The “new normal” of low investment returns poses a challenge for many pension systems, forcing them to invest in riskier assets to meet unsustainably high investment return assumptions. Experts cite declining interest rates, slowing growth in China, political instability, and low inflation as some of the culprits.
But a recent Federal Reserve study attributes almost all of the decline in GDP growth and interest rates to one factor: the aging of the baby boom generation.
The paper argues that when baby boomers entered the workforce in the early 1960s, the increased labor supply led to high rates of economic growth. A ready supply of labor means the returns on a given capital investment will be higher.
However, as these once-productive workers aged, the growth rate in returns from technology slowed and the Great Stagnation set in. Since the financial crisis, the global economy has barely maintained GDP growth above 2%. It is tempting to blame everything on some unique aspect of the financial crisis, but this recovery has been the slowest in almost 70 years, indicating that we are sailing uncharted waters.
The authors expressed concern the (literal) once-in-a-generation phenomenon of persistently low interest rates, “could be misinterpreted as persistent but ultimately transitory downward pressure…stemming from the global financial crisis.” Instead they are concluding that “[w]hen we keep fertility, mortality, and employment rates all fixed at their 1960 values…the entirety of the decline in the equilibrium real interest rate that our model finds for the recent decades is a direct consequence of the demographic changes that happened from 1960 onward.”
So the housing bubble and financial crisis certainly didn’t help, but if the authors’ conclusions are correct, these low returns are here to stay.
This wouldn’t be the first time an aging population handicapped economic growth. Japan’s “lost decade” is turning into a lost 20 years, and much of this is attributable to an aging population leaving the workforce and a slow down in the returns from technology growth.
It is important to clarify that this is not a direct cause of the pension crises many systems face. A shrinking public sector workforce should not affect the fiscal health of a pre-funded defined benefit system, as contributions are supposed to fully cover the future cost of accrued benefits.
These low returns contribute to the underfunded pension crisis because legislators and pension board members failed to adapt their asset allocations, investment expectations, and contribution rates to the changing market environment. At the turn of the century, returns of 7% or more were attainable with a relatively safe portfolio. Now, pension systems need to manage risky investments that put some in a worse position than when they started.
This research contributes to the growing body of evidence suggesting that economic growth and investment returns over the next few decades are not going to reflect the same patterns and trends of the last few decades. For public sector pension plans this is yet another warning that 30-year average returns meeting your current expectations are not a meaningful measure for the probability of future investment success.