In a recent interview in The Wall Street Journal titled "Bad New for Boomers," Rob Arnott presents a fairly grim view of the retirement income that investors can expect to generate from their investment portfolios. His thesis is that aside from all of the economic turmoil that may constrain future earnings growth, there is an additional substantial problem for investors: supply vs. demand. As the Baby Boomers retire, they will become sellers of equities as they draw down their life savings to provide retirement income. Having this huge generation steadily cashing out of the market, will increase the balance of sellers vs. buyers of equities and will thereby drive down equity prices.
It is crucial for investors to understand that the demand for any asset—be it gold, property, or stocks—is largely driven by supply vs. demand. We tend to think of demand for stocks going up when more investors have a positive outlook for stocks (and vice versa) but the demand for stocks may also be driven simply by how many investors there are in a given age cohort. The demand for stocks might be greatest when people are mid-career and focusing on saving for retirement. This will drive stock prices up. As people retire, they will tend to gradually sell off their assets to provide income, increasing the balance of sellers vs. buyers and pushing prices down. This idea has been around for decades, but recent research by Arnott and his coauthor, Denis Chaves, published in the Financial Analyst’s Journal (FAJ) has provided new evidence that there is a strong relationship between national demographics and equity returns. Along with reviewing past work on this problem, they develop a new global data set and apply a robust and intuitive approach to analyzing these data. They find:
Large populations of retirees (65+) seem to erode the performance of financial markets as well as economic growth. This finding makes perfect sense; retirees are disinvesting in order to buy goods and services that they no longer produce, and they are no longer contributing goods and services into the macroeconomy.
As they note, this is not a terribly surprising result and tends to conform to intuition. While Arnott and Chaves are properly cautious about extrapolating historical trends into the future, their conclusions make sense. It is hard to rationalize an increase in demand for risky assets such as stocks when a large fraction of the population is either in retirement or approaching retirement.
What is Arnott’s advice for the Baby Boomers? He recommends three actions for the long-term:
- Save more.
- Invest in assets that will tend to provide inflation protection.
- Invest in healthy emerging market countries with younger populations and less debt.
None of these suggestions is especially radical. Americans clearly need to save more. With interest rates at or near historic lows and below the CPI, it makes sense to invest in assets that will tend to offset inflation. There are plenty of reasons to why investors look to emerging markets for exposure to risky assets, and attractive demographics are one of these.
There is another thing that Baby Boomers (and others) might consider to mitigate the risk associated with the imbalance between buyers and sellers that our aging population may create. Income investing is a style of investing in which investors draw income generated by their portfolios rather than regularly selling off a portion of their assets to support their consumption needs. If the demographic scenario that Arnott is proposing does play out, investing for income has potential benefits from three sources. First, a Boomer who is only consuming income generated by her portfolio is not selling her assets into this market in which her cohorts steadily selling. Second, income-oriented investments are often found in fairly defensive sectors such as utilities. Third, when earnings growth is low (as Arnott’s research suggests may be the case with our aging population), dividends become a larger portion of expected return from equities. In other words, if you don’t believe that we will see high economic growth, it makes sense to focus on dividends and other forms of income. It is notable, I believe, that the PIMCO All Asset fund (PASAX) and the PIMCO All Asset All Authority fund (PAUAX) which Arnott manages on behalf of PIMCO (and which are mentioned in the WSJ article) have substantial yields. According to Morningstar, PASAX (which Morningstar classifies as a World Allocation fund) yields 6.1% and PAUAX (which is also classified by Morningstar as a World Allocation fund) has a 7.5% yield. World Allocation funds can invest in stocks, bonds, and cash across the globe based on where the most attractive returns are available. According to Morningstar, the average yield of funds that they classify as World Allocation is 1.63%.
Baby Boomers are faced with a number of challenges as they approach retirement. Housing prices are down, annuity rates are low because of low interest rates, and market volatility remains quite high. We also know that Boomers have accumulated relatively modest balances in their self-directed retirement accounts. If, as Arnott suggests, the future returns from equities are lowered due to demographic forces, Boomers could be facing something of a ‘perfect storm’ in their financial planning.
The good news is that there are investment alternatives that could help to manage a demographic imbalance between equity buyers and sellers in the U.S. and other developed markets. The bad news is that theory is, well, just theory.
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