Page 1 of 3

AMID THE WELL-HEELED RETIREES WHO PLAY GOLF and walk the beach in Carmel-by-the-Sea, California, economist William Sharpe is hard at work. Professor emeritus at Stanford University and winner of a 1990 Nobel Prize, the 78-year-old Sharpe is deeply immersed in the study of “retirement economics.” He’s tackling the knotty question of how growing ranks of retirees — especially the gray brigade of baby boomers — can live off their savings as they reach ages unimaginable to earlier generations.

Sharpe’s work is crucial to financial firms racing to serve investors who hope somehow to fund their golden years. From 1970 to 2007 the retired lifetime of an American male increased by 34 percent, according to a paper published by Amy Kessler, head of longevity reinsurance at Prudential Retirement, in Longevity Risk Management for Institutional Investors, an Institutional Investor journal. American males now live an average of 17.5 years once they hit age 65, compared with 13 in 1970. Women survive almost 20 more years, up from 15 in 1970.

“I’m trying to understand the properties of different schemes for investing and spending and annuitizing in retirement,” says Sharpe in a phone interview from his home. “And there are zillions of them. Every part of the industry, from insurers to mutual funds to advisers, are all coming up with magic formulas, magic investment strategies. But there are no simple answers. It’s a difficult and complex problem.”

Sharpe and his compatriots studying retirement economics begin with some sobering math: U.S. corporate pension plans face a $689 billion deficit, while public plans in the U.S. are underfunded by about $4.4 trillion, according to a 2012 study by Harvard University’s John F. Kennedy School of Government. Individuals saving on their own fall woefully short of what they need as well — some $4.3 trillion short, according to an estimate by the Washington-based Employee Benefit Research Institute. EBRI’s 2012 Retirement Security Projection Model analyzed retirement income for baby boomers born between 1948 and 1964 (though the generation is usually defined as the 1946–’64 age cohort), and Gen Xers, born between 1964 and 1974. In an analysis for Institutional Investor, EBRI research director Jack VanDerhei concluded that an increase in longevity of just two years would push up his estimate of the shortfall to almost $5 trillion.

Those trillions add up: Institutional and individual investors need to save, and plow into the markets, $9.4 trillion more than they have so far. As a point of comparison, assets in U.S. mutual funds total $13 trillion.

If even a portion of that nearly $10 trillion in future retirement assets moves into markets, it could dramatically redirect global capital flows, changing economic incentives for both issuing and managing securities and possibly distorting whole sectors of the economy. As capital chases asset classes, the characteristics of the assets may change and boundaries blur. But the rush of retirement savings will also spark the invention of new asset classes and structures, and will likely reenergize both old-fashioned annuities (which took off in the U.S. in the 1930s) and the more modern-day securitized products — sorely humbled but not destroyed by the financial crisis.

Capital flows are already choppy. In the past few years, in reaction to historically low interest rates, investors have moved en masse into dividend-yielding stocks, longer-duration bonds and high-yield assets. But in response to even small changes — a slow rise in interest rates, say — they could change course once again. “We could have massive dislocations as people quickly change their personal asset allocations,” says Scott Shay, a founder of Ranieri Partners Management in New York and the chairman of Signature Bank.

Competing pressures face aging baby boomers and those investing for the group’s retirement. On the one hand, there is the classic need as an investor ages to grow more conservative and risk-averse, to favor, all things being equal, bonds over stocks. On the other hand, in today’s near-zero-interest-rate environment, there is an increasingly intense (on occasion desperate) search for yield, which has of late ignited high-yield, real estate investment trust and corporate bond markets.

On a deeper level, retirement investors, like all long-term investors, understand that many of their long-held assumptions have been upended by the financial crisis. They focus particularly on the notable weaknesses exposed in the model of endowment investing pioneered by David Swensen of   Yale University and imitated by his often less sophisticated followers.

Josh Lerner, a professor of investment banking at Harvard Business School, has studied how Swensen’s model has evolved, as well as disappointed, over the years. The Yale CIO’s approach, which stresses diversification into all types of equities and employs huge allocations to alternative assets, including private equity, venture capital, real estate, commodities and hedge funds, generated a 10.6 percent average annual return for the university’s endowment for the ten years ended June 30, 2012.

