Baby Boom Generation: Retirement of Baby Boomers Is Unlikely to  
Precipitate Dramatic Decline in Market Returns, but Broader Risks
Threaten Retirement Security (28-JUL-06, GAO-06-718).		 
                                                                 
The first wave of baby boomers(born between 1946 and 1964) will  
become eligible for Social Security early retirement benefits in 
2008. In addition to concerns about how the boomers' retirement  
will strain the nation's retirement and health systems, concerns 
also have been raised about the possibility for boomers to sell  
off large amounts of financial assets in retirement, with	 
relatively fewer younger U.S. workers available to purchase these
assets. Some have suggested that such a sell-off could		 
precipitate a market "meltdown,"a sharp and sudden decline in	 
asset prices, or reduce long-term rates of return. In view of	 
such concerns, we have examined (1) whether the retirement of the
baby boomers is likely to precipitate a dramatic drop in	 
financial asset prices; (2) what researchers and financial	 
industry participants expect the effect of the boomer retirement 
to have on financial markets; and (3) what role rates of return  
will play in providing retirement income in the future. We have  
prepared this report under the Comptroller General's authority to
conduct evaluations on his own initiative as part of the	 
continued effort to assist Congress in addressing these issues.  
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-718 					        
    ACCNO:   A57622						        
  TITLE:     Baby Boom Generation: Retirement of Baby Boomers Is      
Unlikely to Precipitate Dramatic Decline in Market Returns, but  
Broader Risks Threaten Retirement Security			 
     DATE:   07/28/2006 
  SUBJECT:   Assets						 
	     Baby boomers					 
	     Economic research					 
	     Pensions						 
	     Prices and pricing 				 
	     Retirement 					 
	     Stocks (securities)				 
	     Commercial markets 				 
	     Health and Retirement Study			 
	     Survey of Consumer Finances			 

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GAO-06-718

     

     * Results in Brief
     * Background
     * Financial Evidence from Baby Boomers and Current Retirees Do
          * Concentration of Financial Assets among a Minority of Baby B
          * Analysis of Current Retiree Behavior Reveals a Pattern of Co
          * Defined Benefit Pension Plans Unlikely to Sell Off Large Amo
          * Gradual Entry into Retirement and Subsequent Employment Plan
          * The Role of Housing, a Key Asset for Baby Boomers in Retirem
     * Researchers and Financial Industry Representatives Largely F
          * Academic Studies Largely Foresee Little to No Baby Boom Reti
               * Simulation-Based Studies
               * Empirical Studies
          * Financial Industry Representatives Do Not Expect Baby Boom R
          * Broad Economic Factors Will Likely Have a Greater Impact on
     * Baby Boomers and Future Generations Likely to Increasingly R
          * As Baby Boomers Retire, Fewer May Receive Income from Tradit
          * Financial Stress on Social Security, Medicare, and Health Ex
          * Baby Boomers and Future Generations May Increasingly Rely on
     * Concluding Observations
     * Agency Comments
          * GAO's Econometric Model of the Effects of Demographic, Macro
          * Data and Sample Selection
          * Model Specification, Limitations, and Estimation
     * Contacts
     * Staff Acknowledgments
     * GAO's Mission
     * Obtaining Copies of GAO Reports and Testimony
          * Order by Mail or Phone
     * To Report Fraud, Waste, and Abuse in Federal Programs
     * Congressional Relations
     * Public Affairs

GAO

United States Government Accountability Office

Report to Congressional Committees

July 2006

BABY BOOM GENERATION

Retirement of Baby Boomers Is Unlikely to Precipitate Dramatic Decline in
Market Returns, but Broader Risks Threaten Retirement Security

