How do Demographic Changes Affect Pension Funds?
The problem of demographic changes has been ignored by economic planners for a very long time. This is because economic planners rarely look beyond a period of five years. Demographic changes do not happen over a five-year period. Instead, these changes are glacial in nature. This means that they happen very slowly every year. However, over the years, the cumulative impact can be quite significant. This is what has happened as far as demographic changes in most parts of the western world are concerned.
Today, a significant number of pension funds across the world are underfunded because they have not taken changing demographics into account.
In this article, we will explain how changing demographics tend to affect pension funds.
- Retirement Dependency Ratio: As far as pension funds are concerned, an aging population is measured using a metric called the retirement dependency ratio. The dependency ratio is a ratio of the working-age population over the non-working-age population.
The working-age population is generally defined as people between the age of 15 and 64 whereas everyone else is referred to as the non-working age population. Over the years, this ratio has been quite high with a greater number of people entering the workforce than exiting it. However, these demographic trends have been reversed in recent years. Also, improvement in medical facilities has increased the life expectancy of individuals which further skews this ratio.
- Aging Population Means Higher Payroll Taxes: An aging population has a direct impact on the number of people who are in the workforce. Since an aging workforce inevitably leads to a lower number of workers in the workforce, the end result is that a higher payroll tax has to be imposed on every person in order to be able to fund their pension. A lot of western countries are already witnessing this phenomenon. Hence, in order to overcome the impact of this phenomenon, many of these nations have already increased the working age of their employees.
Higher payroll taxes are a significant detriment to the overall economy. They reduce the purchasing power of the employee and also make it unviable for the employer to hire them. Automation and mechanization witness huge increases in these countries due to the increase in costs caused by this population shift.
- Higher Yields: A typical investment cycle consists of three stages. In the first stage, the investor contributes money to the fund. In the second stage, this money is kept in the fund and allowed to grow at a higher rate.
In the last stage, this money is withdrawn from the funds for personal use. In the case of an aging population, a large number of people are in the last stage. This means that there is more money flowing out of pension funds than there is flowing in. This shrinking size of the pension funds is caused by inelastic demand. Retirees want to withdraw their money regardless of the market conditions. Since fewer funds are available in the market for long-term investments, there is a shortage of funds which ends up pushing the yield higher.
Investment Philosophy of the Funds
Also, when pension funds have a large number of retirees, their asset allocation also undergoes a significant change. This is because it is a known fact that equity investments provide a larger return over a longer period of time. However, they are very volatile in the short run. Therefore, if a fund is investing over a short time horizon, it would be advised to steer clear of equity.
Funds with younger populations can afford to invest in riskier assets and generate higher yields. It is also common for pension funds with a lower average age to invest directly in many companies instead of buying their shares listed on the stock exchange. Since they can hold the investment for a longer duration of time, they are very likely to generate superior returns.
However, funds that have aging populations, they have to invest more in bonds and other short-term fixed-income securities. This brings down the overall yield of the fund.
Increase in International Investments: When economies age, the availability of economic opportunity also declines significantly. This is because the number of people not actively working goes up. The economy becomes more consumption-based. Hence, from an investors point of view, the number of available opportunities to invest in equity assets also goes down considerably. In such a situation, if the pension fund has a large amount of funds that it needs to invest, it is surely going to run out of investment opportunities.
Hence, in order to avail better investment opportunities, the pension funds start investing in foreign markets. Empirical data shows a clear correlation between an aging population and the percentage of funds that have been invested overseas.
The bottom line is that demographic factors are very important for pension funds. They can completely change the manner in which pension funds deploy and distribute their funds. Now since the dependency ratio has reached alarming levels, pension funds have no alternative but to pay attention to the same.
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