UTF - The Aging Population And Its Investment Implications

2023-11-17 07:35:00 ET

Summary

• Aging population and declining fertility rates have investment implications, including deflationary tendencies and excessive retirement savings.
• Lower dependency ratios can lead to moderate or low inflation, but dysfunctional public policy can override the benefits.
• Among developed countries, the U.S. is in a comparatively strong position to continue economic growth going forward. This suggests a U.S.-oriented investment strategy.

Co-authored with Philip Mause.

An analysis of the aging population, how this trend impacts inflation, and the investment implications.

The Aging Population and Its Investment Implications

We are experiencing historical trends in population dynamics that are perhaps, the first we have seen in any recent history. The low worldwide fertility rate and the very low rates in developed countries are lower than ever before, based on available data. For the period from which we have reliable data (starting around 1800), the rates now are the lowest ever. All available evidence indicates that rates in the pre-industrial period, for which we have spotty data, were even higher than they were in 1800. We are facing what can only be described as a totally unprecedented situation. This suggests a peak in global population followed by a global decline by the next century and a decline which may be rather steep in the population of almost all developed economies. This is a dynamic that investors, companies, policymakers, and political actors are not really accustomed to or prepared for. It suggests the need for careful analysis, the development of policy measures, and deeper scrutiny of investment strategies.

The Tools of Analysis

First, we should review some of the statistical tools that demographic experts use. Probably the most important is the fertility rate. It is generally defined as "the total number of children that would be born to each woman if she were to live to her childbearing years and give birth in alignment with the prevailing age-specific fertility rates." Another concept is the replacement rate – this is the level of the fertility rate necessary to maintain the population at its current level in the long term. The replacement rate is generally considered to be a fertility rate of 2.1 – this is because some women do not reach childbearing age. It is important to note that a country's population can increase even after its fertility rate declines below 2.1 because of increased life expectancy, net immigration, or the fact that – at a given time – there may be a large number of women at childbearing ages.

The next concept is the "dependency ratio." This is generally the ratio between people of working age and people not of working age. It can be variously defined as the ratio of people from ages 15-18 to 65, and everyone else. It is calculated using the working-age population as a denominator and the non-working-age population as a numerator. It can sometimes be broken up into youth dependency and aged dependency ratios. The cutoff ages can be changed depending on perceptions of the ages at which people generally start and stop working.

Population pyramids are useful to visualize population trends. Populations are broken into tranches of five-year age groups (e.g., 0-4, 5-9, 10-14), and each tranche is represented by a flat tier with the youngest tier at the bottom. Populations in decline are generally top-heavy, and rapidly growing populations are bottom-heavy (see the pyramids for Japan and Mali).

• Population Pyramid Japan

• Population Pyramid Mali

As to all of this data, there are different sources reaching somewhat different conclusions so that the numbers jump around. On the other hand, the broad trends are pretty obvious and suggest certain policy and investment actions.

The Current Situation - Fertility Rates

Fertility rates have been declining at a pretty fast rate since the 1960s. Using UN statistics, the worldwide fertility rate declined from 4.96 in 1955 to 2.52 in 2015. The World Bank has the current number at about 2.4. Using CIA statistics for 2023 levels, the declines have been greater in developed economies. As a result of these declines, almost all of the "developed world" is below the "replacement level." Europe is well below the replacement level, with Germany at 1.58, the UK at 1.63, and Italy at 1.24. East Asia has gotten very low, with China at 1.45, Japan at 1.39, and South Korea at 1.11. India is just around the replacement level at 2.07 and declining. There is a considerable range in the estimates for China, but they are all well below the replacement level. Southeast Asia is also declining, with Indonesia at 1.99 and Vietnam at 2.04. The Philippines has one of the highest fertility rates in the region, at 2.77.

Latin America, somewhat surprisingly, is below the replacement level, largely because Brazil is at 1.75, and Mexico is at 1.73. However, certain countries – for example, Guatemala (2.57) – are still above replacement level.

The greater Middle East (from Morocco to Pakistan, including the -stans) is above replacement level, with Afghanistan (4.53), Pakistan (3.39), and Egypt (2.76) still considerably above replacement level. But Saudi Arabia (1.89), Turkey (1.91), Iran (1.92), and Tunisia (1.96) are all now below the replacement level. Notably, Gaza is at 3.34.

