggest that the link between age and the toler-
ance for investment risk--and its relation to labor income--may be more
complicated. For example, Benzoni, Collin-Dufresne, and Goldstein (2007)
argue that labor income is a significant source of long-run market risk for
young people, and hence they would be expected to be more averse to
investment risk than middle-aged households whose lifetime labor income
is more certain. They predict a hump-shaped pattern of risky asset holding
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162 AGING AND THE MACROECONOMY
over the life cycle, which in aggregate would imply greater risk tolerance
when a larger portion of the population is middle-aged. Changing tastes
for housing and financial assets over the life cycle may also affect both the
level of required returns and the risk premium for risky as opposed to safe
financial assets. For example, Bakshi and Chen (1994) suggest that the
demand for financial assets may increase as people age and their demand
for housing diminishes; this could, in turn, affect financial market returns.
Empirical and Simulation Evidence on Demographic
Structure and Rates of Return
To address the quantitative effect of population aging on rates of return,
a number of studies have compared historical returns on financial assets in
different time periods or different countries that were characterized by dif-
ferent population age structures. Other studies have used simulation models
that incorporate the supply and demand elements that were described above
to analyze the size of these effects. Each of these research strategies has
strengths as well as weaknesses. Empirical analyses rest on relatively little
historical experience with the type of population aging that many developed
nations are about to undergo. Simulation modeling depends on many as-
sumptions about difficult-to-measure parameters such as discount rates, the
elasticities of substitution between consumption today and in the future,
and the extent of openness in cross-country resource flows.
The committee noted in Chapter 2 that if age-specific asset holdings
were not affected by population aging, the change in population age struc-
ture between 2010 and 2050 would result in a noticeable increase in per
capita asset holdings in the United States. Table 8-3 shows mean net worth
for households, classified by age of the household head, from the 2007
Survey of Consumer Finances. Because of the skewness of the wealth dis-
tribution, age-specific means are typically much greater than medians. For
TABLE 8-3 Household Net Worth by Age of Household Head, 2007
Mean Net Worth
Age of Household Head ($ thousands)
<35 106.0
35-44 325.6
45-54 661.2
55-64 935.8
65-74 1,015.2
>75 638.2
SOURCE: U.S. Census Bureau (2012, Table 721).
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CAPITAL MARKETS AND RATES OF RETURN 163
the 65-74 age group below, for example, the median is $239,400, compared
with $1,015,200 for the mean. For analyzing the total supply of savings,
however, it is appropriate to focus on means. If it is assumed that these
age-specific means and household headship rates will remain constant for
the next 40 years, average per capita net worth (all ages, in 2007 prices)
would rise from $225,900 in 2012 to $248,100 in 2050. This increase
of 9.8 percent would be attributable to the changing age structure of the
population. If we just consider the population in the prime working ages
20-64, the ratio of net worth to population aged 20-64 will increase more
rapidly (21 percent) during this period because the population aged 20-64
will grow more slowly than the total population in the coming decades.
Making projections of future asset holdings based on current age-
related profiles is challenging, because it is impossible to fully disentangle
age and cohort effects on wealth accumulation. For example, it is difficult
to determine whether a decline in assets between ages 60-64 and 65-69
reflects a movement along an age-wealth profile, or the fact that those
who were in the latter age group experienced different labor market and
financial market conditions and were consequently less wealthy than their
slightly younger counterparts. It is also important to recognize that the
wealth distribution is highly skewed, so that average asset levels can be
quite sensitive to the holdings of a small group of households.
There are also important age-related patterns in labor supply. The Bu-
reau of Labor Statistics (2012) reports that the fraction of the population
aged 18-19 that was employed in 2011 was 36.9 percent. The fraction rose
to 60.8 percent for those 20-24 and to 73.8 percent for those 25-34. For
those between the ages of 25 and 54, the average was 75.1 percent, with
relatively little variation across age groups. After age 55, however, labor
market activity begins to decline, with an employment:population ratio
of 68.1 percent for those 55-59, 50.8 percent for those 60-64, and 16.7
percent for those over 65. The rise in the employment:population ratio in
the intermediate age group is more pronounced for men than for women,
who traditionally took time out of the labor force for child raising and who
had a lower peak labor force participation rate. Age-related changes in the
aggregate labor force could affect the rate of return on assets.
