Aging and Financial Markets
| Author | W. Todd Groome, Nicolas Blancher, and Parmeshwar Ramlogan |
| Position | Division Chief/Senior Economist/Special Projects Officer in the IMF's International Capital Markets Department. Oksana Khadarina, a Senior Research Assistant, helped in the preparation of this article |
The implications of population aging for financial markets, and for macroeconomic and financial stability, are getting greater attention as the baby-boom generation approaches retirement. For governments, threats to fiscal sustainability have been brought to the fore in recent years, and pension and health care reforms are increasingly high on the policy agenda. Similarly, the weak financial position of many pension funds has highlighted the need to secure financial resources and improve risk management practices to meet retirement needs, triggering a variety of reform efforts.
Financial markets can play an important role in the management of aging-related risks. For this reason, governments should seek to encourage and influence market developments in this area, and policymakers may need to reconsider the appropriate sharing of risk between the public, private, and household sectors. In some cases, governments may simply provide a framework or otherwise influence market participants to address incomplete markets. In other cases, governments may need to intervene directly to provide some minimum level of insurance coverage. Some risks may be best managed by the household sector, although shifting more risk to households will likely require additional measures to ensure they have some ability to manage such risks. The selection of any combination of these alternatives will be influenced by the sophistication and depth of domestic or regional financial markets and institutions, as well as by cultural and social considerations.
Governments should also act as long-term risk managers, pursuing proactive and comprehensive risk management strategies. In doing so, they would likely benefit from greater market inputs and risk management instruments. So far, few governments have approached aging-related challenges in this manner. However, given the focus that, for example, rating agencies are increasingly applying to sovereign long-term fiscal issues and related risks, and the potential for rating downgrades if such risks are not addressed, greater action may soon be required. Indeed, although the typically shorter-term focus of politicians and much of society may often inhibit more immediate efforts to address these long-term challenges, greater scrutiny from public auditors and legislators, the financial media, and international financial institutions and investors, and possibly even domestic households, is likely to increase the policy emphasis on aging-related challenges.
This article looks at the nature and size of the financial challenges facing aging societies today, the potential role of financial markets in addressing these challenges, and the role of governments as managers of key long-term risks related to aging, drawing on policy work we have done for the IMF's Global Financial Stability Report, the Group of Ten, and a Group of Twenty workshop on demography and financial markets.
As populations age, the relative size of pension fund liabilities grows, but the total theoretical level potentially dwarfs levels recognized thus far (see Chart 1). The adverse impact of aging on defined-benefit pension plans has been compounded since 2000 by lower equity market returns and (even more important) low interest rates. As a result, many such plans have become significantly underfunded, although funding ratios appear to have stabilized somewhat in the past two years. This growing pressure on defined-benefit pension plans may lead to lower replacement rates for retirement income, and has accelerated the trend toward defined-contribution and hybrid pension plans in the United States, Europe, and Japan. However, contribution rates in defined-contribution plans tend to be lower; and where participation in such plans is voluntary, many countries have found that participation rates also tend to be low. Both of these factors adversely affect retirement saving.
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Households in some countries may not be adjusting their saving levels to achieve expected replacement rates. In the United Kingdom, the 2006...
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