GAO-06-718

Contents

Letter 1

Results in Brief 2
Background 4
Financial Evidence from Baby Boomers and Current Retirees Does Not Suggest
a Sharp Decline in Asset Prices 7
Researchers and Financial Industry Representatives Largely Foresee Little
to No Impact on Financial Markets as the Baby Boomers Retire 21
Baby Boomers and Future Generations Likely to Increasingly Rely on Their
Own Savings, Placing Greater Importance on Rates of Return and Financial
Management Skills 31
Concluding Observations 40
Agency Comments 42
Appendix I Scope and Methodology 45
Appendix II Bibliography of Simulation-Based and Empirical Studies 47
Appendix III Summary of the Simulation-Based and Empirical Studies
Assessing the Impact of a Baby Boom on Financial Markets 50
Appendix IV Econometric Analysis of the Impact of Demographics on Stock
Market Returns 57
Appendix V GAO Contact and Staff Acknowledgments 64

Tables

Table 1: Pension Coverage by Plan Design, 2004, as Percentage of Birth
Cohort 32
Table 2: Simulation-Based Studies Assessing the Impact of a Baby Boom on
Financial Markets 50
Table 3: Empirical Studies Assessing the Impact of a Baby Boom on
Financial Markets 54
Table 4: Names, Definitions and Data Sources of Variables Used in Our
Regression Models 59
Table 5: Stock Market Returns Regression Results-Baseline Model 61
Table 6: Stock Market Returns Regression Results-Middle Age Model 62
Table 7: Stock Market Returns Regression Results-Change in Middle Age
Model 62
Table 8: Stock Market Returns Regression Results-Middle-Young Ratio Model
62
Table 9: Stock Market Returns Regression Results-Change in Middle-Young
Ratio Model 63

Figures

Figure 1: U.S. Elderly Dependency Ratio (Population Age 65 and Older
Relative to Age 15 to 64), 1950-2000 and Projected 2005-2050 6
Figure 2: Distribution of Baby Boomer Financial Assets, by Wealth
Percentiles 9
Figure 3: Percentage of Baby Boomers Who Own Financial Assets and Their
Use of Different Investment Accounts 10
Figure 4: Total Financial Assets Held by Boomers and the Rest of the U.S.
Population 11
Figure 5: 2004 U.S. Resident Population, by Birth Year 17
Figure 6: Share of the U.S. Population Age 65 and Older, Projected to 2050
18
Figure 7: Labor Force Participation Rates for Americans, Ages 55 and Older
20
Figure 8: Sources of Stock Market Return Variation 30
Figure 9: Individual Retirement Account and Defined Contribution Pension
Balances for Older and Younger Baby Boomers, 2003 34
Figure 10: Allocation of Assets of Baby Boomers, By Wealth Quartiles 36

Abbreviations

DB defined benefit

DC defined contribution

EBRI Employee Benefit Research Institute

HRS Health and Retirement Study

IRA Individual Retirement Account

S&P Standard & Poor's

SCF Survey of Consumer Finances

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United States Government Accountability Office

Washington, DC 20548

July 28, 2006

Congressional Committees

The aging of the U.S. population is expected to present great fiscal and
economic challenges in the decades ahead. The first wave of the baby boom
generation, the 78 million Americans born between 1946 and 1964 and alive
as of 2005, will turn age 62 and become eligible for Social Security
benefits beginning in 2008. The retirement of the relatively large baby
boom generation, combined with other demographic trends, is expected to
strain the nation's retirement and health systems.1 This impending event
has also raised concerns about the potential market effect should baby
boomers sell off large amounts of financial assets in retirement. If
proportionally fewer workers are available to buy these assets, some
market observers fear that the increase in supply of stocks, bonds, and
other financial assets relative to demand may place downward pressure on
asset prices. At the extreme, some observers have raised the possibility
of a market "meltdown," a sharp decline in stock or other asset prices,
precipitated by the baby boom retirement. In contrast, others have noted
that such an outcome could be mitigated by a rising demand for U.S.
financial assets from developing countries and by immigration.

