The Esoteric Investor: Building the Demographic Framework

This chapter is from the book

Esoteric Investor, The: Alternative Investments for Global Macro Investors

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This chapter is from the book

This chapter is from the book 

Esoteric Investor, The: Alternative Investments for Global Macro Investors

Learn More Buy

Demographics are one of the most important factors when analyzing the future economic prospects of any geographic area. Nations such as India have large young populations (only 5.2% of India's population is older than 65) and therefore have a tremendous amount of future potential due to a growing labor force and a growing pool of consumers. In contrast, nations such as Japan, where 22% of the nation is older than 65, face a serious threat to their economy and will suffer from a shrinking labor force for the next several decades. In the U.S., more than 12% of the nation is over 65; in the UK, that number is 16%. Moreover, since 2006, an astonishing 330 people turn 60 every hour in the U.S. By 2050, Korea will have lost roughly 38% of its population, and Japan and Russia will have lost over 20%.

It is important to consider that although growing and large populations are important for economic growth, adequate infrastructure is required to support them. In India, for example, although the demographics are promising, the nation still faces unimaginable poverty, and basics such as fresh water are scarce. Figure 1.1 illustrates India's rise as the most populated nation in the world by 2030, ahead of China, which is currently at an optimum demographic point. Hopefully by that time, the nation will have taken steps toward adding sufficient schools, hospitals, highways, roads, and other public utilities to accommodate the extra bodies. The country must also address the high illiteracy rate, which currently stands at roughly 61% according the CIA World Fact Book. Although this rate is low, in 1947, when India achieved independence, only 12% of the nation was literate. The point is that demographics are the fundamental drivers of economies.

Figure 1.1 India's population versus China's

Japan, which is referenced quite a bit in this book, suffers from a crippling demographic decline. According to several government sources, and as illustrated in Figure 1.2, Japan is at peak population as of 2010. This creates a number of issues for the nation. The shrinking workforce will face difficulties in manufacturing and exporting products for the West at the same pace as it once did. This is only one of the issues facing the country as a result of its demographic problem. Japan is discussed in further detail later in this chapter and the next.

Figure 1.2 Japan's population 1880–2100

Aging populations have historically been a positive sign of economic prosperity and flourishing developed societies. However, from an economic standpoint, longer-living populations can put a tremendous strain on retirement and health care systems:

• In the U.S., social security and Medicare currently account for roughly 7% of the GDP, but within the next 25 to 30 years these programs will account for nearly 13%, essentially the majority of the entire federal budget. Proposals have been made to prevent these disasters, such as opening borders to immigrants to prop up the work force, privatizing government programs, and increasing the retirement age from 65 to 71. These proposals, however, have failed to adequately address the matter and gain widespread acceptance. Plans have been made to extend the retirement age by two years in some countries over a 20-year period, but this is simply not enough. The retirement age should be at least 71 in order to adjust for dramatic increases in life expectancy over the past 100 years relative to a static 60-to-65-year-old retirement age (in some places 55), which has been in place since as far back as the 19th century.
• Mass immigration will cause a number of national security problems, and people are simply not fungible assets. Skill and education level must be comparable for immigrants to take on many of the skilled labor jobs the baby boomers will leave behind. Moreover, the sheer number of immigrants necessary to counteract the baby boomer phenomenon would be unthinkable.¹

Generally, developed nations are aging rapidly, and their leaders must provide for the increase in health and retirement costs to care for the "gray" population (see Figure 1.3). But even in booming, headline-making nations such as China, demographics are an enormous dark cloud over their economies. China's one-child-per-family policy poses an enormous issue in terms of the nation's dependency ratio, or the ratio of younger workers supporting the elderly (see Figure 1.4). China is currently in a "sweet spot" of dependency ratios; however, every year moving forward China's elderly will become a larger percentage of the overall population. According to the Chinese government, the nation prevented roughly 250 million births between 1980 and 2000. These 250 million additional young workers could have helped carry the additional financial burden of aging and retired workers. The low dependency ratio has helped China reduce its economic drag by limiting the number of children who needed to be cared for. However, this policy is shortsighted in the long term. It is projected that the number of Chinese between the ages of 20 and 24 will drop from 125 million in 2010 to approximately 68 million by 2020, or nearly a 50% decrease.² China also suffers from a severe gender imbalance because families in rural areas prefer males to females due their ability to generate income or work on the family farm. Because of sex-specific abortions, researchers believe that over the next 15 years, there will be roughly 30 million more marriage-age men than women. And we all know that single, sexually frustrated men are a recipe for disaster! Wang Guangzhou, a Chinese researcher for the Global Times, commented: "The chance of getting married will be rare if a man is more than 40 years old in the countryside. They will be more dependent on social security as they age and have fewer household resources to rely on."³

Figure 1.3 Countries' population growth or decline in Europe 2009

Figure 1.4 China dependency ratios

The lighter bars in Figure 1.4 provide some evidence that dependency ratios, especially as a result of sex-specific abortions, have led to China's explosive economic growth. Starting in 2015, the darker bars indicate a dramatic spike in the elderly dependency ratio, which will continue into 2050. Because fewer children are being born, it costs less money to run a family, and therefore more money stays in the economy. The problem now is that those fewer children need to support all the older people who are retiring. The economic result is yet to be seen.

