Boomers as Retail Clerks Shows Why Greenspan Saw Low Growth EraDavid J. Lynch
During his final policy-making meeting as chairman of the Federal Reserve Board, Alan Greenspan glimpsed a force potent enough to trump the law of supply and demand in the world’s largest economy.
Greenspan had said for months that increases in government borrowing would drive up interest rates on bonds maturing in 10 years and beyond. Instead, rates declined. And Greenspan said he thought he knew why: The world’s growing, graying masses were rewriting the rules for both markets and economies.
Before that January 2006 Fed meeting, British pension managers -- stewards of one portion of the globe’s vast pool of retiree money -- had bought enough long-term U.K. government securities to drive their yields below those of shorter-term debt. Similar U.S. investments would eventually feel the same “overwhelming force,” Greenspan told his colleagues.
“What the demographics are telling us is that the issue is large enough to essentially dominate the longer end of the markets,” Greenspan said, according to the transcript. “These pressures may overwhelm the economics.”
Financial markets provided what the outgoing Fed chief called “the first evidence” that the consequences of societal aging would extend beyond funding costly public retirement and health programs. Yet the discussion around the Fed’s 27-foot mahogany table that day only hinted at the broadest and most alarming implications.
As economists and regulators are beginning to recognize, global aging threatens to unleash a wave of aftershocks: chronically weak economic growth, a more volatile international economy and the risk of a new financial crisis triggered by innovative investments dubbed “death derivatives.”
Relentless aging, especially in advanced economies, promises nothing less than a recalibration of the engine that powered growth for more than half a century. Expanding populations -- the American baby boom, its European echo and subsequent boomlets in developing nations such as Brazil -- long fueled global prosperity with both workers and consumers.
Now, as the working-age share of the planet’s 7.2 billion people crests and slowly declines, generating accustomed economic growth will require many people to shelve dreams of idle bliss and labor into their eighth decade. Gray-haired retail clerks, burger flippers and home-care companions hint at a future awaiting millions.
“We’re coming out of an era of the most benign demography for GDP growth in the history of mankind, and we’re coming into a demographic profile that’s more daunting,” said Rob Arnott, chief executive officer of Research Affiliates, a Newport Beach, California-based investment-strategy firm. “If you have vast numbers who no longer produce and a diminished workforce, you’re going to have an assured formula for interclass and intergenerational conflict.”
Some of those conflicts challenge ethical and cultural norms. Is there an age, or mental acuity level, at which sexual activity should stop? When does a family’s concern over an elderly loved one’s suffering take precedence over society’s commitment to safeguarding life?
Those personal dilemmas arise against an unfamiliar backdrop of economic challenge and lowered expectations.
Through 2030, amid falling birthrates and longer lifespans, U.S. output per person will rise only about two-thirds as fast as in the past half-century, according to a 2012 National Academy of Sciences study.
European workers must double their productivity, reaching levels akin to the 1990s Internet boom in the U.S., just to see economic growth reach 2 percent, according to the European Central Bank.
Key developing nations, too, may struggle. China’s working-age population over the next two decades will shrink, a legacy of the one-child policy it adopted in 1979. In coming years, that will be enough to strip more than 2 percentage points from annual growth, which over the past four years has averaged 9 percent, according to Citigroup Global Markets.
Central bankers’ traditional tools may prove ineffective in economies dominated by older populations, leading to greater volatility, according to one International Monetary Fund assessment. Persistently low interest rates could invite frequent brushes with deflation or reckless private-sector borrowing.
And that’s if populations age as expected. If people live just three years longer than current forecasts -- a typical margin of error -- the $15 trillion to $25 trillion in global pension fund obligations will increase by $1.4 trillion to $3 trillion, according to an August report of the Bank for International Settlements’ Joint Forum, a global body of insurance, banking and securities regulators.
To help pension funds cope with this “longevity risk,” a market in swaps, hedges and bonds is emerging. If not carefully policed, these new investments could spread risks akin to those of the complex mortgage securities at the heart of the 2008 financial crisis.
“Losses arising due to longevity risk may affect the stability of the financial system,” the Joint Forum said in its report.