Returns on investment are important in helping many Americans accumulate
sufficient savings throughout their working lives to meet their retirement
needs. From 1946 to 2004, U.S. stocks have returned an average of 8.0
percent annually, adjusted for inflation. From 1986 to 2004, U.S. 10-year
Treasury notes have yielded an annual average of 3.4 percent, adjusted for
inflation. Importantly, returns on financial assets provide retirement
income for many Americans, accounting for 12.6 percent of total income for
Americans age 65 and over in 2004, and over half of this cohort received
some income from financial assets. If the baby boom retirement were to
reduce asset returns, retirees would generate less income from investments
and workers would have more trouble saving adequately for retirement.

1 See GAO, 21st Century Challenges: Reexamining the Base of the Federal
Government, GAO-05-325SP (Washington, D.C.: Feb. 1, 2005); 21st Century
Challenges: Transforming Government to Meet Current and Emerging
Challenges, GAO-05-830T (Washington, D.C.: July 13, 2005); and 21st
Century: Addressing Long-Term Fiscal Challenges Must Include a
Re-examination of Mandatory Spending, GAO-06-456T (Washington, D.C.: Feb.
13. 2006).

In view of such concerns, we have examined (1) whether the retirement of
the baby boom generation is likely to precipitate a dramatic drop in
financial asset prices; (2) what researchers and financial industry
experts expect the effect of the baby boom retirement to have on the
financial markets, and (3) what role rates of return will play in
providing retirement income in the future. We have prepared this report
under the Comptroller General's authority to conduct evaluations on his
own initiative as part of a continued effort to assist Congress in
addressing these issues.

To analyze whether the retirement of the baby boom generation is likely to
precipitate a dramatic drop in financial asset prices, we examined
financial information from the Survey of Consumer Finances (SCF) to
determine what financial assets are held by baby boomers and the Health
and Retirement Study (HRS) to determine how current retirees spend down
their assets.2 To identify the views of researchers and outside experts on
the financial effects of the baby boom retirement, we reviewed
simulation-based and empirical studies analyzing the baby boom
generation's impact on financial markets and interviewed financial and
public policy experts from mutual fund companies, pension funds, life
insurance companies, broker-dealers, financial planning organizations, and
financial industry trade associations. We also conducted our own
econometric analysis of the historical importance of demographics on
financial asset returns. To assess the role rates of return will play in
providing retirement income, we reviewed past GAO reports, academic
literature, and obtained insights from interviews with outside experts. We
conducted our work between August 2005 and June 2006 in accordance with
generally accepted government auditing standards. A more extensive
discussion of our scope and methodology appears in appendix I.

                                Results in Brief

Our analysis of national survey and other data suggests that baby boomers
would be unlikely to sell enough financial assets in retirement to
precipitate a market meltdown, or a sudden and sharp decline in asset
prices. First, a large majority of boomers have few financial assets to
sell, and the small wealthy minority that holds the large majority of this
generation's assets will likely need to sell little, if any, of their
assets in retirement.3 Our examination of the 2004 SCF shows that the
wealthiest 10 percent of boomers own about two-thirds of the financial
assets held by this generation, excluding assets held indirectly in
defined benefit (DB) pensions. About one-third of all boomers do not own
any assets in stocks, bonds, mutual funds, or retirement accounts. Second,
if baby boomers behave like current retirees, a rapid and large sell off
of financial assets also appears unlikely. Our analysis of data on current
retirees' saving and investment behavior reveals that most retirees slowly
spend down their assets in retirement, with many actually continuing to
accumulate assets. Other factors that would mitigate against a sharp and
sudden decline in asset prices include the 19-year span over which boomers
will reach retirement age, the extended life expectancy of boomers, and
the expected increase in boomer employment past traditional retirement
ages, which would facilitate additional asset accumulation and reduce the
need to sell assets to provide retirement income. Finally, to the extent
that boomers may be less reluctant than prior generations to treat their
homes as a source of retirement income through such strategies as reverse
mortgages, they may also depend less heavily on selling their financial
assets for income.

