WPI00l18 IMF Working Paper What Will Happen to Financial Markets When the Baby Boomers Retire? Robin Brooks INTERNATIONAL MONETARY FUND IMF Working Paper This is a Working Paper and the author(s) would welcome any connnents on the present text. Citations should refer to a Working Paper o/the Inlernational Monetary Fund. The © 2000 International Monetary Food vie","'S expressed are those of the author(s) and do not necessarily represent those of the IMP. WP/00118 INTERNATIONAL MONETARY FUND Research Department What Will Happen to Financial Markets When the Baby Boomers Retire? Prepared by Robin Brooks I Authorized for distribution by Peter Isard February 2000 Abstract Tbis paper explores whether changes in tbe age distribution have significant effects on financial markets that are rational and forward-looking. It presents an overlapping generations model in which agents make a portfolio decision over stocks and bonds when saving for retirement. Using the model to simulate a baby boom-baby bust demonstrates that returns to baby boomers will be substantially below returns to earlier generations, even when markets are rational and forward-looking. This result is important because the current debate over how to reform pay-as-you-go pension systems often takes historical returns on financial assets-and on the equity premium-as given. JEL Classification Numbers:E27, GIl, G12, H55 Keywords: equity premium, population aging, pension reform Author's E-Mail Address: [email protected] Special thanks are due to Christopher Sims. I am also grateful to Luis Cubeddu, I Hamid Faruqee, Wouter Den Haan, Peter Heller, Peter Isard, Ivailo Izvorski, Narayana Kocherlakota, Douglas Laxton, and Eswar Prasad for helpful comments. Any errors are mine. -2- Contents Page I. Introduction ....................................................................................................................... 4 II. The Paper vis-a-vis the Literature ..................................................................................... 7 III. The Model ....................................................................................................................... 8 IV. Equilibrium ................................................................................................................... 11 V. The State Variables ......................................................................................................... 11 VI. The Solution Method ..................................................................................................... 12 VII. Accuracy of the Solution Method ................................................................................. 13 VIII. Model Parameterization .............................................................................................. 14 IX. Simulation Results ........................................................................................................ 16 X. Simulating a Baby Boom-Baby Bust .............................................................................. 23 XI. Conclusion .................................................................................................................... 33 Text Tables 1. The Age Distribution over Time ...................................................................................... 9 2. Steady State Values for the Model without Uncertainty ................................................. 16 3. Descriptive Statistics of the Consumption-Saving Model.. ............................................. 17 4. Correlations based on Third-Order Approximation ........................................................ 18 5. Descriptive Statistics of the Consumption-Investment Model ........................................ 18 6. Correlations based on Third-Order Approximation using (4) ......................................... 20 7. Descriptive Statistics of the Consumption-Investment Model with Social Security ........ 20 8. Correlations based on Third-Order Approximation ........................................................ 21 9. Descriptive Statistics of the Consumption-Investment Model using (4') ........................ 22 10 Correlations based on Third-Order Approximation ........................................................ 22 11 Correlations based on Third-Order Approximation ........................................................ 2S Figures 1. Population Growth ........................................................................................................ 23 2. Returns on Capital and the Riskless Asset ..................................................................... 24 3. Wage Income ................................................................................................................ 24 - 3 - 4. Return Differential between Stocks and Bonds .............................................................. 25 5. Per Capita Consumption of Young Workers .................................................................. 25 6. Per Capita Equity Holding of Young Workers ............................................................... 26 7. Per Capita Bond Holding of Young Workers ................................................................. 26 8. Per Capita Equity Holding of Old Workers .................................................................... 26 9. Per Capita Bond Holding of Old Workers ...................................................................... 27 10. Ratio of Old to Young Workers ..................................................................................... 27 11. Per Capita Consumption of Retirees .............................................................................. 28 12. Discounted Lifetime Utility ........................................................................................... 