The Future for Investors

by Jeremy J Siegel

  I would argue that the impact of demographics is now and that the breaking of the bubble and the ensuing bear market were the first lurch into a demographics-driven future. The immense bull market from 1975 to 1999—which turned $1 into $50—was also, most likely, largely demographics-driven. The number of retirees will soar so much in the coming 20 years that capital markets are already starting to look ahead to [poor returns].7

  These demographic arguments clearly challenge the bullish case for stocks. The next three chapters of this book dissect the demographic challenge and what it means to the economy and the capital markets. Chapter 13 puts forward the stark demographic facts. There is little doubt that the developed world is going to see an unprecedented decline in the number of workers per retiree. If current trends are continued, this decline will bankrupt the U.S. Social Security and Medicare programs and bring about both a dramatic increase in the retirement age and reduction in the retirement period. Most important, this chapter shows that not only the Social Security trust fund but also your personal assets are threatened by the age wave.

  Chapter 14 will analyze the solutions currently proposed to counteract the age wave. One by one, the conventional solutions are examined and found wanting. Increased saving by the boomers, faster productivity growth in the developed countries, or even increased immigration will not alone solve the problem.

  But one future development confronts and neutralizes the age wave: the rapid economic growth in the world’s developing nations. I have determined that the economic development of China, India, and other emerging nations can indeed provide the aging nations with the goods and services that they need to enjoy a comfortable retirement.

  I call this the global solution. The global solution simultaneously provides the world with sufficient goods and—just as important—the capital markets with sufficient buyers to support stock prices into the distant future.

  Why am I confident that this solution will become reality? This is the subject of the last chapter of this section: the Global Solution: The True New Economy. The true spark that ignites economic growth comes from the spread of information, knowledge, and ideas to the largest number of people. The communications revolution and development of the Internet, the very inventions that caused so much pain to investors, are set to become the foundation of the most rapid economic growth that the world has ever known.

  CHAPTER THIRTEEN

  The Future That Cannot Be Changed:

  THE COMING AGE WAVE

  “It is said that the present is pregnant with the future.”

  —Voltaire

  When it comes to predicting the future, economists, like those in every other profession, have notoriously poor records. John Kenneth Galbraith, an emeritus professor of economics from Harvard, said of his profession: “We have two classes of forecasters: Those who don’t know—and those who don’t know they don’t know.”

  But there are professionals who know a lot about the future: demographers, who study population trends. The reason for their foresight is straightforward. If there are 20 million Americans currently between the ages of thirty and thirty-four, five years from now these same 20 million people will be between thirty-five and thirty-nine, and ten years from now they will be forty to forty-four years of age. Of course, as we go forward, the mortality of this population must be factored in, but mortality rates are very low until the population becomes considerably older.

  Since we know the age profile today, we can predict with great accuracy the age profile in the future. Following the end of the Second World War, specifically between 1946 and 1964, there was a burst in the birth rate that leveled off and then declined to record low levels. The baby boom turned into a baby bust.

  As a result, the wave of 80 million Americans that is the baby boom generation is edging toward a hoped-for lengthy and prosperous retirement at the same time the workforce is declining.

  These facts are immutable. This is the future that cannot be changed.

  Why Should Investors Care?

  The impact of the age wave is enormous. The most visible repercussions of aging will be felt on public pension funds. Years ago the United States and most other developed countries set up Social Security and medical plans for their senior citizens. Starting in the next decade, the baby boom generation will put unprecedented strains on these government programs. And as bad off as the United States is, most European countries and Japan are in worse shape and have pension obligations that are far greater.

  There is a looming problem of supply and demand in the capital markets reminiscent of an old Wall Street story. A broker recommends that his client buy a small speculative stock with good earnings prospects. The investor purchases the stock, accumulating thousands of shares at ever-rising prices. Patting himself on the back, he phones his broker, instructing him to sell all his shares. His broker snaps back, “Sell? Sell to whom? You’re the only one who has been buying the stock!”

  The words “Sell? Sell to whom?” could haunt the baby boomers in the coming years. Who will be the buyers of the trillions of dollars of assets that boomers have patiently accumulated over the past several decades? The generation that has swept politics, fashion, and the media in the last half of the twentieth century has been part of an age wave that threatens to drown the economy in financial assets. The consequences could be disastrous not only for the boomers’ retirement, but also for the economic well-being of the entire population.