2 The SCF is a nationally representative survey sponsored by the Federal
Reserve Board containing detailed information on assets and debt of U.S.
households. We define baby boomers in our analysis of SCF as a household
headed by an individual born between 1946 and 1964. HRS is a nationally
representative biennial survey of older Americans produced by the
University of Michigan and sponsored by the National Institute on Aging.

Researchers and financial industry representatives largely expect the baby
boom retirement to have little or no effect on stock and bond markets.
Studies that used models to simulate the market effects of a hypothetical
baby boom followed by a baby bust generally predicted that the baby boom
retirement will have a small, negative effect on financial asset returns.
Similarly, most of the empirical studies, which statistically examined the
impact of past changes in the U.S. population's age structure on stock
returns and bond yields, suggested that demographic shifts have had a
minimal or no effect on stock returns or bond yields. In addition,
financial industry representatives whom we interviewed generally did not
expect the baby boomers to have a significant impact on the financial
markets when they retire. They said factors that could slow the sale of
assets or increase demand and thereby mitigate any demographic effect
included the possibility that the minority of boomers who own the majority
of financial assets will likely bequeath rather than sell their assets,
boomers will hold stock well into retirement to hedge inflation and the
risk of outliving their savings, and international factors such as
immigration and an increase in asset demand from developing countries.
Finally, our statistical analysis indicates that macroeconomic and
financial factors, such as dividends and industrial production, have
explained more of the variation in stock returns from 1948 to 2004 than
shifts in the U.S. population's age structure-suggesting that such factors
could outweigh any future demographic effect on stock returns.

3 We define financial assets as stocks, bonds (excluding U.S. savings
bonds), mutual funds, Individual Retirement Accounts, Keogh accounts,
account-type retirement savings plans, and assets in annuities, trusts,
and managed accounts that are invested in stocks and bonds.

While the baby boom retirement is not likely to cause a sharp decline in
asset prices or returns, the retirement security of boomers and future
generations will likely depend increasingly on individual savings and the
returns these savings can earn. The decline in traditional DB pensions
that provide income for life and their replacement with account-based
defined contribution (DC) plans mean that fewer boomers will have a
dependable income during retirement other than that from Social Security.
However, fiscal uncertainties about Social Security's solvency may result
in reduced future benefits for certain age groups and income levels,
thereby placing more responsibility for saving on individuals.
Collectively, these trends would increase the dependence of individuals on
rates of return to accumulate enough financial assets at retirement and to
produce sufficient income from their assets during retirement. Given the
need for individuals to rely increasingly on their ability to manage their
own accumulation and spending of assets and savings, financial literacy
will likely play an ever important role in the retirement security of baby
boomers and future generations.

                                   Background

In the 21st century, older Americans are expected to comprise a larger
share of the population, live longer, and spend more years in retirement
than previous generations. The share of the U.S. population age 65 and
older is projected to increase from 12.4 percent in 2000 to 19.6 percent
in 2030 and continue to grow through 2050. At the same time, life
expectancy is increasing. By 2020, men and women reaching age 65 are
expected to live another 17 or 20 years, respectively. Finally, falling
fertility rates are contributing to the increasing share of the elderly
population. In the 1960s, the fertility rate was an average of three
children per woman.4 Since the 1970s, the fertility rate has hovered
around two children per woman, meaning relatively fewer future workers are
being born to replace retirees. The combination of these trends is
expected to significantly increase the elderly dependency ratio-the number
of people age 65 and over in relation to the number of people age 15 to
64. In 1950, there was 1 person age 65 or over for every 8 people age 15
to 64. By 2000, the elderly dependency ratio had risen to 1 person age 65
for every 5 people of traditional working age, and by 2050 this ratio is
projected to rise further to about 1 elderly to every 3 working age people
(see fig. 1).5 Consequently, relatively fewer workers will be supporting
those receiving Social Security and Medicare benefits, which play an
important role in helping older Americans meet their retirement needs.