Sub-Sahara Africa is still the area with by far the highest fertility rates ranging from South Africa (2.17 ) to Niger (6.73) and with a considerable number of countries still above 4.

The United States, at 1.84, is among the highest of the developed economies but is still below the replacement level.

It should be noted that different sources give somewhat different numbers, but almost all sources show a decline on a worldwide basis and in almost all countries.

As noted above, a fertility rate below the replacement level does not necessarily mean that there will be a net population decline – that depends on the number of women of childbearing ages, the trend in longevity, and net immigration, but some countries already have declining populations.

Dependency Ratios

Dependency ratios vary enormously, with youth dependency very high in countries with high fertility rates and aged dependency becoming high in countries that have had low birth rates for some time. One way to look at it is to calculate a "youth dependency rate," an "elderly dependency rate," and an aggregate dependency rate. The youth rate is the ratio of those under 15 to those between 15 and 65, the elderly rate is the ratio of those over 65 to those between 15 and 65, and the aggregate rate is the sum of the youth rate and the elderly rate.

The table below provides the youth rate, the elderly rate, and the aggregate rate for a representative group of countries.

This table illustrates the different patterns that occur based on current and past fertility rates. Countries that have had very low fertility rates for a while (Italy, and South Korea) have low youth dependency rates. Countries with very high fertility rates (Niger) can have very high youth dependency rates. Niger has roughly as many people below age 15 as it has between ages 15 and 65. Japan's over-65 population is more than 50 percent of its 15 to 65-year-old population. South Korea has a low dependency ratio but is headed into trouble due to its extremely low fertility rate. Countries that have had high fertility rates over the past 65 years (India, Brazil) are likely to have low elderly dependency rates. Countries that have had low fertility rates for a considerable period of time (Japan, Italy) can wind up with very high elderly dependency rates depending in part upon life expectancy.

Countries can find themselves in the "sweet spot" of an overall low dependency rate if they have had a high fertility rate in the past which has been dramatically lowered in the past 15 years.

Of course, these statistics are crude and do not reflect the fact that many people continue to work beyond age 65 and that many people (especially in developed economies) do not enter the workforce until well after age 15.

In addition, the participation of women in the workforce varies considerably based on a number of factors (it is generally higher if the fertility rate is low, and it can vary depending on cultural factors). Finally, immigration and emigration can affect the numbers by removing or adding individuals to the population at certain ages.

Excessive Retirement Savings

Another phenomenon that is likely to occur in countries with a large population of retirees and/or individuals nearing retirement age is excessive savings for retirement. This will lead to a reduction in spending and thus can be deflationary.

It is important to understand exactly what we are saying here. We are not saying that individuals save too much for retirement. Instead, we are saying that – in the aggregate – a group of retirees save "too much" and wind up with excess funds at the end of their lives.

How can this happen? In a country like the United States, in which upper-middle and even middle-income households can no longer rely on defined benefit pension systems to fund what they consider adequate retirement expenditures, these households will set aside funds to provide for retirement. This saving is encouraged by government programs such as IRAs and 401(k)s. But additional funds may also be set aside, and there is also a tendency to put funds aside to pay off or pay down mortgages.

In planning for retirement, individual households will likely be risk-averse and will not plan for funds that are merely sufficient to support a retirement of average length. Due to uncertainty about how long they will live, individual households will set aside sufficient funds for a longer-than-average life span in order to protect against the "risk" of above-average longevity. This behavior will continue during retirement years because total life expectancy increases as people age. For example, a person at age 65 may – on average – anticipate living to age 82. But when that same person reaches age 75, the actuarial tables will suggest that – on average – he will live to age 87.

In systems with defined benefit retirement plans (like social security), funds can be set aside based on average life expectancy, and this will prove sufficient as the savings due to premature deaths provide funds for those with greater longevity. However, to the degree that households perceive the need for funds in excess of those provided by whatever defined benefit system is available, they will tend to save for a longer-than-average retirement in order to protect themselves against the risk of "outliving their savings." On an individual basis, this behavior is rational and prudent, but in the aggregate, it produces excessive savings. The long-term impact is probably lower interest rates and somewhat of a bias toward deflation that may have to be offset with fiscal policy.

Thus, in developed countries – and especially those like the United States with a large dependency on defined contribution retirement funding – the phenomenon of excessive retirement savings can emerge and lead to deflationary tendencies and, perhaps, excessive investment producing lower returns.

What Does It Mean?