In many ways, population aging is an emblem of prosperity and progress, the quintessential good problem to have. Declines in infant mortality and progress in treating diseases such as cancer and HIV/AIDS translate into longer lifespans. More women are free to enter the labor force, thanks in part to modern contraceptives letting couples limit their number of children.
Such advances mean older societies. In 1940, a newborn American male could expect to live a bit more than 61 years. His grandson born last year should live more than 76 years; on his 65th birthday, he will anticipate an 18-year retirement, roughly 50 percent longer than his grandfather’s.
Some economists are sanguine about prospects for adjusting to such a world. In its 2012 study, the National Academy of Sciences panel concluded that, assuming early changes to Social Security, Medicare and Medicaid, higher saving and longer working lives, the U.S. didn’t face “an insurmountable challenge.”
Yet none of the needed changes will be popular or cost-free. Most involve trading leisure for work and consumption for savings. Already, almost 19 percent of Americans age 65 and older are in the workforce -- the highest rate since 1965 and almost twice the 1985 low.
Aging is emerging as the economic equivalent of climate change, a slow-moving, inexorable process that will profoundly challenge established patterns of life.
“We need to adjust our expectations to a lower level of economic growth,” wrote Arnott and Denis Chaves, Research Affiliate’s research director. “It is dangerous to expect our political leaders to deliver the same pace of growth -- from a workforce that is both slower-growing (even shrinking) and aging -- that we enjoyed in the past.”
Across the developed world, fewer births today mean fewer members of the labor force 18 years from now. Longer lifespans mean more elderly people to be supported by those less-numerous workers. Today, four European workers labor to support each of their retired neighbors. By 2050, there will be fewer than two, according to Eurostat, the European Union statistical agency.
In January, the Chinese government said the country’s working-age population declined in 2012 by 3.4 million, to 937 million. After decades of surplus labor, that turnaround is contributing to rising factory wages, which have encouraged companies such as New York-based Coach Inc. to shift production to Vietnam and other lower-cost venues.
By 2030, more than one of every five Americans will be at least 65 years old, up from about one in seven today. By 2056, those over 65 for the first time will outnumber those under 18, according to the Census Bureau.
“The labor supply is going to become stressed,” said George Magnus, senior economic adviser at UBS in London.
The U.S. labor force over the next decade will grow at an annual rate of just 0.5 percent -- one-fifth the pace experienced between 1974 and 1981. That was when many boomers, those born between 1946 and 1964, entered the workplace. The slowdown reflects the start of their retirement and a plateauing in the rate of women moving from home to work.
Even as the 76 million boomers’ every taste and whim has been scrutinized, the economic consequences of aging -- on work, savings, consumption, interest rates and international capital flows -- have drawn scant discussion.
Living standards are likely to rise more slowly as the demographic tailwind of the post-World War II era turns into a “headwind,” according to Arnott and Chaves. Annual U.S. growth rates will likely slump to less than 2 percent compared with more than 3 percent during the two decades that preceded the last recession. Under that scenario, the lost American output would be roughly the equivalent of the New Zealand or Kuwaiti economy disappearing from the globe.
“Hoping that we’ll get back to 3 or 4 percent growth I think is -- that’s negligence, actually, because that’s not going to happen,” said Magnus.
While much of aging’s economic toll can be ameliorated, the needed remedies are easier to envision than to implement. Europe could make long-debated structural reforms to labor and product markets. Magnus says immigration at “10 to 20 times current levels” could help Europe avoid further declines in the working-age share of its population.
“But that’s just not going to happen,” he said.
Stepped-up immigration is also unlikely to cure U.S. aging ills. Even if the U.S. admitted almost 1 million extra immigrants each year -- more than doubling the 2012 figure -- the retiree-to-worker ratio would continue rising, according to the National Academy of Sciences.
Change will also take time. In 1983, the U.S. Congress passed legislation increasing the retirement age for full Social Security benefits. The changes were modest: Those who were 45 years old had to wait two months past their 65th birthdays to begin receiving Social Security. Those born in 1960 or subsequent years, who were just entering the labor force when the legislation passed, must wait until age 67.
Thirty years later, additional reductions in planned entitlement spending remain the subject of partisan warfare.
Yet a 2007 study by three Federal Reserve economists said that waiting to change course risked “a dramatic effect” on living standards. Unless Americans work longer or save more, per-capita consumption will fall 4 percent to 14 percent below what it would be if the country’s demographic profile hadn’t changed, according to economists Louise Sheiner, Daniel Sichel and Lawrence Slifman.