Again we can see that demographics may be used to predict the direction of a particular nation or economy. Granted, China's dependency ratio does not provide much insight into where the Shanghai Stock Exchange (SSE) will trade over the next week, month, year, or even five years. But over the next 10 or 20 years, it provides an excellent picture of the nation's position relative to other nations. India, which many believe is 10 or 20 years behind China at the moment, does not have a large future dependency ratio to worry about. Therefore, India maybe primed to surpass China in economic output over the next 50 or 100 years.

It is no coincidence that major growth in the U.S. coincided with the aging of the baby boomers, the largest generation in U.S. history. Certain market pundits, such as futurist Harry S. Dent, associate peak spending of families with the performance of the U.S. equities market. Figure 1.5 illustrates the various spending habits of different age groups within the U.S. Not surprisingly, people between the ages of 46 and 50 spend the most. They probably are supporting their two teenage, college-bound children, and maybe even their parents. Notice the sharp decline in spending after the children have moved out and entered the working world.

Figure 1.5 Spending life cycle

Figure 1.6 illustrates the concept of "peak spending" as it relates to the performance of the Dow Jones Industrial Average (DJIA). The thick line represents the DJIA, and the shaded area represents the number of people at their peak spending phase of life. Dent theorizes that one of the major reasons for the 2008 market downturn was a decline in peak spending. Furthermore, Dent cities this drop in peak spending as indication that a bear market will persist over the next two decades.

Figure 1.6 DJIA versus peak spending

In summary, demographics are an important element in investment analysis. A 2011 report released by PriceWaterhouseCoopers (PWC) projected that the G-7 economies will be replaced by emerging markets by 2032. The report estimated that by 2028, India will eclipse Japan in economic size, and Brazil will surpass Germany. China has already passed Japan to become the second-largest economy in the world. This sets the stage for a dramatic shift in global power from West to East and old to new. However, historically India and China have been the wealthiest and most powerful nations. Western prominence starting in the late 18th century was merely a blip in the context of human history. However, do not discount the importance of the unknown. Any competent actuary will admit that actuarial science and population projections are never entirely accurate. On the other hand, you cannot ignore the baby boomer population as they begin retiring. Nations and corporations must be prepared for any swing in population size.

Economic Implications of Longevity and Mortality Risk

Given that demographics play such a significant role in a nation's economic growth, it is easy to see why corporations must pay close attention to not only the demographic makeup of their customers, but also their employees. Pension obligations, if mismanaged or miscalculated, can be the downfall of any otherwise fundamentally sound business. This section examines two major demographic risks facing governments and corporations: longevity risk and mortality risk.

Longevity risk is the risk that a group of people, whether employees at XYZ Corp. or U.S. citizens, are living longer than originally estimated, and therefore collecting social security for a longer period of time. Although we use the term "risk," it is more of a certainty that requires adequate planning. For example, although the retirement age in many developed countries is between 60 and 67 (see Table 1.1), in many of these nations, the average life expectancy is well over 75. This means that the average taxpayer collects social security (as well as any health benefits) for 10 to 15 years. In the U.S., the average life expectancy is about 78; in Japan, it is 82.6, the highest in the world.

Table 1.1. Retirement Age and Percentages of Employed Older Workers

Figures 1.7 through 1.9 show the exponential increase in human longevity. As technology rapidly advances, so does our ability to live longer. Life expectancies have increased dramatically since 1840 due to the eradication of smallpox and a general improvement in health conditions. Thereafter, life spans increased at an average rate of 2.5 years per decade for the next 160 years. By 1900, the highest average life expectancy was roughly 60, and by 2000 it was over 80.

Figure 1.7 Global life expectancy in 2009

Source: CDC

Figure 1.8 Life expectancy since 1960 in long-lived populations and the U.S.

