I believe that given a large enough sample size, the past is the best indicator of the future. From credit expansion and collapse to global terrorism, the human race has experienced almost everything in some form.
However, there is a new and unprecedented phenomenon. The world is rapidly aging, and in the 21st century populations will age more rapidly than ever before. This demographic shift will take place throughout most of the developed world resulting in sizeable reductions in labor forces, thus triggering mass immigration. Moreover, this demographic shift will further weaken global pension programs due to mortality improvements and a decrease in the number of current workers to beneficiaries. Aging will also generate a number of opportunities for investors such as a massive boom in the healthcare sector and give rise to reverse equity transactions and global longevity risk markets.
AGING & PENSIONS
The idea that aging will have a profoundly negative impact on the global economy has been around for decades but has been dismissed or taken a back seat to other more “important” problems. Unfortunately, all the years spent avoiding the aging & pension problem has served to magnify the issue.
In 2008 the number of deaths in Japan outnumbered the number of births 1.14 million to 1.09 million respectively and the population fell by 51,000 according to the Health Ministry. By 2050 both Japan and Russia will lose over 20% of their populations and 38% of Korea will be over 65, making it one of the oldest nations in the world. Since 2006, an astonishing 330 people have turned 60 every hour in the US. Over 12% of the US’s population and 16% of the UK’s population is 65 or older, compared to 5.2% in India and 8% in China, suggesting the East will be the economic powerhouse of the new era.
Although longer living populations are a good thing, increased longevity can strain the economy, specifically retirement and healthcare programs. In the US, 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 2 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 60-65 (in some places 55) year old retirement age, 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.
It is not only an increase in life expectancy that is troublesome, but also the increasing uncertainty of life expectancies. For many pension funds this uncertainty creates a tremendous amount of unquantifiable risk, leaving them unprepared to address future obligations. Given that each additional year in life expectancy at 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 (Blake et al 2008, p. 23). Coupled with the current economic crisis, which has left major US corporations with $400 billion in underfunded programs (from a $60B surplus at the end of 2007); longevity risk management should be of the utmost importance to pension fund managers.
LONGEVITY RISK MARKETS
The capital markets have developed a number of possible solutions to allow pension programs to hedge and manage this longevity risk, and to allow large investors to capitalize on this extension in life expectancy.
Longevity Bonds (LBs) pay a coupon that is proportional to the number of survivors in a specified cohort. The cohort can be defined as a group of individuals from a specific geographical location(s) turning 65 in the year that the bond is issued. The subsequent coupon payments are proportionate to the number of survivors left in the reference pool, thus decreasing annually until the maturity of the bond.
A “longevity swap” is another life based derivative and it addresses many of the weaknesses of LBs, making it more attractive to investors. Swaps trade as a fixed spread between the payer and receiver of the mortality /longevity protection. Investors seeking to gain exposure to, and profit from, longer living populations, should be “long” mortality risk, essentially receiving an annual premium (for example 600bps on the notional amount of protection) in exchange for mortality contingent payments. Speculators may use these swaps to capture an arbitrage between expected and actual life expectancies and to generate cash flows uncorrelated to other fixed income, commodities, real estate, or equities markets.
Although these and other longevity products are still in their nascent stages, given the magnitude of the market (according to Watson Wyatt’s Global Pension Assets Study in 2007 there is roughly $23 trillion of longevity risk exposure among defined benefit pension funds) I am confident in the impact longevity derivatives will play in the coming years.
As the population continues to age demand for various forms of healthcare will skyrocket, causing a massive boom in the healthcare sector. In fact, the U.S. News & World Report reported that although the US has lost roughly 3.6 million jobs since Dec 2007, the healthcare industry has continued to hire. The only other sector reporting similar job growth is the government…which is alarming!
Currently the boomers are the largest consumers of prescription medication in the US. Seniors over the age of 65 spend on average $3,899 per year on healthcare and boomers will spend roughly 22% of the US GDP over the next 10 years to meet their medical needs. Women account for roughly 50% of the baby boomer population (almost 55% by 2030 as women typically outlive men) and are more likely to require medical treatment for longer periods of time. Older populations will also create increased demand for long term care and assisted living facilities. The high level of spending on healthcare, will further contribute to the extended life expectancies of this population segment.
It is important to note that the healthcare industry is subject to the whims of desperate politicians who believe in unsound economic principles. A nationalized healthcare system could greatly compromise private sector profits.
REVERSE EQUITY TRANSACTIONS
As pension funds continue to lose value over the next several years, greatly amplifying the current economic crisis, seniors will be left wondering how they will be able to fund their retirements. This unfortunate chain of events will give rise to “reverse equity transactions” such as life settlements and reverse mortgages. Although these types of transactions have been around for quite some time, in the coming years seniors will scramble to extract the remaining equity in their homes and sell their insurance policies to meet their daily cash obligations.
A life settlement is a transaction whereby a senior sells his insurance policy to an institutional investor for more than the cash surrender value but less than the coverage amount. The investor pays all subsequent premiums until the death benefit is collected. This gives investors revenue streams uncorrelated with other markets and allows consumers to receive a lump sum to pay off debt, or simply provide financial stability. For example, a senior citizen may sell a $1m life insurance policy for $350,000 to an investor. Life Partner Holdings (NASDAQ:LPHI) is a publicly traded firm that facilitates life settlement transactions and its performance over the past few years indicates seniors are seeking alternative sources of cash during times of financial duress. Life settlements also trade in pools on the tertiary market, allowing investors to capture substantial returns insulated from the broader economy. Many large investment banks and multi strategy hedge funds have already deployed billions of dollars in life settlements or linked products. The current market for life settlements is roughly $16 billion (up from $50 million in 1990) and is projected to grow to $160 billion in the near future.
Around the world, and especially here in the U.S., people are experiencing pandemic bouts of fiscal reality. I do not see this as an economic meltdown, but an inevitable reversion to the mean. Now more than ever it is crucial that we carefully evaluate our next step. The aging of the developed nations and its effects are NOT theory, rather economic and political fact. Massive government spending during times of financial instability, will only exacerbate the aging problem and further cripple US growth.