Empirical Analyses of Past Returns and Demographic Structure
Data on population age structure and rates of return, both over time
in individual countries and across nations, can be used to examine the
correlation between demographic factors and asset market returns. While
several studies identify a strong relationship between a particular measure
of demographic structure and a particular set of asset market returns, others
find little or no association. The research has used a number of different
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164 AGING AND THE MACROECONOMY
measures of age structure, and some demographic measures do not seem to
be related to return outcomes while others do.
Arnott and Chaves (2011), one of the latest studies in this tradition,
examine the empirical relationship between population age structure and
stock and bond returns in a number of developed countries. They allow
for a relatively flexible relationship between age structure and returns and
conclude that rapidly aging countries will experience substantially lower
equity returns than other countries. The United States, however, is roughly
in the middle of the country group that they study, with only modest return
effects. Their analysis presumes that each country's demography is related
to its asset returns, in contrast to the committee's focus on global aging as
the key determinant of rates of return. Brooks (2006), in contrast, studies
a number of nations and finds no robust relationship between age structure
and asset returns. In fact, in countries with extensive stock market partici-
pation, such as Australia, Canada, New Zealand, the United Kingdom, and
the United States, he finds that many households continue to accumulate
assets well into old age. Poterba (2001) finds that measures of demographic
structure have only a weak correlation with asset returns in the United
States, with the strongest relationship observed between the price:earnings
ratio and the share of the population in middle age. Geanakoplos, Magill,
and Quinzii (2004) report that variation in the ratio of middle-aged to
young households has predictive power for equity returns in the United
States and several other nations. They also develop a simulation model that
suggests a substantial decline in the price:earnings ratio for U.S. equities in
the decades ahead.
The large variation of findings in the empirical literature is probably
due to the relatively slow evolution of demographic variables in the recent
past, which means that even when data are available for many years, there
may be relatively little effective variation in the explanatory variables.
Simulation Evidence
The simulation literature on the effects of changing demographic struc-
ture has included studies of a single economy, best interpreted as represent-
ing the global economy with fully integrated capital markets, as well as
studies that recognize the different current and prospective demographic
structures of various regions of the global economy. Most studies consider
a single asset category, which can be thought of as all capital invested in
productive uses. The return on such an aggregate capital measure would
correspond to a weighted average of the returns that investors earn on
stocks and bonds issued by corporations and on their investments in owner-
occupied housing and other real estate. The simulation studies suggest that
there may be a modest decline in rates of return--between 30 and 100 basis
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CAPITAL MARKETS AND RATES OF RETURN 165
points1--in response to population aging of the type that will take place
in the United States and other developed nations in the next few decades.
A number of simulation studies have also considered how population
aging may affect the equity premium--the difference between the expected
return on risky assets such as corporate stocks and safe assets such as Trea-
sury bills. Brooks (2004) suggests that when baby boomers retire, there will
be an increase in the equity premium. This would translate into a decline in
the value of corporate stocks and generate low returns for investors in this
cohort. This result is driven by a large sell-off of equities by retiring baby
boomers who want to hold less risky portfolios during retirement. Boersch-
Supan, Ludwig, and Sommer (2007) reach the same conclusion. As with
the effect of demographic change on overall returns, there is some disagree-
ment about the potential effect of aging populations on the risk premium.
Geanakoplos, Magill, and Quinzii (2004) and Brooks (2002) both predict
a fall in the equity premium. Kuhle (2008) shows that whether the return
on risky relative to less risky assets rises or falls depends on the relative
price elasticities of the two asset classes. Existing empirical work does not
provide definitive evidence on this elasticity.
FINANCIAL MARKET INTEGRATION AND
CROSS-BORDER FINANCIAL FLOWS
The discussion so far has assumed that cross-border financial flows
equalize the returns to assets invested in different nations. In such an
integrated global financial market, when the aging population in one na-
tion leads to a rising supply of savings and in the associated physical
capital:labor ratio in that country, households can invest in other nations
and take advantage of the lower capital:labor ratio elsewhere to earn a
higher return than the one that would be available if the domestic economy
was an isolated entity. If the population of a small, "open" economy grows
old but the rest of the world has a stable age profile, there may be very
little if any effect on the rate of return earned by its residents--by investing
abroad, they can continue to earn the prevailing global rate of return. The
open economy setting implies that rate-of-return effects may be small, but
it also implies that there may be substantial cross-border financial flows in
response to changing demographic structure. These flows may be of inde-
pendent interest as a macroeconomic phenomenon.