Figure 1.9 Average life expectancy

Between 1960 and 2002, average life expectancy rose from 36 to 71 in China, from 56 to 71 in Latin America and the Caribbean, from 47 to 69 in the Middle East and North Africa, and from 44 to 63 in South Asia.⁴

Given that each additional year of life expectancy after age 65 adds roughly 3% to the present value of pension liabilities, the cost of providing pensions in 2050 may be 18% higher than currently expected.⁵ For many pension funds, this uncertainty is a substantial and unquantifiable risk, leaving them unprepared to address future obligations (see Figure 1.10).

Figure 1.10 Pension deficits and surpluses (UK-based defined benefit pensions)

The first pension fund was created by Otto von Bismarck, the Prime Minister of Prussia from 1862 to 1890, under the Old Age and Disability Insurance Bill of 1889. This program used tax revenues to make annuity payments to seniors who reached the age of 70. Average life expectancy at birth during this time was 46. In 1918, the German government lowered the eligibility age from 70 to 65, where it remains, more or less, even though average life expectancy in Germany has skyrocketed to 80.

Retirement ages should have been hiked decades ago around the world; however, any politician who suggested doing so was met with disdain by party rivals and voters. In 2010, when French parliament raised the retirement age from 60 to 62, workers took to the streets in violent protests. The same occurred in Greece after the nation announced that it plans to increase the retirement age to 63 from 61 and ban early retirement.

Coupled with the recent economic crisis, which has left major U.S. corporations with $400 billion in underfunded programs (from a $60 billion surplus at the end of 2007), the risk of longer-living populations is substantial. Uncertainty in retirement programs has resulted in the growth of reverse equity markets such as life settlements and reverse mortgages. These allow seniors to sell their life insurance policies or equity in their homes in exchange for an upfront lump sum. Moreover, the number of working seniors has more than doubled over the past 20 years (see Figure 1.11) due to the destruction of the nest egg.

Figure 1.11 U.S. workers by age

Source: U.S. Bureau of Labor Statistics

Even though increased life expectancy is the logical result of improvements in modern medicine, life expectancies have become increasingly uncertain (see Figure 1.12). Many factors can hinder longevity and cause life expectancy to fall. For example, obesity rates in the U.S. for both children and adults are at alarming levels (and the rest of the world is following suit). Perhaps we as a society take our health for granted and rely too heavily on medicine to bail us out.

Figure 1.12 Longevity fan chart at age 65

Figure 1.13 (a-f) is a state-by-state mapping of body mass index (BMI) levels in the U.S. Keep in mind that this data includes lower-income individuals. The disparity in life expectancy estimates between individuals of higher and lower socioeconomic levels, as well as between white and black Americans, is significant. On the other hand, the disparity between men's and women's life expectancies is actually narrowing.

Figure 1.13a U.S. BMI levels, 1985–2008

Figure 1.13b U.S. BMI levels, 1985–2008 (continued)

Figure 1.13c U.S. BMI levels, 1985–2008 (continued)

Figure 1.13d U.S. BMI levels, 1985–2008 (continued)

Figure 1.13e U.S. BMI levels, 1985–2008 (continued)

Figure 1.13f U.S. BMI levels, 1985–2008 (continued)

Historically, developed nations have experienced a general mortality improvement rate of roughly 1% per annum, with a "mortality shock" ranging from plus or minus 3%, with 5% being an absolute extreme. A positive mortality improvement shock could result from, for example, a cure for cancer. A negative mortality improvement shock could result from the spread of a new disease or an unforeseen side effect of artificially grown foods. The last major mortality shock was the Spanish influenza pandemic of 1918, which lasted from 1917 to 1920. Almost 3% of the world's population (50 million) died of the disease, and 28% (500 million) were infected. This disease was unique in that infections in younger people were more fatal than those of their older counterparts. This has also been the case to a much lesser extent in outbreaks occurring in 1976, 1988, 1998, and 2007. Figure 1.14 shows typical mortalities among various ages from 1911 to 1917 compared to the mortality distribution in 1918.

Figure 1.14 Mortality disparity of the Spanish flu

Generally, mortality risk is the inverse of longevity risk. It is the risk that a group of individuals dies before and unexpectedly relative to estimates. As mentioned, longevity "risk" is actually more of a given that requires adequate planning. In contrast, unexpected mortality is a risk in the more traditional sense because it is unforeseen. For example, whereas a pension fund's obligations increase as life expectancy increases (longer-living retirees mean the pension must make more payments), a life insurance company may be subject to the risk of substantial numbers of early deaths. In the latter example, the life insurance company would have to pay more claims than expected and would experience a reduction in premium inflows. Table 1.2 shows the relationship between longevity risk and mortality risk and lists organizations that may be exposed to each.

Table 1.2. The Relationship Between Longevity Risk and Mortality Risk

The next chapter provides more details on why certain groups are exposed to either longevity or mortality risk.