An immediate two-year increase in the retirement age would limit the drop in living standards to just 1 percent. If the increase were delayed by 20 years, consumption would be 11 percent lower.
“The size of any consumption reduction depends critically on whether the adjustment happens sooner or later and on whether the labor force participation of the elderly changes,” the study concluded.
The perils of waiting to act are on display in Japan, where the struggle to emerge from two decades of stagnation has been complicated by an aging, change-resistant society.
Even as the percentage of people age 65 and older doubled from 1990 to 2010, Japanese policy makers were slow to recognize the role that demographics was playing in their economic plight, according to Masaaki Shirakawa, the former governor of the Bank of Japan.
“In addition to the delay in recognition of the ongoing demographic changes, comprehension of the far-reaching implications of the changes was even more delayed,” Shirakawa said in a 2012 speech.
The result was an economy in near stasis, averaging 0.2 percent annual growth over the past decade. More than 40 percent of Japan’s population is neither employed nor looking for work. And only now is Japan eyeing fundamental change.
Prime Minister Shinzo Abe this year proposed increasing child-care slots by 20 percent by 2017 to enable more women to join the workforce.
Central bankers may find economies dominated by older populations to be more difficult to manage. Greenspan, the Fed chief credited with a prosperous era known as “The Great Moderation,” was among the first to grapple with that reality at the U.S. central bank meeting held on Jan. 31, 2006.
Eight months earlier, new regulations prompted British pension managers to buy huge quantities of long-term U.K. government securities to more closely match their expected cash flow with their obligations to retirees. Markets felt the pension funds’ power as the yield on the longest-dated British debt, a 50-year government bond, unexpectedly fell below that of the 30-year bond.
For decades, such inverted yield curves -- where long-term yields dip beneath those of shorter-duration securities -- had signaled the onset of recessions. With rates responding in the future more to demographics than to economic strength or weakness, the yield curve might no longer be a reliable guide, Greenspan suggested to his colleagues.
Today, that suggestion has hardened into certainty. The sheer number of retiring baby boomers, who began turning 65 in 2011, already has rendered obsolete this forecasting tool, Greenspan told Bloomberg News in an interview.
“The effects are so distorting that the presumption that you’re going to get clean economic signals is just not relevant,” he said.
Central bankers may need to adopt different strategies. Older individuals, with little appetite for borrowing or risk, may be less sensitive to interest-rate movements than younger populations, said economist Patrick Imam of the International Monetary Fund.
It’s the young, after all, who borrow to buy homes and cars and thus are acutely sensitive to interest-rate movements. The Federal Reserve and its counterparts may need to act more dramatically to get the attention of an economy dominated by the old -- raising or lowering interest rates by a full percentage point rather than the quarter-point moves that have been customary over the past two decades, Imam wrote.
Or central banks may tinker more with capital requirements -- slowing the economy by making banks keep more in reserve, or spurring growth by reducing required cushions.
Aging may lead to low global interest rates. Workers will be in demand in a slowly growing labor force, so wages will rise while capital will be abundant and cheap. The price of money -- interest rates -- might remain 0.5 to 1 percentage point lower than otherwise warranted by the economy, according to one ECB estimate.
Such a world threatens a perpetual veering from bubble to bust. Persistently low rates would leave central bankers in danger of undershooting inflation targets and tipping into deflation, an environment of falling prices that leads consumers to delay purchases and companies to postpone investment and hiring.
Alternatively, low rates could seduce companies into dangerous and “excessive borrowing,” Lucas Papademos, then an ECB vice president, said in March 2007.
Those aren’t the only risks to global financial stability. If pension participants live longer than expected, it would increase the estimated $15 trillion to $25 trillion that annuities and pension plans are obligated to pay out and even shake the financial system, according to the IMF and the Joint Forum, the global regulatory body.
Most corporate pension plans already are underfunded. In the U.S., the 429 Fortune 1,000 companies that sponsor defined-benefit plans were $418 billion short at the end of 2012, according to Towers Watson, a New York-based professional services company.
If each covered person lived on average one year longer than anticipated, the global pension bill would rise by $450 billion to $1 trillion.