4 The fertility rate is the average number of children born to a woman
between the ages 15 to 44, among all women who survive to age 44.

5 These demographic changes are not unique to the United States. Other
developed countries are undergoing demographic change similar or greater
in magnitude than the United States. For example, the elderly dependency
ratio for Italy and Japan is projected to rise from around 1 person age 65
or over for every 4 people age 15 to 64 to around 1 older person for every
1.5 younger people from 2000 to 2050; Spain and Germany will also face a
steeply rising dependency ratio over the same period. In comparison, the
ratio for the United Kingdom is expected to increase at a similar pace as
the U.S. ratio.

Figure 1: U.S. Elderly Dependency Ratio (Population Age 65 and Older
Relative to Age 15 to 64), 1950-2000 and Projected 2005-2050

Note: Population Division of the Department of Economic and Social Affairs
of the United Nations Secretariat, World Population Prospects: The 2004
Revision and World Urbanization Prospects: The 2003 Revision. Data for
2005 through 2050 are projected. The elderly dependency ratio equals the
number of people age 65 and older divided the number between age 15 and
64, expressed as a percentage.

By causing a large shift in the U.S. population's age structure, some have
suggested that the baby boom generation may affect stock and other asset
markets when this cohort retires. This concern stems from hypothetical
spending and saving patterns over people's lifetimes, which economists
describe in the "life cycle" model. The model hypothesizes that people
attempt to smooth their consumption over their lifetime. As individuals'
earnings typically grow over their working life, this suggests that
younger workers, with relatively low earnings, may save relatively little
or borrow to finance current consumption (or to buy a house); older
workers may save significantly more in preparation for retirement; and
retirees may spend down their savings. The model therefore predicts that
the saving rate is hump-shaped over an individual's lifetime.

Over the course of their lives, individuals make decisions about not only
how much to save but also how to distribute their savings among a mix of
assets, such as stocks, bonds, real estate, and bank accounts. For
example, older workers are expected to shift their portfolios toward less
volatile assets, such as bonds or cash accounts, because they will tend to
prefer assets with a more predictable flow of income since they will have
less time to weather potential price declines in riskier assets such as
stocks.

In addition to their saving and consumption patterns, baby boomers also
may affect stock returns in particular through broader macroeconomic
channels. Stocks represent claims on the profits earned by firms, and in
the long run the returns on these assets should reflect the productivity
of the firms' capital. Generally, economic theory states that capital
becomes more productive with more and better quality labor to use that
capital. Because the baby boom retirement is expected to reduce the growth
rate of the U.S. labor supply, it may reduce returns to capital, which
could reduce the returns to stocks. More generally, investors may price
stocks in relation to the underlying value of the firm, taking into
account the value of firm's current assets and stream of future profits.

  Financial Evidence from Baby Boomers and Current Retirees Does Not Suggest a
                         Sharp Decline in Asset Prices

Our analysis of national survey data indicates that the baby boom
generation is not likely to precipitate a sharp and sudden decline in
financial asset prices as they retire. Our analysis of the 2004 SCF shows
that just 10 percent of boomers own more than two-thirds of this
generation's financial assets, excluding assets held indirectly in DB
pensions. These wealthiest boomers may be able to support themselves on
the income from these investments without spending them down
significantly. About one-third of all boomers do not own any stocks,
bonds, mutual funds, or retirement accounts.6 As with the prior
generation, baby boomers may continue to accumulate financial assets in
retirement and liquidate their assets only gradually with the hope of
leaving bequests. The gradual entry of the boomers over a 19-year period
into retirement should further reduce the likelihood of a sudden decline
in asset prices.7 Further, boomers have indicated that they plan to retire
later than generations that retired in the recent past, with almost half
not planning to leave full-time employment until age 65 or later. Many may
also continue to work throughout retirement, reducing or delaying their
need to sell financial assets. Housing represents a greater share of total
wealth for most baby boomers than do financial assets, and therefore the
housing markets present more financial risk to most boomers than the
financial markets.

