July 22, 2005

Future Shock: How Can Investors Respond to Changing Demographics?

Like the rest of the developed world, the U.S. faces some dramatic changes in demography, which may drastically impact the government's budget, the fate of retirement assets, and the performance of financial markets, including the behavior of the investment community.

These demographic shifts center on the aging and imminent retirement of the so-called "Baby Boom" generation, those roughly 80 million Americans who were born between 1946 and 1964. As the baby boomers enter their twilight years, the next group coming up, "Generation X" -- about 75 million Americans born between 1961 and 1981 -- may be unwilling or unable to support the immense financial and health care needs of their elders.

A rapidly aging population, combined with a falling number of active workers, would represent an unprecedented tandem in U.S. history, and could significantly change the way we invest and what we invest in. Doomsayers have forecasted that this confluence of events could bankrupt Social Security and exhaust Medicare and Medicaid long before the middle of the century.

In essence, because of low birth rates and longer life expectancies, the developed world is getting older faster, and the number of workers required to support the their retired elders is shrinking.

According to the Center for Strategic and International Studies (CSIS), a Washington D.C.-based research firm, about 20% of the current population in developed countries is aged 60 or older. By 2040, that figure will rise to 35%. In fact, in the fastest-aging nations like Japan, Spain and Italy, the percentage of elderly people will approach an astounding 50%. Indeed, some observers have speculated that the economic malaise gripping once-powerful nations like Japan and Germany is directly tied to their rapidly aging populations, and the enormous social services and medical care they require, most of which is provided by a dwindling workforce and high taxes.

The U.S. actually has the most favorable demographic profile among the developed world: About 16.3% of the population is elderly now, and that figure is expected to project to 26.0% in forty years. The birth and immigration rates in the U.S. will likely ensure the country will not suffer negative population growth. Indeed, the working-age population is already shrinking in Japan and southern Europe.

Still, the potentially large numbers of retirees will impose a heavy burden on the U.S. economy, taxpayers, the heath care system, and the sustainability of today's retirement programs. The CSIS estimates that by 2040, public benefits (including pensions, health care benefits and unemployment insurance) to the elderly in the developed world will reach 25% of GDP, or about double today's levels. For the U.S., these figures amount to 9.4% and 20.3%, respectively.

Neil Howe, an economist and author who has written extensively about future demographics, said that baby boomers are entering their peak earnings years, and that this is largely driving the economy. "After the oldest Boomers become eligible to retire on Social Security in 2008, a steadily growing share of this large generation will be selling assets and consuming less," he said. "This could spell trouble for the stock market and the economy. A smaller and more income-strapped Generation X may not be able to pick up the slack."

What do these bleak forecasts mean for stock investors and mutual funds themselves? Do they present opportunity, or reasons for long-term pessimism?

It is impossible to say, since mutual fund managers and market participants cannot invest with a multi-decade perspective. Indeed, most average investors don't look beyond the next year or so for their portfolios.

"The impact on mutual fund investing will probably not be as severe as other prognosticators are warning," said Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consultant. "When the baby boomers reach retirement, the assumption is they will sit in a rocking chair and smoke a pipe. But the fact is, people in retirement are beginning new careers. I see a regeneration and a reentry into the workforce of these 'retired' folks, which gives them another 25 years in the labor force. The impact on investing is that we won't see a sudden shift from accumulation to withdrawal; rather, we'll likely see a gradual shift, a stabilization. Most retirees will keep their money in the market in one form or another."

However, Harvey cautions that "mutual funds became an investment for ordinary people only in the 1980s, so we don't really have enough history to make any determinations on future fund investor behavior."

In many cases, retirement is being postponed, people are living and working longer, says Charlie Mayer, Director of U.S. Portfolio Management at Pioneer Investment Management Inc. "With tax laws changing and interest rates so low, many older investors could substitute equities for conservative bonds in their retirement portfolios," he said. "Baby boomers, in particular, have to not only take care of their children, but also their parents. But it's up to each individual's own risk profile to see how they can cope with retirement."

Howe strikes a more admonitory tone. "Baby boomers are worried that there will not be enough Social Security for them; and are worried about their overall financial security," he said. "They are uniquely lacking of confidence regarding their retirement. Boomers have trouble getting beyond their early expectations that 'the system' would somehow always take care of them. They had hoped they wouldn't really have to take personal responsibility."

On the other hand, Howe points out, Generation X seems to have more confidence in their future retirements and financial health. "Gen-X never trusted the system, and they know it won't be there for them," he noted. "As such, they're making alternative arrangements for their futures"

Mayer concurred that "baby boomers looked at pensions and Social Security as their savior, that is not the case today with Generation X."

As far as the behavior of investors of different generations, Harvey notes that no generalizations can be easily made. "The theory of financial planning holds that the older one gets, the more conservatively one invests, but this is not true in practice," he said. "Financial planners have a rule of thumb: your exposure to bonds should match your age. If you're 40 years old, your portfolio should be 40% invested in bonds, and so on. In practice, the younger investors -- Generation X -- tend to use fixed-income investments because they're not really paying attention to their assets. They stick their money in the bank or a CD, walk away and don't manage their investments. Those who are serious investors, regardless of age or generation, tend to be people who have accumulated, or inherited, some wealth."