“Even on a global scale, these are massive amounts,” said the forum’s report.
Especially in the U.S., pension managers have a poor track record of predicting future lifespan increases.
“Folks are not really using up-to-date tables. They may perceive that their liability is lower than it actually is, or lower than it is reasonably expected to be,” said Amy Kessler, Prudential Financial Inc.’s head of longevity reinsurance.
To avoid the risk of coming up short, pension funds have turned to an embryonic market in what’s called longevity risk transfer. Over the past seven years, the market, which originated in the U.K., has seen a total of $100 billion in such deals, according to David Blake, a professor of pension economics at Cass Business School in London.
The idea is to shift to another party the danger of a firm’s retirees outliving the pension plan’s assets. Typically, pension funds buy protection against that risk from insurers -- as companies do against the threat of fire and flood.
In November 2012, General Motors Co. cut its pension exposure by $26 billion in a deal with Prudential, the nation’s second-largest life insurer. The automaker transferred the pension assets and liabilities for about 42,000 retirees to the insurer while spending about $4 billion on a Prudential group annuity for the former workers. If the retirees live longer than expected, Prudential -- not GM -- gets the tab.
Insurance companies can’t absorb all the financial risk that pension funds want to shed. So investment banks including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Deutsche Bank AG have emerged as another potential channel for mitigating longevity risk.
“The insurance industry isn’t big enough,” said Blake, who developed with JPMorgan a longevity index called LifeMetrics. “It’s got to go into the capital markets. There’s no other way.”
The banks act as intermediaries between those that want to sell longevity risk -- pension plans or insurance companies -- and investors such as hedge funds or sovereign wealth funds that want to buy it as part of a diversified portfolio.
In February 2012, Deutsche Bank completed the first longevity transaction that relied on third-party investors, a 12 billion euro swap with Aegon NV, a Dutch insurer. Aegon paid Deutsche Bank a fee to assume some of its pension risk. The bank then sold the risk to investors, who receive a floating payment from Deutsche Bank based on how quickly pensioners die relative to an index derived from Dutch population statistics.
The prospect of more widespread use of such investment vehicles, collectively dubbed death derivatives, concerns some regulators, who see in this fledgling market a resemblance to earlier financial innovations that turned toxic. Derivatives are investments whose value depends upon the performance of another asset, index or interest rate.
In the early 2000s, banks expanded the use of derivatives such as credit default swaps, which were intended to limit risk. Instead, they helped bring on the worst financial crisis since the 1930s. In the U.S. alone, $13 trillion of household wealth was vaporized, according to Fed data.
Now, as this new market sputters to life, some regulators are concerned about potential weak spots such as a lack of open market pricing. Since only a handful of insurers, reinsurers and banks are active in the market, risks over time could become concentrated. Losses would probably hit most firms at the same time.
A cure for cancer, for example, may not be celebrated at the investment banks and other institutions that had assumed longevity risk. They would face catastrophic losses as pension plans around the world simultaneously confronted the prospect of participants living years longer than envisioned.
One firm’s default could send losses cascading through its counterparties, rattling global confidence and ultimately ricocheting back onto pension funds. Investment bank involvement “could even lead to a systemic risk event,” the Joint Forum said.
“This risk might be transferred from these original holders of risk to other sectors, other financial sectors and other nonfinancial sectors as well,” said Thomas Schmitz-Lippert, chairman of the Joint Forum and executive director for international policy affairs at BaFin, the German banking regulator. “If you do it wrong, you might do exactly what we did in the early stages of the CDS market.”
Even as the Joint Forum completes its recommendations, due in January, industry executives said they expect Deutsche Bank, Societe Generale SA and others will soon unveil additional deals.
For now, though, the market remains small. Higher capital requirements -- mandated in response to the 2008 financial crisis -- have cooled the ardor of investment banks, including JPMorgan Chase, for such transactions. On Oct. 22, Goldman Sachs sold 64 percent of its European insurance subsidiary, Rothesay Life Ltd., which has completed longevity swaps for companies such as IAG SA’s British Airways.
Adam Posen, a former member of the Bank of England’s monetary policy committee, said the demographic changes approaching pension funds and insurance companies remain among the biggest dangers.
“There is simply no good answer to this,” he said. “It is a very scary thing.”