PensionReforms' summary and comments

This paper (for a G-20 workshop hosted by the Reserve Bank of Australia and the Australian Treasury) suggests that demography may matter to asset prices.  This contrasts with an alternative view reported here.

This paper suggests that the combined effect of ageing populations and the move by governments towards more pre-funding of future pension obligations must affect capital markets (including house prices) as different countries turn from accumulation to decumulation at different times.  

"Hence, to the extent that capital is internationally mobile, population ageing will induce capital flows between countries. All three effects influence the rate of return to capital and interact with the demand for capital in production as well as the supply of labour.

"In order to quantify these theoretical effects, the Mannheim Research Institute for the Economics of Aging (MEA) has developed a computational multi-country overlapping generations (OLG) general equilibrium model. We feed this model with detailed long-term demographic projections for seven world regions and compute the time paths of saving, capital flows and returns to productive capital as demographic change proceeds. Our simulations indicate that capital flows from fast-ageing regions to the rest of the world will initially be substantial but that trends are reversed when households decumulate savings. We also conclude that closed-economy models of pension reform miss quantitatively important effects of international capital mobility."

The analysis suggests there will be "no devastating 'asset-price meltdown' " but, because of the difficulties with population projections more than a generation ahead, the results of the analysis beyond 2030 need to be "interpreted with care."

"Finally, this paper shows the importance of the interplay between saving and labour supply adjustments in response to population ageing.  Saving rates, rates of return and international capital flows react substantially less to demographic change once households absorb some part of the demographic shock by working more."

PensionReforms notes a couple of potential gaps in the OLG-MEA model - first it assumes no changes to exchange rates over the modelling period.  Because the exchange rate is one outcome of money flows and supply/demand, it is one way that markets price a country's prospects on a continuous basis across and between countries during the ageing process.

Secondly, the "households in the OLG-MEA model offer a fixed amount of work".  The paper itself suggests that this may not be the future experience.  PensionReforms agrees.  As ageing countries adapt their PAYG pensions to cost pressures, their State Pension Ages (and the retirement age) are likely to increase.

PensionReforms wonders whether returns to capital will in fact be sensitive to demographic change.  Housing may be an exception to this because, as the paper notes, the markets for houses are less 'international' (though that could itself change because the international markets for their occupants will probably become more open).

Demography will certainly change things but PensionReforms suspects that will be the opening up of new business opportunities (retirement villages; aged healthcare facilities, annuities) and new markets and the reduction of other types of business.  The paper implies either that the accumulation/decumulation processes will change the base, risk-free rate of return or that the premium demanded by equity investors will change (or both).  It seems hard to see why demography might affect those, even when retirees start decumulating.  The evidence on whether retirees actually decumulate before getting to quite old ages, incidentally, seems equivocal.

So, will demographic changes reduce or increase the demand for capital?  If there is to be a change (either way) might the market self-correct or will the then current young savers accept a lower return or demand a higher return?  Will that happen suddenly or gradually?   If gradually then normal market volatility may not allow the shift to be picked up.

As the paper itself points out, some of the outcomes it describes will be mitigated by older workers working for longer than has been the recent experience.  PensionReforms expects that will happen but only if labour markets are as open as their capital counterparts.  Free labour markets seem almost as important in this discussion as free capital markets. The paper suggests that the labour supply matters a lot whereas other parameters matter less.   However, it might have been nice had there been more in the paper about behavioural changes regarding work and retirement and the transition from one to the other.  92