A handful of mutual funds, like the $396-million AIM Dent Demographic Trends Fund/A (ADDAX), were devised specifically as a play on changing demographics. The portfolio was based on the ideas of economist Harry S. Dent, who has identified a number generational trends, and the sectors expected to profit from them. In a nutshell, the fund focuses on the information technology, financial services, consumer discretionary and health care industries -- these are typically the businesses most widely regarded as benefiting from population trends, but the overall picture is extremely complex and subject to much conjecture. However, AIM Dent Demographics Trends Fund, which has performed poorly, is about to be folded into AIM Weingarten Fund/A (WEINX).

Some have speculated that the graying of America will spell big profits for the health care sector. However, Rodney Hathaway, co-manager of the Heartland Value Plus Fund (HRVIX), doesn't necessarily agree. "A large pool of elderly retirees will require all kinds of medical care, and the product pipeline of the biotech and pharma companies may be there to meet this huge new demand -- but who will pay for it all?" he says. "For example, diabetes will likely become an epidemic disease because of trends in aging and obesity; and a lot of companies are chasing these new patients, but, where's the money coming from to pay for new drugs? Medicare is on the verge of bankruptcy. Private employers like General Motors (GM) can't even pay their pension and health care costs now." Hathaway notes that in a changing marketplace, he believes many health care companies may see "either squeezed margins or lower-than-expected utilization, which may cause them to cut pricing. It's a complex and murky picture."

Instead of looking at broad sectors that might benefit from future trends, Hathaway suggests investors should consider a company's long-term business strategy, or explore niche subindustries. "For example, companies that focus on lowering health care costs or those involved with preventative medicine might make a good long-term investment.," he suggested.

Some mutual funds are demographically-oriented due the very nature of their investment mandate. For example, the Aquila Rocky Mountain Equity Fund/A (ROCAX) was formed to take advantage of the extraordinary population growth of the Rocky Mountain States. "In the 1990s, according to the U.S. Census, the average Rocky Mountain state grew 29.6% in population, while the remainder of the country gained only 9.8%," said Barbara Walchli, the fund's portfolio manager. "Both retirees and younger people are moving here, attracted by the lifestyle and lower costs of living, and they are followed by companies and venture capitalists." Walchli noted that most companies in the region tend to be young and entrepreneurial, i.e., mostly micro-, small- and mid-cap stocks with high growth forecasts.

One particular industry that is a direct demographic play, Walchli says, is the burgeoning casino/gaming sector, particularly in rapidly-growing Nevada. "With a large number of baby boomers entering their peak earning years and possessing substantial spending power, casinos, hotels and other leisure/entertainment businesses tend to flourish," she says.

Another sector that some think might benefit in the coming years is financial services; particularly companies devoted to managing retirement assets. "Baby boomers are keeping their retirement savings in traditional pension plans, including 401(k)s," Hathaway said. "But as they retire, they'll need a way to optimize that nest egg to last them longer, since they will live much longer. Thus, investment advisor companies will likely be in great demand."

Hathaway also believes online/internet service providers will continue to grow in popularity, and will serve a plethora of different needs -- many of which probably haven't even been recognized yet. "For example, consider the 'Echo Boomers' (about 75-million strong) who are mostly the children of the baby boomers," he said. "They're now between 10 and 30 years old, mostly in their 20s. Their consumption habits are very different from their parents; they're more likely to transact business online. Internet retailers are likely here to stay; this is just one avenue of distribution that is likely to keep growing - and this is being driven by the behavior of these Echo-Boomers, as well as Gen-X, who are also deeply committed to the Internet."

Others believe that a large pool of affluent retirees will be a boon for the travel/leisure industry, specifically benefiting airlines, high-end hotels, cruise-lines, casinos, gambling, health clubs, etc. Once again, Hathaway cautions that investors might be wise to focus on certain specific niche businesses catering to particular services. For example, within the travel sector, he cites the motor-home industry as benefitting directly from aging baby boomers retiring, since they seem to enjoy touring around the country in RVs.

Certain "old economy" industries, which most investors have given up on may also benefit from demographics, Hathaway adds. "For example, consumer products are getting more disposable and are packaged in smaller individualized quantities," he said. "This means more packaging, more plastic, more aluminum foil, more paper, etc. This is potentially good for paper, plastic packaging and aluminum companies, among others."

Demographics can also play a role in bond investing. Zane Brown, director of fixed income at Lord, Abbett & Co, notes that municipal bonds are an extremely attractive investment now, with the yield on munis now matching those of Treasuries. "With muni bonds, you currently have great demand and limited supply, and this has been driven by the baby boomers," he said. "When the boomers moved to the suburbs, there was a huge development of infrastructure, including schools, bridges, water treatment plants, etc.; all this construction required a heavy supply of muni bonds. But now, all the infrastructure is pretty much in place, and the population of the new generation of kids is falling. The high school graduation class of 2006 will be the largest one for the next 15 years, ensuring that the supply of school-related municipal bonds will remain limited."

While certain future trends and behavior patterns may be predictable, it must also be remembered that baby boomers represent a wide, diverse cross section of the population, with vastly differing lifestyles, attitudes, and spending power. Generally speaking, the older boomers, who are now on the verge of retirement, have done better financially than later-stage boomers. As a result, the boomers' spending habits, and the force with which they spend, will vary somewhat over time.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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