Eager to replicate those handsome returns, other endowments, as well as pension funds, followed Swensen’s lead and deployed similar strategies. Inevitably, though, the flood of money depressed returns for many of Swensen’s followers. Significantly, the promise of alternative assets — the group historically has not correlated with publicly traded equities — proved false in the dark days of the global financial crisis. In a flight to safety, investors bought U.S. Treasury bonds and not much else. Almost every asset class was hammered.

That’s one reason endowment performance dramatically deteriorated during the crisis and has remained subpar in recent years. According to a study by the Commonfund Institute and the National Association of College and University Business Officers, which represents the endowments of 2,500 colleges and universities, 823 endowments posted an average annual return of 5.6 percent for the ten years ended June 30, 2011. In preliminary results for 2012, endowments dropped 0.3 percent, on average.

Today smart long-term investors know that no rule is written in stone. “If you take a by-the-book approach, you’re less likely to succeed,” Lerner says. “Because the book will change. That’s assured.”

DEMOGRAPHERS CALL THE BABY BOOM generation the pig in the python because the horde so dramatically changed the course of U.S. population growth.

Baby boomers came of age in the halcyon postwar U.S. economy: steady growth (except for the nasty recessions of 1973–’75 and 1981–’82), modest inflation (except for the double-digit inflation of the late 1970s) and a rising standard of living, along with good-paying factory jobs, affordable college tuition, the promise of a defined benefit pension and, not least, income inequality that looks mild by today’s standards.

The strong economic growth that the U.S. experienced from the 1960s to 2000 was in many ways powered by the life experience of the baby boomers. That’s the conclusion of a 2012 paper titled “Demographic Changes, Financial Markets, and the Economy” by Robert Arnott and Denis Chaves, published in the Financial Analysts Journal. In the 1960s, when the leading edge of boomers was between the ages of 15 and 25, they kicked off a substantial marginal boost in productivity as they entered the workforce; they continued to deliver big productivity gains as 25- to 35-year-olds and 35- to 45-year-olds. Although there isn’t meaningful productivity growth in workers from 45 to 55, productivity doesn’t start to fall off until they are between 55 and 65.

If the baby boom generation was the face of postwar prosperity, it was also the engine fueling the great bull market in equities that ran from 1982 to 2000. Between July 1982 and August 2000, the Standard & Poor’s 500 Index rose an average annual 15.6 percent, while 30-year bonds averaged 8.8 percent.

Baby boomers started getting serious about their retirements as they entered middle age, with the oldest members of the group turning 40 in 1986.   When they experienced the adrenalin high of double-digit stock returns, they poured even more money into the markets. In 1985 individuals held $750 billion in IRA and defined contribution plans; by the market peak in 2007, that number had rocketed to $9.2 trillion, according to the Investment Company Institute.

Financial markets zig and zag in response to demand for their assets. In the 1980s bull market, price-earnings multiples of companies in the S&P stock index doubled; P/Es doubled again in the 1990s. Earnings of the companies climbed about 6 percent a year, while the stock prices increased 14 percent annually. That multiple expansion reflected in large part the supply-demand imbalance that occurred when baby boomers started investing for their retirements.

The specter of increased longevity requires that investors save even more money to meet their retirement goals. Indeed, if mortality rates fall 1 percent per year below their expected trend, the cost to a defined benefit plan of providing an inflation-linked pension to a 45-year-old preretiree rises 11 percent, according to Guy Coughlan, chief risk and analytics officer of Pacific Global Advisors in New York. Coughlan created the first product that transferred longevity risk from an insurance company to the capital markets when he worked at J.P. Morgan in 2008.

Many academics and investment practitioners suggest that equities will be depressed for years as baby boom investors and the asset managers handling their retirement plans sell off some of their riskier assets and buy more-conservative bonds, hedged strategies and annuities. Again the laws of supply and demand kick in. Just as the P/E ratios on stocks expanded during the boomers’ peak earning years, they will contract until 2021, according to Zheng Liu and Mark Spiegel, a research adviser and a vice president, respectively, in the economic research department of the Federal Reserve Bank of San Francisco. Real stock prices will decline in aggregate by 13 percent, they predict.

Single Page    1 | 2 | 3
Related Topics: retirement· baby bommers· asset allocation