6 In determining wealth for the purposes of this report, we added all
assets that each household owns and subtracted all outstanding debts.

7 For purposes of this report, we consider people to be retired if they
self-report they are retired in the SCF or HRS. We refer to full
retirement as when an individual stops working for pay altogether.

Concentration of Financial Assets among a Minority of Baby Boomers May Lessen
Their Market Effect

The potential for the baby boom generation to precipitate a market
meltdown in retirement may be substantially reduced by the fact that a
small minority of this population holds the majority of the generation's
financial assets. According to our analysis of the 2004 SCF, the
wealthiest 10 percent of boomers owned over two-thirds of the
approximately $7.6 trillion held by boomers in stocks, bonds, mutual
funds, Individual Retirement Accounts (IRAs), and other account-type
retirement savings plans in 2004. This wealthiest group held $1.2 million,
on average, in these financial assets, plus over $2 million in other
assets such as home equity and other investments.8 Figure 2 shows the
concentration of financial assets among boomers. This concentration of
wealth is very similar to that of current retirees and could mitigate a
sharp and sudden impact on financial asset prices if wealthy boomers need
not spend down their financial assets in retirement. Research on current
retirees indicates that the wealthiest of these individuals tend to not
sell their financial assets, contrary to what the life-cycle model would
predict; instead, they choose to live from the income these assets
generate.9 Our analysis of the 2004 SCF also found that of the wealthiest
10 percent of current retirees born before 1946, less than 16 percent
spent money from their savings and investments over and above their income
during the previous year. In this same group, over 65 percent responded
that their income in 2003 exceeded their spending, indicating that they
had accumulated more assets without having a net sale from their holdings.

8 Because DB pension plans are future income payments and not assets held
in an account, they are not included in calculating financial assets or
wealth with the SCF data.

9 Christopher D. Carroll, "Portfolios of the Rich," National Bureau of
Economic Research, Working Paper No. 7826 (August 2000).

Figure 2: Distribution of Baby Boomer Financial Assets, by Wealth
Percentiles

Note: Financial assets include stocks, bonds, mutual funds, IRAs, Keogh
plans, and other account-type retirement savings plans. The distribution
of baby boomers is based on total wealth, defined as the net of all assets
that each household owns and all outstanding debts.

The possibility of an asset meltdown is further reduced by the fact that
those households that would seem more likely to need to sell their
financial assets in retirement do not collectively own a large portion of
the total stocks and bonds in the market. Although the majority of baby
boomers hold some financial assets in a variety of investment accounts,
the total holdings for all boomer households, $7.6 trillion, account for
roughly one-third of the value of all stocks and 11 percent of bonds
outstanding in the U.S. markets, and the wealthiest boomers own most of
these assets (see figs. 3 and 4).10 Those households that are most likely
to spend down their assets in retirement-those not in the top 10 percent
by wealth-collectively hold just 32 percent of all baby boomer financial
assets. As a group, the influence of these households on the market is
less substantial. One-third of this group does not own any stocks, bonds,
mutual funds, or retirement accounts, and among those who do, their total
holdings are relatively small, with their median holdings totaling
$45,900.

10 At the close of 2004, assets invested in the New York Stock Exchange
and NASDAQ totaled $16.1 trillion, and assets in domestic bonds, both
corporate and government, excluding money markets, totaled $20.7 trillion.

Figure 3: Percentage of Baby Boomers Who Own Financial Assets and Their
Use of Different Investment Accounts

Figure 4: Total Financial Assets Held by Boomers and the Rest of the U.S.
Population

Note: Due to rounding, total does not equal 100 percent.