This section describes the patterns of U.S. financial flows that could
emerge over the next three decades in a fully integrated world economy. In
addition, it highlights the potential importance of restrictions on financial
1A basis point is a unit of measure equal to 1/100th of a percent (i.e., 0.01 percent), often
used to describe the percentage change in the value or rate of a financial instrument.
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166 AGING AND THE MACROECONOMY
flows when different countries are aging at different rates. The evidence on
how global population aging will affect financial flows is based on analysis
of historical experience and calculations using simulation models. Bryant's
(2006) analysis suggests that between the 1950s and the mid-1970s, de-
mographic forces were a major factor behind flows of financial capital and
direct investment from the Northern to the Southern Hemisphere. However,
beginning in the 1970s, he finds that demographic change dampened, rather
than augmented, these flows. His analysis suggests that the pattern of recent
decades may persist for some time to come.
While the evidence on financial flows from simulation models is some-
what varied, several findings warrant attention. First, the paths of factor
prices--the rate of return to capital and the wage rate--as well as aggregate
variables such as assets, consumption, and investment, are considerably
different under different assumptions about interregional financial flows.
Attanasio, Kitao, and Violante (2007) and Boersch-Supan, Ludwig, and
Winter (2006) find that population aging has significantly less influence
on these macroeconomic variables in an open economy than in a closed
economy. In these studies, developed-country wages increase less and rates
of return decrease less under the open-economy than the closed-economy
assumption. This affects the welfare of different generations differently, as
shown by Krüger and Ludwig (2007) and Ludwig, Krüger, and Boersch-
Supan (2007). Younger generations profit from the increase in wages, while
older generations are likely to suffer from a modest decline in rates of re-
turn on assets. These patterns may be partly offset by government transfer
programs that reallocate resources across age groups.
Financial flows have a moderating effect because they reduce the rela-
tive changes in capital:labor ratios. In these stylized models, initially, sav-
ings flow from fast-aging regions to the rest of the world, but this trend
is reversed when households in aging economies start to draw down their
saving. Yet these model-based predictions do not account for a number of
other factors that may affect financial flows, and they also do not fit the
recent experience of major financial flows from the developing world to
developed nations like the United States. The recent experience underscores
that other factors, such as cross-national differences in underlying saving
rates, can play key roles. Prospective changes in social insurance programs
in some developing nations could alter the demand for precautionary sav-
ing in those nations, thereby affecting their national saving patterns and
financial flows.
Just as cross-border saving flows could play an important part in offset-
ting the impact of population aging in a given nation, cross-border labor
flows could also matter. Immigrants tend to be younger than native popula-
tions, and if immigrant flows are large relative to existing populations, they
could affect measures of the population age structure. The demographic
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CAPITAL MARKETS AND RATES OF RETURN 167
projections that underlie our analysis incorporate forecasts of future im-
migrant flows to the United States. Since the United States is already at the
high end of the developed world in its immigrant inflow, it seems unlikely
that the rate of immigration will increase enough in the future to substan-
tially alter the rate of population aging (see Chapter 3).
The comparisons between simulation analyses with and without open
capital markets underscore the significance of capital controls and other
factors that might affect cross-border financial flows in determining the
effects of population aging on rates of return. At the moment, the United
States is not experiencing financial outflows and is instead a destination for
financial flows. The prospect of any restriction on outbound investments
therefore does not seem like a near-term possibility. Over the longer term,
however, if global economic conditions shift and developed nations with
aging populations assume a larger role as asset suppliers, public policies
that affect financial flows could matter.
An additional factor that may affect cross-border financial flows is the
global pattern of debt:GDP ratios. The trend in this ratio is quite different
in developing and developed nations. The International Monetary Fund
(2011) observes that the debt:GDP ratio in emerging market economies
has fallen since 2006 and is projected to fall further by 2016, while the
analogous ratio in developed countries is rising sharply. For the world as a
whole, the ratio of government debt to output is expected to change rela-
tively little from 2006 to 2016.