28 13. Wage Income ................................................................................................................ 30 14. Workers per Retiree ....................................................................................................... 30 15. Per Capita Retirement Benefit ....................................................................................... 30 16. Returns on Capital and the Riskless Asset ..................................................................... 31 17. Wage Income ................................................................................................................ 31 18. Return Differential between Stocks and Bonds .............................................................. 32 19. Per Capita Consumption of Retirees .............................................................................. 33 20. Discounted Lifetime Utility ........................................................................................... 33 References .......................................................................................................................... 35 -4- I. INTRODuCTION This paper explores the effects of changes in the age distribution on returns to financial assets. The aging of the baby boomers and speculation over possible effects on financial markets has raised the profile of this issue, both in the financial press and in academic circles.2 Broadly speaking, there are two opposing views. The first holds that retiring baby boomers will be selling their assets to a smaller generation of young investors. This will drive asset prices down, leaving baby boomers with a smaller nest-egg than anticipated. The second maintains that forward-looking financial markets are pricing assets to incorporate the aging of the boomer generation. As a result, there will not be a market meltdown when the baby boomers retire. This paper bridges the gap between these opposing arguments by asking the following question: can demographic change, which is slow-moving and predictable, have a significant impact on financial markets that are rational and forward looking? It presents a model in which rational, forward-looking agents of different ages trade in financial assets, and uses this framework to simulate a baby boom-baby bust of the kind observed in many developed countries over the post-war period. The main finding ofthe paper is that changes in the age distribution have significant effects on asset returns, even when investors are rational and forward-looking, and that these effects have important implications for the welfare of baby boomers and surrounding cohorts. The model used is a stationary overlapping generations model with two assets: shares of ownership in risky capital and a riskless one-period bond that is in zero net supply. The representative agent lives for four periods: childhood, young working-age, old working-age, and retirement. In childhood, the agent relies on her parent for consumption and is not a decision maker. In both working-age periods she supplies labor inelastically and earns a wage. In retirement she consumes down her savings, there being no bequests. The model features only aggregate uncertainty, a technology shock to production and random population growth, and is solved numerically using the parameterized expectations approach. Although agents' degree of risk aversion is constant over time, they invest as if increasingly risk averse with age: young workers short the riskless asset in order to hold equity, while old workers hold mostly the riskless asset. This portfolio behavior stems from the risk and life cycle characteristics of a nontradable asset, human capital, which agents implicitly hold. Young workers anticipate receiving wage income in old working-age, so that next period consumption does not depend on savings alone. In addition, since the return on capital is positively but imperfectly correlated with wage income, equity is an attractive investment because it will diversify the effects of an adverse technology shock. In contrast, old workers' investment decision reflects the fact that next period consumption is out of savings alone. As a result, they largely eliminate consumption risk by investing mostly in the riskless asset. Using the model to simulate a baby boom-baby bust yields the following effects. First, there is an aggregate saving effect on asset returns as changes in the age distribution affect aggregate saving and therefore the real interest rate. During the boom this effect will push up returns on capital and the riskless asset, a result of higher aggregate consumption 2 For examples of articles in the financial press, see Passell (1996) and Colvin (1997). - 5 - because of relatively large cohorts of children. During the bust aggregate saving is relatively high, pushing returns on both assets down. Second, the return differential between stocks and bonds changes over the demographic shift. This effect derives from the fact that agents shift from stocks to bonds as they age. At the turning point of the boom-bust, when a large boomer cohort of old workers trades with a smaller cohort of young investors, this investment behavior generates excess demand for the riskless asset. As a result, the bond return falls sharply relative to the return on capital, and the return differential rises. Third, wage income moves inversely with the size of the labor force, even though capital accumulation in the model is endogenous. The quantitative effects of the boom-bust can be summarized as follows. During the baby boom the expected one-period returns on capital and the riskfree asset rise above their steady states by 3.2 and 7.8 percent respectively. On an annualized basis this means that the expected