Analysis of Current Retiree Behavior Reveals a Pattern of Continued Accumulation
and Slow Spending of Assets

Our analysis of national data on the investment behavior of current
retirees reveals an overall slow spending down of assets in retirement,
with many retirees continuing to purchase stocks. To the extent that baby
boomers behave like current retirees, a rapid and mass sell off of
financial assets seems unlikely.11 In examining retiree holdings in
stocks, using biennial data spanning 1994 to 2004 from HRS, we found that
many people continue to buy stocks in retirement. More than half of
retirees own stocks outside of an IRA, Keogh, or pension account and,
among this group, approximately 57 percent purchased stocks at some point
over the 10-year period in retirement.12 We found that from 2002 to 2004
the stock ownership for most of these retirees either increased or
remained at the same level. Among those who owned stock, almost 31 percent
reported buying stocks during this 2-year period, while just fewer than 26
percent reported selling.13 For the retirees who both bought and sold
stocks, approximately 77 percent purchased at least as much value in stock
as they sold.14

11 An important distinction between current retirees and baby boomers is
that the latter are more likely to rely on DC pensions for retirement
income, which may affect how they spend down their assets. Research has
shown that there is a lower propensity to spend assets from a DC plan when
compared to income from a DB plan. While approximately 16 percent of
people older than baby boomers have DC pensions as part of their
retirement savings plan, about 42 percent of older boomers and 45 percent
of younger boomers have DC pensions. A DB pension provides a guaranteed
benefit usually in the form of an annuity, whereas a DC pension is an
individual account whose value depends on contributions and investment
returns. Another difference is that benefits from DB plans are insured up
to specified limits by the Pension Benefit Guaranty Corporation.

Additionally, although retirees might be expected to have a low tolerance
for market risk and will therefore divest themselves of equities in favor
of bonds, the SCF data does not suggest such a major reallocation.15
Comparing households' holdings in stocks and bonds by age, we found only a
small difference in aggregate stock and bond allocation across portfolios.
Specifically, data from the 2004 SCF shows that of total wealth among
households headed by people over age 70, more is invested in stocks than
bonds.16 In 2004, households headed by those over age 70 had roughly 60
percent of their investments in stocks and 40 percent invested in bonds,
while those households headed by someone aged 40 to 48 held 68 percent of
their portfolios in stocks and 32 percent in bonds.

12 This measure of stock purchases includes stock or money put into a
mutual fund, including automatic reinvestments.

13 This measure of stock sales and purchases does not include IRAs,
Keoghs, or pension accounts.

14 In addition, for investments in real estate (not including a primary
residence) and private businesses, assets that few retirees hold, we found
that the majority of retirees do not sell these assets off quickly.
According to the HRS, approximately 22 percent of retirees owned real
estate and about 10 percent owned shares in a private business in 2004.
These assets represented a significant share of net wealth among those
retirees who held them-for retirees with both real estate and private
business holdings, these combined assets represent, on average, about half
of total wealth. However, from 1994 to 2004 time period, only about
one-quarter of these retirees sold real estate and 8 percent sold an
interest in a private business.

15 While investments in equities are viewed to be a hedge against
inflation and have higher average returns than bonds, they are riskier
investments compared to most bond investments, and therefore pose more of
a risk of loss of value in the short run. A loss in portfolio value would
be especially harmful to retirees, as they are less likely to be able to
return to work to make up for a loss in wealth and they have a shorter
time horizon to recoup their losses in the market.

16 Researchers similarly have found that the percentage of net worth
invested in common stocks shows very little decline after age 60, with the
share of net worth held as common stocks never falling below the
percentage observed for 45 to 49 year-olds. See Barry P. Bosworth, Ralph
C. Bryant, and Gary Burtless, "The Impact of Aging on Financial Markets
and the Economy: A Survey" (Washington, D.C.: The Brookings Institution,
July 2004).