"HUMAN CAPITAL DEEPENING": HOW MUCH
OFFSET TO LABOR FORCE DECLINE?
The foregoing discussion of how population aging affects the labor
force treated the age-specific pattern of labor market activity as fixed, even
though there are a number of margins on which adjustment is possible.
These include an increase in labor force participation at old and young ages,
an increase in female labor force participation, which is still below male
labor force participation in most developed nations, and an increase in the
quality of labor through more training and education (human capital deep-
ening). Increases in the global supply of labor, whether through expanded
labor market participation or through increases in the effective per capita
supply of labor, would tend to raise rates of return. The migration of labor
from rural to urban economies in developing nations such as China and
India is one of the important factors that may continue to influence the ef-
fective level of global labor supply.
Both physical and human capital serve to transfer wealth over time
and even between generations. Savings and human capital accumulation
are therefore closely linked. Worker investment in human capital is a fac-
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168 AGING AND THE MACROECONOMY
tor that may attenuate the effects of population aging on asset returns. For
example, if laborers are scarcer in an older society than in a younger one,
and if young workers observe rising returns to supplying labor and take
actions to enhance the value that they can deliver to an employer per hour
of work, the resulting deepening of human capital will partly offset the rise
in the capital:labor ratio and the associated change in the marginal product
of physical capital.
Some broadening and deepening of the labor force is likely in response
to the wage changes that will be associated with population aging. Such
reactions are observed in simulation results from models calibrated to the
U.S. economy. They show that increasing capital intensity as a consequence
of aging will increase human capital investment, which in turn increases the
productivity of physical capital. Ludwig, Schelkle, and Vogel (2010) find
that the strength of that mechanism will depend, among other things, on the
relationship between private investments in human capital and subsequent
after-tax, net-of-transfer program returns.
It is also possible that changes in the labor markets of other nations,
particularly those in the developing world, could affect the productivity of
capital invested in the United States as well as the wages of U.S. workers.
There are few, if any, quantitative studies of the cross-border effects of hu-
man capital accumulation. Because human capital levels across Organisa-
tion for Economic Co-operation and Development (OECD) countries are
already high and rather homogeneous, spillover effects are probably small
and they are likely to be difficult to measure. On the other hand, further
human capital deepening in emerging countries can, and probably will, play
a significant role in determining the capital:labor ratio of those countries.
The committee is not aware of any macroeconomic studies calibrated
to developing nations, but it is possible to use microeconomic studies to
assess the potential consequences of increases in educational attainment in
these countries. Psacharopoulos and Patrinos (2002) report that the social
return on an additional year of secondary schooling is about 10 percent
in rich countries, 13 percent in middle-income countries, and almost 16
percent in poor countries. Private returns are even higher. Average years
of schooling are 9.4 for rich countries, 8.2 for middle income countries,
and 7.6 for poor countries. This suggests that in many nations, there is
still room for improvement in human capital and for associated reductions
in the capital:effective labor ratio. Such human capital deepening would
raise the marginal physical product of capital.
As economically important developing nations that are well integrated
with the global economy, such as China and India, embark on growth paths
with rapidly growing educational attainment, they will play an increasingly
important role in determining the global capital:labor ratio. Restuccia and
Vandenbroucke (2011) present some evidence on prospective catch-up
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CAPITAL MARKETS AND RATES OF RETURN 169
trajectories, suggesting that relatively rapid human capital deepening is pos-
sible in a number of developing nations. The trajectory of human capital
acquisition in these nations will be a potentially important influence on the
global rate of return to capital in the decades ahead.
Human capital investments in developing nations can moderate the
decline in the rate of return available to U.S. investors as a result of global
population aging. There are likely to be substantial differences across de-
veloping nations in the rate of human capital growth. In countries with
relatively low birth rates and an aging population (e.g., China), the process
of raising average human capital per worker by educating young workers
can take a very long time. However, in countries such as India with rapid
population growth and a large flow of young entrants to the labor force,
raising the average education level in the population can take place over a
shorter time period and potentially proceed for a longer time period.