return on capital rises above its steady state by ten basis points, while the riskfree rate is 23 basis points higher. In contrast, during the baby bust the expected one-period return on capital falls below its steady state by up to 3.8 percent, while the riskfree rate falls by up to 10.6 percent relative to its steady state. This translates respectively into up to ten and 24 basis points on an annual basis. The greater sensitivity of the riskfree rate to the boom-bust is significant for older investors who want to minimize consumption risk in retirement. These magnitudes are also substantial relative to the impact of other fundamentals on asset returns. And while they are small relative to the recent run-up in stock indices, this simulation exercise holds non-demographic fundamentals constant over the boom-bust and ignores the possibility of a speculative bubble. These effects go against baby boomers, especially those in the tail-end of the baby boom. But are baby boomers worse off? The simulated boom-bust consists of two boom followed by two bust periods, so that the first boomer cohort has relatively more children than the second. This reduces consumption per head of the first boomer cohort in parenthood below the steady state. Ifutility of young workers is additively separable in their consumption and that of their children, this effect dominates adverse asset market effects. This means that the lifetime utility of the first boomer cohort is below steady state, while that of the second is above because positive consumption effects as a parent more than offset the effects oflower returns on retirement savings. In other words, adverse asset market effects are second-order. The fact that raising children is costly is more important. This result is reversed if young workers' utility is defined over household consumption. This specification reduces the effective weight of consumption when young, so that adverse asset market effects dominate earlier positive consumption effects. Since the asset market implications of the model are qualitatively unchanged across specifications, and since it is not obvious how to model parents' utility, the reversal of the welfare result is interesting. It also points to a deficiency of the model, since humans derive utility not only from consumption, but also from having children. As such, the welfare implications of the model should be viewed as incomplete. The result that the return differential between stocks and bonds shoots up at the turning point of the boom-bust is arguably the most interesting result of the paper. As noted above, it derives from two characteristics of the model: the shift from stocks to bonds over the life cycle, and the limited number of agents trading at anyone point in time. A critic of -6- this result might say: if baby boomers know they will retire in roughly 10 years, and that they may face adverse asset markets at that point, why not lock in wealth ahead of time? But this is exactly what boomer cohorts do in the model. In old working-age they invest in the riskless asset, in order to reduce consumption risk down the road. It is precisely this behavior, and the demographic imbalance, which drives down the bond relative to the stock return. A number of papers have recently noted that a risk associated with switching to individual retirement accounts is that investors may be subject to adverse movements in asset prices that persist over time.3 This paper makes this argument explicit, by presenting a framework in which investors are subject to cohort-specific risk that is linked to demographic change. Furthermore, the model corresponds to a world in which pay-as-you-go pension systems have been replaced with individual retirement accounts, with no government regulation over agents' portfolio decision. Thus the key result ofthe paper, from a policy point of view, is that the historical distribution of asset returns may be inappropriate for computing the gains to investors from switching to individual accounts, since the baby boomers are only now approaching retirement. Indeed the model suggests that baby boomers will earn returns that are substantially below returns to previous generations' This argument should not be understood as an endorsement of pay-as-you-go systems, since a defined benefit pension system can be fully funded. Indeed, the paper augments the model with a simple pay-as-you-go pension scheme and shows that such a system does not eliminate cohort-specific risk that comes from demographic change. Instead the paper underlines the role of government as an infinitely-lived agent, one that can insure agents against cohort specific risk by adjusting government borrowing over time to stabilize the riskfree rate. Of course such a move would reflect a political consensus, since it involves transfers of wealth across generations. There are a number of objections to the approach in this paper. It presents a closed economy model, which ignores investors' ability to insure against cohort-specific risk by holding an internationally diversified portfolio. Though this is an important consideration, most countries with significant asset markets have experienced post-war demographic shifts similar to the US. In effect, the model should be thought of as representing the developed world as a whole. Of course, there are regions with very different age distributions, such as Africa or parts of Asia. However, it is unlikely that assets in these markets have risk-return s characteristics attractive to baby boomers preparing for retirement. 3 See, for example, Heller (1998) and Hemming (1998). 