What are your expectations with regards to capital returns?

Based on fully-fledged quantitative models that take into account equilibrium relationships of supply and demand for capital on the international capital market, we expect that the average rate of return on capital will drop by no more than 0.8 percent by 2030-2035, from its current level of roughly 7 to 7.5%. So, compared to papers from the early 1990s, where some authors predicted a tremendous decrease in the capital return rate, we do not foresee a huge asset market meltdown. The average annual growth rate of GDP per capita will decrease by at most 0.5 percentage points according to our findings (Ludwig et al., 2012).

In your calculations, do you consider the effects of capital mobility?

With international diversification across industrialized countries only, you cannot affect the rate of return too much, because demographic trends are broadly correlated across these countries. If you assume that China or India are going to experience very high growth rates for the foreseeable future, then the picture changes because you have very big, very young economies that will need a lot of capital; and thereby including them in a portfolio would stabilize your rate of return. But I would question whether this is a realistic scenario. And if you – conservatively or probably even more realistically   include them with a trend growth rate of other OECD countries, which would be 1.5% in real per capita GDP growth per year, their impact on stabilizing growth in Europe and capital returns will not be huge.

Could the overall quantity of workers in the labor force increase – say, due to people starting work earlier, retiring later, or more women entering the workforce?

To address this question, you have to look at the aggregate hours worked in an economy, and these are not going to increase in the same proportion when you add more people to the workforce. The reason is behavioral responses to policy reforms at the extensive margin. When you take these into account in a realistically calibrated model, reforms are at least partially offset (Börsch-Supan et al., 2014). Regarding female labor supply, take for example Germany and the Nordic countries. The role model in Germany is still – somewhat exaggeratedly – that, in an average household, the man works full-time and the woman works part-time, i.e., yielding the equivalent of 1.5 units of work. In the Nordic countries, men and women in households typically each work three quarters of average work hours, thus still adding up to the equivalent of 1.5 units of work. So, whatever reform you will have on the extensive margin of labor supply, say better childcare provision, there has still to be someone who picks up the children from the childcare institution. This means, if women start to work more, there will be an extensive margin adjustment of men working less. Thus, the effect will be zero, in the extreme example. An increase in the retirement age will have a small positive effect on the working population but not one-for-one. People who have sufficient assets will work fewer hours.

Can you mitigate the effects of demographic change by a rise in human capital?

Yes, educating the workforce better can mitigate a lot of the effect of a shrinking labor force. According to our predictions, the projected fall in the rate of return on capital of 0.8 percentage points would be just 0.5 percentage points in the case of sufficient adjustments in human capital. The expected average growth rate reduction of 0.5 percentage points in the baseline scenario instead becomes a less pronounced drop of 0.2 to 0.3 percentage points (see Figure 2).

We assume that the demographic transition will automatically drive more people into higher education. The “return on skills” will go up as skilled labor becomes scarce, and technological progress will help the skilled to be more productive. When, for example, companies realize that labor is becoming scarce, they will invest more in education programs. On top of that, policy measures could help by making it easier for people to attend university.

Do you find differences between the United States and Europe?

There is not that big of a difference. The U.S. is going to have less of an aging problem in the baseline scenario, which means fewer losses of productivity growth. If you looked at the U.S. and Europe as closed economies each and separated them, the reduction in the rate of return would be stronger in Europe. But, in reality, you need to assume global capital markets, so you have basically the same pictures.

Going back to the first question you raised: What do your results imply for social insurance systems?

On the one hand, a contribution-based system puts more and more pressure on the shrinking fraction of workers. On the other hand, saving on your own is difficult when the rate of return on capital is going down. There are probably two perspectives to take on this. One is that rates of return on capital are still higher than the implicit returns in social insurance systems. As rates of return fall due to demographic effects, you should diversify your portfolio internationally and probably relax some of the restrictions on how to reinvest retirement funds that institutions in Germany face. Restrictions on how much you can invest abroad or on how much you are supposed to invest in risk-free versus risky assets should be revised.

The thing is, the return on risk-free assets is going to shrink to a larger extent than the return on risky assets. This is because old people have a higher preference for holding or investing in risk-free assets. As the population ages, the demand for risk-free investment will go up, dampening its returns more as compared to the return on risky assets. Overall, I would expect that the short-run effects on risk-free interest rates that we currently see as a consequence of the recession will last, due to the demographic effects. I suppose that we are going to be seeing relatively low interest rates for many years to come.

The other perspective is that you need a mixture between a contribution-based and a capital-funded system. The first provides more insurance than any asset you can purchase on the capital markets. And the last years have taught all the critics that wanted to abolish the public system entirely a lesson about capital market risk. So, the “optimal portfolio” should be a mixture between the two systems. I think that Germany – based on the pension reforms in 2001 and 2003 – is on the right track here. These reforms were based on relatively realistic scenarios for what is going to happen to the overall workforce.

The latest political reforms in Germany do not discourage you?

The early retirement at age 63 with 45 years of work does not affect a big fraction of the population. It is more the bad signal that worries me. People always talk about how someone who does manufacturing, or has to climb on roofs, will not be able to do that anymore at the age of 63 or 65. But people forget that a 65-year old today is not the same as 20 years ago. They are simply fitter. When life expectancy increases, then, of course, morbidity goes down. Politicians, not only in Germany, but all over Europe have to understand this. After all, the time that people spend in retirement has about doubled since 1960.

Selected Publications by Alexander Ludwig

Börsch-Supan, A., Härtl, K., Ludwig, A. (2014)
“Aging in Europe: Reforms, International Diversification, and Behavioral Reactions“,
forthcoming in American Economic Review, Papers & Proceedings.

Krueger, D., Ludwig, A. (2013)
“Optimal Progressive Labor Income Taxation and Education Subsidies When Education Decisions and Intergenerational Transfers are Endogenous”,
American Economic Review, Papers & Proceedings, Vol. 103, Issue 3, pp. 496-501.

Ludwig, A., Schelkle, T., Vogel, E. (2012)
“Demographic Change, Human Capital and Welfare”,
Review of Economic Dynamics, Vol. 15, Issue 1, pp. 94-107.

Ludwig, A., Reiter, M. (2010)
“Sharing Demographic Risk: Who is Afraid of the Baby Bust?”,
American Economic Journal: Economic Policy, Vol. 2, Issue 4, pp. 83-118.

Krueger, D., Ludwig, A. (2007)
“On the Consequences of Demographic Change for Rates of Return to Capital, and the Distribution of Wealth and Welfare”,
Journal of Monetary Economics, Vol. 54, Issue 1, pp. 49-87.

Börsch-Supan, A., Ludwig, A., Winter, J. (2006)
“Aging, pension reform, and capital flows: A multi-country simulation model”,
Economica, Vol. 73, pp. 625-658.

SAFE profile page of Alexander Ludwig