GDP, debt, longevity & pensions …through a demographic lens

In a lively presentation to delegates at the recent Sanlam Investments Institutional Insights conference in Johannesburg, Dr Amlan Roy, Head of Global Demographics and Pension Research at the investment banking division of Credit Suisse in London, took an in-depth look at demographics and how it impacted the investment strategies of retirement funds.

Roy said demographics played a crucial role in global macro-economics in its entirety –  across inflation, GDP growth, debt, asset prices and pensions –  because demographics was all about consumers and workers, not just people count, age or mortality. “Consumers consume as much as two-thirds of GDP in most countries, while workers make up the actual GDP,” said Roy. So on both a micro and macro level, demographics affects a multitude of valuation metrics as well as GDP drivers, including assets, liabilities, inflation and macro-policy.

Correlation does not always equal causation
The most common misconceptions about demographics pertain to people thinking demographics is all about age or that it is all about head count.

Both of these are blatantly incorrect.

Myth #1: demographics is about people numbers

While we agree that counting people is important, said Roy, the behaviour of people as workers and consumers is far more relevant. To give you an example, a head count of 300 or 400 million young workers in China or India will not automatically guarantee a demographic dividend, particularly if they are unskilled, have low education and poor health. So the demographic dividend does not automatically come about just by looking at the number of people (or youth), and growth is not automatically generated just because you have a high number of people or a growing population.

Myth #2: demographics is about age

Even though many people might fall into the same age category, they each have distinctive consumption behaviours and individual risk preferences.  Equally so, factors such as whether you were raised in a small rural village or in the heart of a major metropolis will affect consumption behaviour. There are other critical factors, apart from people’s age and actual headcount, that matter.

Most importantly, demographics is NOT predictable. The only predictable component in demographics is that people age. Yes, people’s age will increase every year, but five years later, what they consume and where they work and how they consume (ie their behaviours) is not predicable.

Harnessing the power of the ‘demographic dividend’
The concept of the demographic dividend is often confused because throughout the world, investors have mistakenly thought it is related to GDP per capita growth only. It is so much more than that, said Roy.

An example is the success story of the Asian Tigers of South East Asia.  Initially, in the 70’s and 80’s, when Singapore and Korea and Malaysia and Taiwan industrialised, they went from being an agriculturally-based economy to a manufacturing one; women and whole families moved from the rural into the urban areas. At the same time, they realised they no longer needed so many children. In addition, raising them in urban areas became more expensive, so people decided to have fewer children (fertility rates declined) but provided them with better education instead. These better educated children entering South Korea, Taiwan, Malaysia in the 90’s is often referred to as the “demographic dividend”.

As a result of this, we saw a sharply accelerated growth in South East Asia. But, importantly, the essential ingredients for this growth were also good health, good education, good infrastructure and most importantly but underplayed globally, the empowerment of women and youth. It was not just about the numbers.

The demographic drivers of real GDP growth
Our understanding of GDP growth has traditionally been understood through the framework introduced by the ECB in 2005/2006. Previously, the three main drivers of GDP growth were capital, labour and multi-factor productivity or technology. However, today the new framework developed by the ECB says that we need to consider measurable, tangible factors to understand GDP growth.

These 3 measurable factors are:

1. Working age population growth
2. Labour productivity growth
3. Labour utilisation growth (this refers to the number of hours worked. If hours worked goes up, that also need to GDP growth).

In the case of SA, we believe it is very important to increase labour productivity growth AND labour utilisation growth. Put more simply, not only does everyone need to work that bit harder but we also need to bring more well-educated women and better-educated youngsters into the labour force.

That is an essential ‘must-do’ if South Africa is to become the kind of global player that China and Mexico have become.

Addressing flawed longevity models: a multi-pronged approach
It has been well documented that one of the most significant trends across the globe is the continuing increase in human longevity. But while improved longevity can be a gift, says Roy, it is also a very big risk facing retirees after retirement.

A prominent concern currently is industry’s flawed longevity models which do not accurately calculate retirement ages. For individuals, existing asset and time allocation frameworks need to be challenged, along with intergenerational dynamics; policy changes in labour, education, health, pensions and social benefits need to be taken into account; and governments needs to re-assess their frameworks and assumptions in order to develop new solutions for clients as well as new approaches to understanding longevity.

To address longevity challenges, what is required is a “multifarious, multi-pronged approach”:

1. People must work for longer
2. People need to work smarter – with women, with youngsters and also with their peers – and in a globalised context
3. People need to keep themselves in good health
4. They need to accept they won’t get paid the onerous, unrealistic promises made because of the fundamental misunderstanding of how long people will live after retirement. While living longer is a boon, living in poorer health and in poverty is not something most people will strive for.

“Hybrid solutions” were required by the financial services industry to match a consumer’s expectations with the right product or investment strategy for their retirement needs. “You cannot sell the same solution to a 65-year-old and an 80-year-old, despite them being in the same supposed demographic group,” he said. “We have to reassess our frameworks and assumptions.”

An integrated approach to asset allocation and risk management
And bringing this home to the world of investing said Roy, is that we need to look at asset allocation and risk management in a much more integrated fashion. Assets should be linked to liabilities, liabilities should be linked to assets and the underlying factors making up asset allocation should also be correlated to liabilities. For instance, living for longer not only affects liabilities but also working age population growth.  It also affects labour productivity and labour utilisation.

Said Roy, we need to think about assets and liabilities as the 2 Rs of finance: risk and returns. In a sense, risk management has become like liability management for pension funds. We need to be more sophisticated in our approach to risk management so that we can leverage options or other clever strategies to limit our losses. But at the same time, proper asset management requires both active as well as passive management, and an openness to the newer alternative trends, be they investing in an Africa fund or investing in infrastructure or private equity. But most of all, we should embrace multi-asset class strategies on the asset front and on the liability front, we need better liability longevity models which are calibrated  – not once every 5 years –  but once every 6 months, because we have the technology, we have the quantitative expertise and we have a richness of data at our disposal to arrive at better retirement promises for our fund members who are going to retire.

Roy said traditional methods of asset allocation between bonds, equities and cash had been radically revised during this decade’s market upheaval. He suggested more sophisticated solutions were required for a pension fund to avoid under-funding and to more accurately match its liabilities with its market value.

Finally, Roy concluded with a key, bottom line message: “Demographics is about consumers and workers, not just people count and age. We need to look more broadly than longevity and mortality”.