4 For papers that use the historical distribution of asset returns to compute gains from switching to individual retirement accounts see, for example, MaCurdy and Shoven (1992) and Feldstein and Ranguelova (1998). For a discussion of home country bias in portfolio allocation, see French and Poterba S (1991). -7- The model also ignores bequests. Bergantino (1998) finds that, using data from the Survey of Consumer Finances, intergenerational transfers are of minor importance to households. Fewer than 25 percent of households report having ever received a substantial inheritance, trust, or transfer. Of those that did, the median value in 1995 dollars was about $17,000 per spouse, or about 60 percent of the median annual income per spouse. This evidence suggests that intergenerational transfers are of minor importance to most households, especially relative to wage income, in determining the life-cycle path of asset holdings. . A further shortcoming of the model is that it does not replicate the equity premium observed in the data. In large part this is because what is called equity in the model is not a levered asset, in the sense that there is no corporate debt. Adjusting for this, the model supports a Sharpe ratio of roughly ten percent, the same order of magnitude as Storesletten, Telmer, and Yaron (1997) whose overlapping generations model has agent-specific, persistent income shocks. In contrast, Constantinides, Donaldson, and Mehra (1998) generate an equity premium in an overlapping generations model in which young investors are borrowing constrained, which underscores that this model features no market imperfections that might generate an equity premium. The implicit assumption is that the behavior of relative returns over a demographic shift can be adequately characterized in the absence of such features.6 The next section presents a brief overview of related papers. Section three presents the model, with subsequent sections devoted to equilibrium conditions and the solution method. Section eight discusses calibration of the model, while section nine characterizes the solution. Section ten uses the model solution to simulate the effects of a baby boom-baby bust on asset returns. Section II concludes. ll. THE PAPER VIs-A-VIS THE LITERATURE The rationale for agents with constant risk aversion to substitute from equi~ to bonds as they age has been previously explored by Jaganathan and Kocherlakota (1996). They make the point that investors have fewer working years ahead of them as they age. Assuming that most investors' labor incomes are poorly correlated with stock returns, they demonstrate that it is rational for agents to shift the composition of their financial wealth from stocks to less risky assets as they grow older. This paper demonstrates that this behavior obtains even 6 For a review of recent papers on the equity premium, see Kocherlakota (1996). 7 A more recent discussion of the role oflabor income as a non-traded asset and its impact on investment behavior over the life cycle can be found in Campbell, Cocco, Gomes, and Maenhout (1999). - 8- when labor income and stock returns are positively correlated, a result ofthe interaction of the life-cycle features of the model with the risk-return characteristics of its assets' A number of empirical papers have recently explored the link between changes in the age distribution and financial markets. Bergantino (\998) presents evidence linking the level of real stock prices in the US to time series for aggregate demand of financial assets, which are derived from Survey of Consumer Finances data on portfolio composition by age. Brooks (1998) finds that real stock and bond prices across developed countries are positively related to the share of the population that is middle-aged, using the cross-section dimension of the data to control for unobserved fundamentals. In contrast, Poterba (1998) fails to find a significant relationship between returns on a range of assets and different measures of the age distribution. However, his focus on asset returns rather than prices could be interpreted as effectively measuring the high frequency correlation between demographic change and returns, when intuition would suggest that the relationship should be strongest at low frequencies. In essence this is the problem that bedevils the empirical analysis to date, since the effective number of observations is so small that statistical tests have limited power. Perhaps this is the strongest argument for the simulation exercise that follows. m. THEMODEL The representative agent lives for four periods: childhood, young working-age, old working-age, and retirement. In childhood the agent makes no decisions of her own, with consumption, CtO, determined by the parent, the next older cohort. In young working-age the agent inelastically supplies one unit oflabor and earns a wage W,. Out of wage income, she consumes c/ for herself, and assigns (I+nJctO to her offspring, where nt is the period I S./ , population growth rate. In addition, she may hold shares of ownership in risky capital, and invest Sb/ in a riskless, one-period bond, which is in zero net supply. The budget constraint of a period t young worker, born in period I-I, is therefore: (1) The agent born in period I-I reaches old working-age in period t+ J. She again supplies one unit oflabor inelastically, earning Wt+) , and receives income from stock and bond holdings chosen in the previous period. Out of total income she consumes only for herself, since her children, having entered young working-age, are now self-sufficient. She consumes Ct+/, invests Set+/ in risky capital, and Sbt+/ in the safe asset. The budget constraint of a period t+ 1 old worker is: 8 The approach in this paper contrasts with Bakshi and Chen (1994) who hypothesize that agents become more risk averse with age. They find that the average age of the US population is positively correlated with future excess returns on stocks over treasury bills.