Posted on March 01, 2014

Age matters for economic performance. When comparing the growth rates of advanced economies, many commentators often forget that Europe and Japan have a larger percentage of their population above the age of 60. Such aging population has a direct impact on economic performance, fiscal policy and asset allocation. It is also a critical indicator for long-term financial sector developments.

According to a recent UN study, between 2010 and 2050 about 1.25bn people will be added to the global population aged 60+, while the number of people under 25 is projected to hold steady at 3bn. This implies that an increasingly smaller share of the population will be working, the so-called support ratio, while older people will depend on public transfers, their children or their own assets to sustain their old-age consumption.

Declining support ratios are already an acute problem in countries like Germany, Japan and Spain. These countries all experienced a baby boom after World War II. As that generation is now retiring, the support ratio is falling rapidly. According to a 2011 International Monetary Fund (IMF) study, declining support ratios in these countries are expected to depress economic growth by an average 0.7 percentage points (pps) a year over the next four decades.

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Declining support ratios will also be a problem in China, albeit somewhat later in time. As part of the one-child policy, China experienced a significant decline in the average fertility rate between 1979 and 2009. As a result, its support ratio has started to decline recently and will become more acute as the population born prior to 1979 starts to retire. The IMF estimates that the overall impact on the Chinese economy will be lower average growth rate by 0.4pps a year between 2012 and 2050. In the United States, where population is aging more slowly, a larger share of the population is made of immigrants from other countries, and life expectancy is lower, the IMF estimates that the impact of declining support ratios on growth will be 0.3pps over the same period.

The biggest policy challenge of declining support ratios is how to pay for old-age consumption. In countries with well-developed pension and social safety nets, governments are increasingly seeing a larger proportion of their expenditures devoted to pension benefits for older people. Since 1990, public pension spending has increased by 1.25% of GDP in advanced economies.

Without an increase in the retirement age or a reduction in pension benefits, such trends could jeopardize public finances and lead to unsustainable public debt burdens. Taxing the young to pay for the old also has its limits. As in the case of Greece and Italy, excessive taxation leads the young to emigrate, thus further exacerbating the declining support ratio. An alternative is to facilitate immigration, like in the United States, so as to increase the share of the working population.

In countries without social safety nets, it is left to the younger generations to support their parents through family transfers. This, however, also has a similar impact on private finances as public finances to the extent that younger generations have to work harder to support their older parents and may not save sufficiently for themselves. Where tradition requires younger generations to care for the old, the extent to which such family transfers work well depends critically on current economic conditions. The experience in these countries during a recession suggests that the old are the ones that pay the highest economic price when the economy turns sour.

The final way to pay for old-age consumption is for the old to sell their assets. In advanced economies, the largest asset usually accumulated during a lifetime is in the form of real estate. As the support ratio falls, retirees may use the equity accumulated in their house to finance their consumption. This could result in the outright sale of the house or, as in recent years in the United States, a reverse mortgage where the owner of the house receives monthly payments from a bank in exchange for giving up an ever larger equity share in their house. In this context, declining support ratios could be a leading indicator of lower real estate prices.

Population aging has also significant implications for the financial sector. In countries with aging populations, the demand for pension annuities, reverse mortgages, and private medical and disability insurance are likely to rise. In addition, private asset management will grow in importance as public pensions will increasingly become a less reliable form of financing old-age consumption. Overall, the financial sector has a critical role to play to smooth consumption across different age groups, a function that is likely to rise in significance over time.