Asset Meltdown?

Demographic pressures on retirement savings has been a hot topic in Australia since the 1990s where the impact of retiring Baby Boomers on various aspects of the economy have often led to dire predictions.

Initially the fear was a on the productive capacity of an ageing population. The debate has now shifted to the impact on health and retirement pensions, and the sustainability of such – given current policy.

Tucked away somewhere in the superannuation debate is the potential causal link between financial asset returns and age.

Based on the well known and accepted life-cycle theory, Siegel established a possible scenario between asset returns and age, called the Asset Meltdown Hypothesis (AMH). It sounds a bit dramatic, but the question is a very simple one:

The words “Sell? Sell to whom?” might haunt the Baby Boomers in the next century. Who are the buyers of the trillions of dollars of boomer assets?

It would be easy to dismiss any link between age or demographic changes to asset returns. However, we often read column pieces on the property market in terms of demand and supply affecting returns in that segment of the investment market.

Doomsday prophets such as Harry Dent often argue that Australia’s property bubble is set to burst due to demographic changes.

But just how grounded in reality are links between asset returns and demographics? What can the empirical evidence attest to?

Theoretical models produce, via simulation and calibration, results that suggest a modest impact on asset values and returns.

A comprehensive study by James Porteba of MIT in 2004 found that the correlation between asset returns on stocks, bonds, or bills, and the age structure of the US population over the last 70 years is statistically weak at its best. His result was based on 70 years of data, and therefore could be assumed to be fairly robust.

Italian scholars Brunetti and Torricelli explored the issue in the context of Italy. Italy is somewhat a unique sample as it already in the midst of a booming ageing population. If evidence of a link between age and demography is to be found, it would be there.

In contrast to Porteba, Brunetti and Torricelli find evidence largely in line with the AMH. The greater the proportion of elderly people, the lower the equity returns whilst fixed income security returns pick up. The results are robust even in the presence of various other financial and economic ratios.

So why are the US and Italy different? Comparing differences in economies is always problematic, but strictly speaking in demographic terms, the two countries have substantially different dependency ratios. More importantly, what do the results potentially mean for Australia?

The dependency ratio is used to measure the pressure on the productive population of a country. As the ratio increases there is an increased burden on the productive part of the population to maintain pensions of the economically dependent.

As is evident in the graph below, Italy’s ratio is far above that for the US. Australia’s ratio is largely in line with the US. Given the high dependency ratios in Italy it is not surprising that demographic pressures have a strong impact on asset returns.

The data presented below is from the United Nation and projects the dependency ratios out to 2030. By 2030, both Australia and the US will have ratios commensurate with what Italy has had in the past decade.

Assuming the AMH and the life cycle theory hold, by 2030 we shouldn’t be surprised if we start witnessing flatter equity returns and increased fixed income returns, as in Italy.

With the SG increase in Australia from 9% to 12% set to become legislation, the underlying impact of age should also be taken into consideration – and the possible impact on the future wealth of younger Australians.