  Peter Peterson, author of Gray Dawn and Running on Empty, has been sounding the alarm for years. He warns, “There’s an iceberg dead ahead. It’s called global aging, and it threatens to bankrupt the great powers.”1

  Peterson calculates that the developed countries have unfunded pensions of about $35 trillion and health care liabilities of at least twice that. As he says, “To paraphrase the old quiz show, this makes the global issue at least a ‘$64 trillion dollar question.’ ” He cautions that unless significant action is taken to rectify the crisis, “personal living standards will stagnate or decline.”2

  These demographic realities could spell disaster for the financial markets. The baby boomers must begin selling their assets to fund their retirement needs: family vacations with grandchildren, medical bills, and everyday living expenses. But assets such as stocks and bonds have no intrinsic value—you cannot eat your stock certificates. The only way their value can be realized is by selling them, and you can sell them only if there are enough willing buyers. These buyers have traditionally come from the working-age population, and in the past the number of these workers has been much greater than the number of retirees. Now, however, because of the baby bust, there are not nearly enough Generation Xers (the generation born in the late 1960s and 1970s) with sufficient wealth to absorb the boomers’ substantial portfolio of stocks and bonds at the prices the boomers paid for them. With a lack of buyers, asset prices must fall, and they may fall dramatically.

  Many investors do not understand the gravity of this situation. Some acknowledge that Social Security and Medicare may not be available to them when they retire, but they comfort themselves by believing that their own portfolio of stocks, bonds, and real estate is adequate to support them during their retirement.

  But this confidence is unwarranted. The age wave impacts the value of personal assets just as it will impact the government pension and medical programs. If the age wave plays out as the pessimists assert, asset values will fall, the retirement age will rise, and benefits will be cut across the board. The “remarkable persistence” of strong equity returns that we reported in the previous chapter will be a relic of the past.

  Because the age wave is the biggest threat to investors’ wealth in the coming decades, this chapter spells out its origins and consequences in much greater detail. We will show how much the retirement age will have to increase so that retirees can maintain their consumption levels if current trends continue. We will also expose the public’s misunderstanding of the Social Security trust fund and
show why problems will arise well before that fund’s assets are depleted. Finally, we shall discuss what actions investors should take if the age wave hits us with full force. This chapter will set the stage for a critical analysis of the many “solutions” offered to solve the Social Security crisis and related age wave problems.

  The Aging World

  The aging of the world’s economy is taking place in nearly every developed country, especially in Europe and Japan. Take Germany, the world’s third-largest economy. By 2030, people over sixty-five will account for almost half of the German adult population, compared to one-fifth now. The number of workers will fall by 25 percent. Japan’s population will peak at about 125 million in just a few years, and by midcentury, according to the more pessimistic forecasts of the government, it will shrink to below 100 million, with the number of workers falling even more.3

  Figure 13.1 shows the projection of the age distribution in Japan in 2005 and at the middle of this century. These data are based on the demographics data provided by the U.N. Demographic Project and constitute the most extensive compilation of population data ever assembled. The age data for Japan are equally applicable to many European countries such as Italy, Spain, and Greece.

  By midcentury, the most populated five-year age bracket in these countries will be seventy-five to eighty years old. The number of people over eighty will almost equal those under twenty. Although centenarians are rare enough to be newsworthy today, by 2050 for every four children under the age of five, there will be a Japanese man (or most probably a woman) over the age of one hundred.

  FIGURE 13.1: POPULATION PROFILE IN JAPAN IN 2005 AND 2050

  The data for the United States, shown in Figure 13.2, are slightly more encouraging. The fertility rate, the number of children born to a woman, is the key variable that determines population growth. The rate needed to keep the population constant is about 2.1, slightly higher than 2 because of infant and childhood mortality.

  Following the U.S. baby boom, the period of high births that occurred from 1946 to 1964, the fertility rate in the United States and Europe dropped below 2. But the European rate continued to fall, while the U.S. rate stabilized and is now just below the replacement rate. The U.S. fertility rate stabilized because U.S. baby boomers were having more children than their European and Japanese counterparts, and immigrants, with higher fertility rates, contributed to U.S. population growth. Nevertheless, there is a large number of baby boomers who are now in their late forties and fifties and moving toward retirement.

  FIGURE 13.2: POPULATION PROFILE FOR THE UNITED STATES IN 2005 AND 2050

  The term “age wave,” which has been applied to these bulges in population, is made visible in the population profiles in Figures 13.1 and 13.2. Be-ginning in less than a decade and continuing for the next twenty years, the baby boomers will move into retirement, collect pensions, cash in their assets, and consume goods, services, and especially medical care.

  The Dearth of Workers

  All the goods and services distributed to a given population must be produced by those who are in their working years. There is very limited ability to transfer output from one year to the next. This is where the problems lie: the working population is shrinking dramatically relative to the retired population. Take a look at Figure 13. 3, which shows the number of workers per retiree over the past fifty years and over the next fifty years in both Japan and the United States.4

  FIGURE 13.3: DECLINING WORKERS PER RETIREE IN UNITED STATES AND JAPAN

  In 1950, there were seven workers for every retired person in the United States. This shrank to 4.9 workers per retiree in 2005, and by 2050 it is expected to fall to 2.6 workers per retiree. In Japan the problem is even more severe. The number of workers per retiree was 10.0 in 1950 and 3.1 in 2005, and it is projected to fall to 1.3 by 2050. And these numbers assume that the retirement age in Japan is raised to sixty-five. If the retirement age remains in the low sixties, the number of workers will fall below the number of retirees. This will also happen in Spain, Italy, and a number of other European nations.

