The „Asset Meltdown“: A Popular Hypothesis Put into Perspective

According to the lifecycle theory of consumption and savings, households de-cumulate their asset holdings during retirement. In an aging society this effect leads to a decrease of aggregate household savings. Two developments additionally accelerate this process. First, in aging societies, the rate of return to capital goes down which may further decrease retirement savings. Second, the retirement of the baby boomers will speed up this process. Pessimists therefore forecast a massive decline of household demand for financial assets, as well as a decline in capital returns and a massive meltdown of wealth to occur when the baby boomers retire. This financial horror scenario, also known as the “Asset Meltdown Hypothesis”, has been challenged by Axel Börsch-Supan, Alexander Ludwig and Joachim Winter.
While correct, the arguments underlying the pessimistic scenario are incomplete. According to Börsch-Supan et al. mechanisms exist, which may attenuate or even reverse the negative effects of aging. On the one hand, the analysis by Börsch-Supan et al. verifies the main effects underlying the asset meltdown hypothesis: household savings will indeed decline when the baby boomers retire. On the other hand, the authors give several arguments against a massive decline of capital returns.

The effects of aging on capital returns are noticeable, but they are within ranges that do not justify the dramatic catchword “Asset Meltdown”. As a consequence of demographic change, returns to capital will fall by roughly 0.8 percent points until 2035 if capital flows freely within the OECD. Based on the long-term average annual return on productive capital over the last 50 years, returns are lowered from 7.7 to 6.9 percent. Under the counterfactual scenario of a closed capital market, the decline of the rate of return in Germany would be about 0.4 percentage points higher. ?

The pure demographic decline of capital returns will be aggravated when asset accumulation of retirement provisions covered by capital will rise because the increased demand leads to an additional downward pressure on the rate of return to capital. This effect will be in the order of magnitude of about 0.4 percent percentage points. ?

However, the size of the additional effects of fundamental pension reforms on the rate of return also depends on labour supply reactions. As a fundamental pension reform decreases the level of distortionary taxation and since such a reform leads to incentives to work longer, age-specific labour supply shares will rise. As a consequence, capital productivity will increase – relative to a scenario without changing labour supply ? which dampens – or even reverses ? the projected additional decline of the rate of return.?

An aging society needs more not less capital because it has to substitute labor for capital. The rising demand for real capital increases capital returns during exactly the time period for which pessimists expect the “Asset Meltdown” to occur.?

The “Asset Meltdown” does not take place, because the demographically induced adjustment on capital markets will neither be a sudden nor an unexpected event. The retirement of the baby boomers will last for a period of about 20 years. Because of the fact that demographic developments are largely foreseen, capital markets will anticipate this development. Therefore the decline of returns will spread over 20 years and can hardly be perceived in single periods.?

In a globalized world capital returns are not dominated by the demographic developments of individual countries. The international diversification helps especially the strongly aging countries (Germany, Italy and Japan) to reduce the magnitude of declines in rates of return to capital. Despite population aging, countries like Great Britain, France and the U.S. do not experience such a strong decrease of working age population ratios because of higher fertility rates. Capital productivity will therefore not shrink as much in these countries.

For more information please have a look at: Börsch-Supan, Axel; Heiss, Florian; Ludwig, Alexander; Winter, Joachim (2003): Pension Reform, Capital Markets, and the Rate of Return, German Economic Review, Vol. 4, Issue 2, May 2003, 151-181.