Thought Leadership

Could an ageing population be a double whammy for pension schemes?


Earlier this year the Bank for International Settlements (BIS) published a paper* on the effects of demographics on inflation. Its conclusions were surprising and could have profound implications for pension scheme trustees and sponsors. Rather than reducing inflation, the research suggests that an ageing population may actually produce higher inflation.

The prevailing view is that, all else being equal, older populations should create less inflationary pressures than younger populations. After all, retired people are less economically active than working people, which should lead to lower economic growth and, therefore, lower inflation. Also, retired people tend to be more exposed to the negative effects of rapidly rising prices. This should, in theory, lead to more political pressure on governments with older populations to control inflation.

The BIS paper examined the inflation and demographic experience of 22 countries since 1955. Its conclusion is that populations with a higher dependency ratio (more young and old non-workers compared to working people) have tended to experience higher inflation. One explanation for this is that the elderly and children consume more than they produce. This leads to excess demand in an economy, which pushes up inflation. They argue that this effect may outweigh the factors traditionally cited as pushing in the opposite direction.

The BIS study suggests that the global economy has benefited from lower inflationary pressures by around four per cent over the past 40 years due to an increase in the relative share of the working age population. This has broadly been as a result of the baby boomer generation having fewer children. However over the next forty years the authors predict demographic tailwinds will change to headwinds as populations around the world age and dependency ratios rise. The BIS estimates that, in the UK, the ageing population will lead to inflation that is 2.5% higher in 2050 than it would have otherwise been if left unchecked.

Should they prove correct, the conclusions of the BIS report could have profound implications for UK pension schemes. Ultimately, whether they do will depend on the impact of demographics on inflation, interest rates and economic growth. If central banks leave inflationary pressures unchecked, then pension schemes’ inflation-linked liabilities will rise. Using the BIS estimate for the UK, an inflation-linked pension payment due in 20 years’ time would be worth 13% more and a payment in 40 years’ time would be worth around 60% more**. Defined contribution members will also face greater cost of living pressures, as well as having to fund a longer retirement due to the longer lives they are expected to enjoy.

However, if central banks adopt stronger measures to control inflation, for example by raising interest rates faster than expected, the result could be beneficial for defined benefit pension schemes if discount rates also rise. While higher inflation would require higher levels of pension to be paid, the discounted value of pension liabilities could be smaller if interest rates turn out to be higher than expected. This assumes, of course, that the benefit is not offset by weaker economic growth and poorer returns on equities and other growth assets.

So if the BIS research is to be believed, increasing longevity may be a double whammy for pension scheme trustees and sponsors. As well as extending the period over which they must be paid, longer lives may require pension payments to be increased to match higher inflation. This could raise the pressure on trustees to explore inflation protection strategies, such as liability-driven investment.

* Bank for International Settlements Working Paper no. 485, “Can demography affect inflation and monetary policy?”, Mikael Juselius and Elöd Takáts, February 2015. 
** Assumes linear increases in inflation over 40 yrs, ending 2.5% a year higher than current break-even yields suggest.

This article is taken from the Winter 2015 edition of the Pension Newsletter to view click below.