HOUSING ASSETS
Much of the foregoing discussion treats assets as though they are com-
petitively traded in an integrated world economy. While that might be an
apt description of the markets for stocks and bonds, it does not apply to
assets such as land or owner-occupied housing. Such housing, in particular,
looms large on the balance sheets of older households in the United States.
Poterba, Venti, and Wise (2011) report that for many older households,
Social Security and owner-occupied housing are the primary sources of
retirement security. Housing equity may provide an important source of
financial support in response to adverse shocks. One of the first studies of
demographic variation and asset prices (Mankiw and Weil, 1989) focused
on how a shifting age structure might affect housing demand and ultimately
house prices. That research suggested that an aging population would lead
to lower housing demand and falling house prices.2 While the two decades
since that analysis have drawn attention to many other factors that may
affect housing markets, a feature that distinguishes owner-occupied hous-
ing from stocks, bonds, and many financial assets is that it must be owned
domestically. This results in a tighter linkage between a nation's population
age structure and the level of demand for such housing than, for example,
between its age structure and the demand for corporate equity claims.
In nations with declining population numbers as well as aging popu-
lations, such as some countries in Europe, the demand for housing will
2The Mankiw and Weil analysis spurred considerable methodological discussion and cri-
tique in the 1990s (e.g., Hamilton, 1991; McFadden, 1994; Green and Hendershott, 1996)
and continued to motivate research in subsequent decades (e.g., Federal Reserve Board of San
Francisco, 2005; Takats, 2010).
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170 AGING AND THE MACROECONOMY
decline in future decades. This will lead to a smaller total value of housing
assets. This can occur through a decline in new construction, depreciation
of the existing stock of housing, and/or a drop in the price of existing
houses. The drop in house prices is a signal to builders to reduce the flow
of new construction. Land prices are also likely to decline, since land, unlike
residential structures, does not depreciate. The effects in the United States
are likely to be more modest, because the U.S. population is projected to
continue to grow through the next century. The effects on house and land
prices are also likely to vary substantially across regions and even metro-
politan areas.
CONCLUSIONS
Population aging in the United States, as well as global population ag-
ing more generally, is likely to have only a modest effect on rates of return.
There is substantial uncertainty about the magnitude of this effect, as well
as about the channels that will prove to generate the strongest effects.
Some asset classes may be affected more than others. For example, owner-
occupied housing in areas with rapidly aging populations may experience
a decline in values, while land in the central business district of cities with
rapid population inflows may rise in value. Cross-border capital flows and
immigration could influence the ultimate effects. Moreover, there are close
links between policies discussed elsewhere in this report, notably fiscal
policy, and the long-run effect of population aging on rates of return.
There are important links between the financial markets in different
nations, so the committee's focus for studying population aging and rates
of return is on an integrated global economy. In considering how U.S.
population aging may affect the rates of return available to U.S. investors,
therefore, it is important to examine a number of features in the global
economy such as the prospective growth rate of currently emerging econo-
mies and the degree to which immigrant labor can move from savings-poor
to savings-rich nations. Given the uncertainties in the many forces that
could strengthen or attenuate the effect of population aging on rates of
return, the committee concludes that it is reasonable to assume that such
an effect will be modest. It recognizes that financial markets in recent years
have become more volatile, and its conclusion in part reflects the view
that future volatility is likely to be dominated by nondemographic factors.
If volatility remains high, this could affect the asset allocation choices of
older households. It is important to recognize, however, that there are
scenarios in which rate-of-return effects could be substantial and in which
they would have significant effects on the retirement income of the future
elderly population. Volatile financial markets may increasingly challenge
older households with the need to make sound financial decisions.
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CAPITAL MARKETS AND RATES OF RETURN 171
ATTACHMENT 8-1
PHYSICAL RETURNS, ASSET PRICES, AND THE
TERM STRUCTURE OF FINANCIAL RETURNS
In a competitive financial market, the expected rate of return varies
over time in a manner that equates the supply of, and demand for, savings.
Savers directly invest in financial assets such as stocks and bonds that are
issued by companies, they hold bonds issued by governments, and they also
invest indirectly through financial institutions such as banks and mutual
funds. Firms use the money raised from households and intermediaries to
invest in physical assets--property, plant, and equipment--that are inputs
into the production process. Over time, the income generated from such
physical investments, net of expenses such as wages and maintenance, is
used to pay interest and principal to bondholders and to pay dividends to
stockholders or to repurchase their shares.