On a very general level, lower dependency ratios tend to mean that a higher percentage of the population can be working, and thus, the economy has relatively fewer non-working members to support. This would generally increase production and create several phenomena. It could lead to net exports, a favorable balance of trade, and a strong currency. It may depress domestic prices because production will exceed demand. It may create the opportunity to set aside funds for investment in infrastructure, research, and/or education, which can lead to a "take off" in development.

Lower dependency rates can, therefore, be deflationary or at least disinflationary due to the strong currency impact as well as the excess of production over demand. They can coincide with strong economic growth and development. However, this depends upon the society's ability to harness its workforce effectively, create incentives, and allocate resources efficiently. It is entirely possible for a society to "blow the opportunity" by having a stagnant economy overly burdened with regulation, taxation, and corruption. It may spend funds on educating some of its young people only to have them "vote with their feet" and leave.

More ominously, countries tend to go through phases, and if the fertility rate drops to too low a level, after a period of time, elderly dependency can start to increase rapidly with the result that overall dependency becomes excessive. If a country has not used its "window" of low overall dependency to develop, it can "become old before it becomes rich."

Investment Implications

Low dependency ratios will likely produce moderate or low inflation (depending, of course, on fiscal and monetary policy). Thus, it is not an accident that, as Japan experienced much lower fertility rates, it also experienced a challenging period of deflation. The Economist has recently identified deflation as a danger for the Chinese economy. It should be noted that, despite this deflationary factor, policymakers are entirely capable of mismanaging any economy – regardless of its dependency ratio – into the mire of hyperinflation. This appears to have happened recently in Turkey.

Policymakers can also mitigate the danger of a declining fertility rate and a prospective higher elderly dependency ratio by:

• encouraging immigration of individuals at ages in their teens, twenties, and thirties (U.S. policy during our period of rapid growth between 1865 and 1929)
• encouraging workers to continue working after age 65 (in the U.S., 5% of those over age 80 are still in the workforce)
• squeezing more people into the workforce by assisting the disabled to find appropriate work;
• adopting educational policies aimed at enhancing productivity; making life attractive for young people so that they are not encouraged to emigrate
• and creating incentives for entrepreneurship.

Many policies that countries have adopted make more sense when one considers dependency ratios. Totalitarian states routinely prohibit emigration because those who emigrate are likely to be of working age, and their departure worsens dependency ratios. China's "one child" policy temporarily resulted in a dramatic improvement in its dependency ratio and may have been a factor kicking off its rapid growth.

Certain countries that have attractive dependency ratios (Brazil, Mexico, India) may be at a point where developmental "take off" is underway or can be achieved. However, investors should be aware of the fact that dysfunctional public policy can overwhelm the beneficial effects of a low dependency ratio.

The United States is in a relatively strong position among developed economies. Its fertility rate – while below replacement – has not collapsed. It can still attract and assimilate promising immigrants and has done so in the past. Its policies prohibiting age discrimination and providing social security payments for working seniors probably result in a higher percentage of the elderly in the workforce. Its culture has adapted to a much higher percentage of women in the workforce. All of these factors should mitigate inflationary pressures generated by expansive fiscal policy.

On the other hand, its political system has become dysfunctional – especially in the area of immigration, but also in the area of budget control and excessive local real estate regulation, which has made it almost impossible to build high-density housing in some of the areas in which it is most needed and has thus resulted in high occupancy costs for young families in the very areas where jobs are most plentiful. These has delayed family formation and discouraged large families.

Still, on balance, investment in the United States remains comparatively attractive and due to uncertainties about China as well as Japan and the slowing growth in the EURO zone, the dollar's place as the global reserve currency (if only, by default) may be stronger than it has been at any time since the 20 years after the Second World War.

With HDO's focus on dividends and income, investments we like:

1. Depressed REITs where sectoral growth seems promising (multifamily housing) and other diversified REITs, such as Realty Income ( O ), yield 5.8%
2. In the domestic energy sector, Antero Midstream ( AM ), yielding 7%, is a midstream company focused on Natural Gas, with pipelines and storage across the United States is very attractive as well.

Some attractive opportunities suggested by this analysis are also closed-end funds ("CEFs"), such as Liberty All-Star Equity ( USA ) yielding 9.7%, Royce Value Trust ( RVT ) yielding 7.9%, and Cohen & Steers Infrastructure ( UTF ) yielding 8.7%.

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