  The Rise and Fall in Fertility

  Why are we undergoing such extreme demographic changes? Economic forces and medical advances provide most of the explanation. Until recently, the world was forever young. Not only was life expectancy much shorter and mortality much higher, but children were viewed as prized assets: workers who could plow the land, fish the seas, and take care of the elderly.

  Three hundred years ago, as North America was being settled, widows with children were much sought after. In 1776, the year America became an independent country, Adam Smith noted that women were “frequently courted as a sort of future. The value of children is the greatest of all encouragements to marriage.” Today, single women with children are often spurned by potential suitors.5

  In the twentieth century, as mortality was reduced through better nutrition and health care, populations in much of the world exploded. As late as 1970, Paul Ehrlich wrote the best-seller The Population Explosion, claiming that the rapidly rising population would strain the world’s resources.

  Ehrlich could be described as a modern Thomas Malthus, a nineteenth-century British economist who claimed that population increases condemn much of humanity to subsistence levels. Malthus believed the world was destined to experience a vicious circle: every technology improvement would lead to higher food output, which would lead to higher birth rates and more people, who would again exhaust available resources until starvation pushed the population down.

  But the advances in the standard of living had an impact very different from what both Malthus and Ehrlich predicted. As economies developed and the level of incomes rose, adults decided to have fewer children, not more. The fertility rate fell dramatically in Europe from more than 2.5 in 1960 to less than 1.4 currently. And in some countries, such as Spain, Italy, and Greece, the level has fallen to between 1.1 and 1.3. Even the fertility rate of China has fallen, hastened by the Communist Party’s one-child policies, from 6.1 in the late 1960s to 1.8 today.6

  The reasons for the fall in fertility are not hard to find. In China it was the dictates of the Communist Party, but elsewhere, changing social norms and the shift in the nature of work from physical activity to intellectual activity favored women entering the labor force. As women’s wages increased, the opportunity cost of staying home and raising children rose.

  Preparing children for today’s more highly skilled jobs requires extensive and expensive education. Even if tuition is paid for by the government, parental support is still needed. Furthermore, the increase in government pensions, such as Social Security, means that in their old age parents are less dependent on, and less likely to receive support from, their children.7 As parents with sons and daughters in college already know, instead of being the prized assets that Adam Smith wrote about in 1776, children can become expensive burdens.

  Rising Longevity

  But the fact that parents are having fewer children is only one factor contributing to the age wave. People are living longer than ever before, and this rise in longevity means that individuals are living well past the historically accepted retirement age of sixty-five.

  Longer life expectancies are nothing new, as death rates have generally been falling since the Industrial Revolution. Until the middle of the twentieth century, life expectancy rose primarily because infant and childhood deaths declined. Between 1901 and 1961, male life expectancy at birth rose by more than twenty years, but the life expectancy for men age 60 rose by less than two years.8

  But now life expectancy is being extended by advances in medicine that treat, and sometimes cure, the afflictions of old age. The fastest growing age bracket today is those age one hundred and above. This helps explain why from 1961 onward, the increase in life expectancy for sixty-year olds rose at three times the rate of the previous sixty years. Looking forward to all of the advances in biotechnology and advanced medicine, the trend toward longer lives will likely accelerate.
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  The mapping of the human genome has spawned hopes that scientists are close to turning Ponce de Leon’s dream of discovering the “Fountain of Youth” into a reality. Some scientists are debating whether the aging process can be slowed dramatically or even stopped.

  James Vaupel, the director of the Max Planck Institute for Demographic Research, observed in the summer of 2000, “Half of the girls born today in Minneapolis, Tokyo, Bologna, and Berlin will probably celebrate the dawn of the twenty-second century as centenarians.”9

  Vaupel’s projection is probably optimistic, although he will tell you he is “middle of the road.”10 But most demographers believe that most official U.S. government estimates of life expectancy, such as those made by the Social Security Administration and the trustees that project the health of that program, are far too low. For example, the Social Security Administration’s forecast for U.S. life expectancy is eighty-one for both sexes in 2070, up only four years from the current seventy-seven.

  In testimony before a Senate special committee on aging, Vaupel asked, “Is it realistic to assume that the United States will fail to catch up in half a century with expectations of life already exceeded in Japan and France? Is it realistic to assume that the United States will fall more than a decade behind Japan and France?”11 These are very good questions. The increase in life expectancy forecasted by Social Security is far smaller than what has occurred in the past. Vaupel, with his colleague James Oeppen of Cambridge University, found that since 1840 life expectancy in the developed world has increased at a remarkably constant rate of 3 months per year, or 2.5 years per decade.12 The increase has been remarkably stable and has shown no signs of abating. If this trend persists, life expectancy at birth will almost reach ninety by the middle of this century and hit ninety-five by 2070. Furthermore, the number of “old old,” defined as those over eighty-five years of age, is likely to be two to three times as large as the 18 million predicted by the Social Security Administration.