A simple example may help to illustrate the relationship between re-
turns on financial assets, physical assets, and asset prices, and how those
quantities are affected by the demand for and supply of savings. Consider a
machine that produces $10 worth of output in excess of operating expenses
every year forever. A firm finances the purchase of this machine by issuing a
share of stock. The market value of the stock depends on the rate of return
available to investors on similar investments. For example, if the expected
rate of return is 5 percent over the next year and also for every year in the
future on similar assets, then the price of the share would be $200. This
is because the present value of a perpetual claim on $X, discounted at r
percent per year, is $X/r. This price is consistent with the required return
for investors: a 5 percent return on $200 is $10 per year.
If the cost of building another machine exceeded $200, no new ma-
chines would be produced because investors could make a higher return
on alternative investments. Alternatively, if the production cost were less
than $200, manufacturers would find unlimited demand for their products,
since buyers could earn more than the 5 percent available on alterna-
tive investments. Thus, new machines would be put into production until
the cost of building the units rose or the value of their output fell to the
point where any additional machine built would earn 5 percent. Hence the
forces of supply and demand for capital cause the expected return on any
incremental unit of physical investment--the "marginal physical product
of capital"--to equal the expected return on financial assets. The prices of
existing financial and physical assets also adjust so that expected rates of
return are equalized across investments. Those forces operate internation-
ally; because investors seek the best investment opportunities at home and
abroad, expected returns tend to be similar around the world. A more pre-
cise statement is that expected risk-adjusted returns are equalized; invest-
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172 AGING AND THE MACROECONOMY
ments with higher levels of risk that cannot be reduced by diversification
have higher expected returns than less risky investments. Tax differences
across jurisdictions, and other market frictions, can also generate differ-
ences in rates of return across places.
The expected rate of return also depends on consumer preferences,
which determine the supply of savings. When the aggregate supply of sav-
ings increases, for example because in an older society more people hold
substantial retirement savings, the demand for existing assets rises. This
puts upward pressure on asset prices and lowers expected returns, thereby
encouraging greater investment in physical capital. In the foregoing ex-
ample of a machine, if the expected rate of return were to fall unexpectedly
from 5 percent to 4.5 percent, then the price of existing machines would
immediately increase from $200 to $222 (= $10/.045). The higher price
would encourage additional investment in new machines, which would
continue until the cost of producing them rose or the value of their output
fell to the point where the expected return on an incremental investment or
the purchase of an existing machine was 4.5 percent.
Population aging is a predictable process that is unlikely to cause sud-
den changes in asset prices, but it may affect the time pattern of returns
that investors expect to earn in the future. Investors may, for example,
expect to earn different rates of return in different years. Continuing with
the previous example, imagine that investors expect the rate of return on
the machine to be 5 percent per year for the next 5 years, then to fall to
4.5 percent annually for the 5 years after that, and then to stay at 4 percent
for the indefinite future, reflecting the higher amounts of per capita savings
held by the older population at that time. The price of the machine would
rise each year during the first 10 years, so that the sum of the $10 profit
from the machine's production, plus the capital gain, would generate the
return demanded by investors. It would reach $250 (= $10/.04) in year 10.
Table 8-A-1 shows the price path that would provide investors with a total
return--the combination of the $10 profit and the associated capital gain
on owning the machine--that would equal their required return. In year 9,
for example, when investors require a 4.5 percent return, the price would
begin at $248.80, and the profit of $10, plus the $1.20 appreciation of the
machine, would generate a return of 4.5 percent: [(10 + 1.20)/248.80 =
.045]. Note that the price path rises gradually over time and levels off after
year 10, at which point returns remain constant forever.
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CAPITAL MARKETS AND RATES OF RETURN 173
TABLE 8-A-1 Illustrative Price Path Needed to Provide Investors with
Their Required Return
Elapsed Number of Years Price of Machine (dollars)
0 234.88
1 236.62
2 238.45
3 240.37
4 242.39
5 244.51
6 245.52
7 246.56
8 247.66
9 248.80
10 250.00