Our finding that retirees slowly spend down assets is consistent with the
results of several academic studies. One recent study that examined asset
holdings of elderly households suggests there is a limited decline in
financial assets as households age.17 Prior work also finds evidence that
retirees spend down at rates that would leave a considerable portion of
their wealth remaining at the end of average life expectancy and a
significant number of retirees continue to accumulate wealth at old
ages.18 For example, a 1990 study estimated that most single women would
have approximately 44 percent of their initial wealth (at age 65)
remaining if they died at the average age of life expectancy.19 Other
studies have shown that over the last several decades the elderly have
drawn down their lump-sum wealth at relatively conservative rates of 1 to
5 percent per year.20

Retirees may spend down assets cautiously as a hedge against longevity
risk. Private annuities, which minimize longevity risk, are not widely
held by older Americans.21 As life expectancy increases and people spend
more years in retirement, retirees will need their assets to last a longer
period of time and, thus, should spend them down more slowly. The average
number of years that men who reach age 65 are expected to live has
increased from 13 in 1970 to 16 in 2005, and is projected to increase to
17 by 2020. Women have experienced a similar rise-from 17 years in 1970 to
over 19 years in 2005. By 2020, women who reach age 65 will be expected to
live another 20 years.22

17 James Poterba, "The Impact of Population Aging on Financial Markets,"
Working Paper No. 10851 (Cambridge, Mass..: National Bureau of Economic
Research, 2004).

18 Michael D. Hurd, "Research on the Elderly: Economic Status, Retirement,
and Consumption and Saving," Journal of Economic Literature, Vol. 28, No.
2 (June 1990, 565-637); and Laurence J. Kotlikoff, "Intergenerational
Transfers and Savings," The Journal of Economic Perspectives, Vol. 2, No.
2 (Spring 1988, 41-58).

19 Hurd, "Research on the Elderly: Economic Status, Retirement, and
Consumption and Saving," p. 612.

20 Alicia H. Munnell, Annika Sunden, Mauricio Soto, and Catherine Taylor,
"How Will the Rise in 401(k) Plans Affect Bequests?", Issue Brief No. 10
(Boston: Center for Retirement Research at Boston College, Nov. 2002.)

21 Research has shown that inefficiencies exist in the annuity market due
to a lack of competition and adverse selection among those who purchase
annuities. Adverse selection in the annuities market occurs because people
who buy annuities also tend to live longer, which is adverse to the
insurer. See Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky, and
Jeffrey R. Brown, "New Evidence on the Money's Worth of Individual
Annuities," The American Economic Review, Vol. 89, No. 5 (Dec. 1999) and
National Center for Policy Analysis, "Social Security and Market Risk: The
Annuity Market: Present and Future,"
http://www.ncpa.org/pub/st/st244/s244c.html (accessed June 21, 2006).

Another factor that may explain the observed slow spending down of assets
among retirees is the bequest motive. National survey data show that many
retirees intend to leave a sizeable bequest, which may explain their
reluctance to spend down their wealth. Because more than three-quarters of
retirees have a bequest motive, many may never sell all of their assets.
To the extent that retirees bequeath their assets instead of selling them
for consumption, the result could be an intergenerational transfer rather
than a mass sell-off that would negatively affect asset markets. In
addition to current retirees, data from the HRS indicates that the
majority of older baby boomers (those born between 1946 and 1955) expect
to leave a bequest. Approximately 84 percent of these baby boomers expect
to leave a bequest, while 49 percent expect the bequest to be at least
$100,000.

It is important to note that the baby boom generation's asset sale
behavior in retirement might differ from that of recent generations of
retirees. First, fewer baby boomers are covered by DB plans that typically
pay a regular income in retirement and increasingly have DC plans that
build up benefits as an account balance. To the extent that this shift
means that boomers have an increased share of retirement wealth held as
savings instead of as income, this may require boomers to sell more assets
to produce retirement income than did previous generations.23 Second,
unanticipated expenses, such as long-term care and other health care
costs, may make actual bequests smaller than expected. Although 2002 HRS
data indicates that only 8 percent of the leading edge of baby boomers
have long-term care insurance, recent projections show that 35 percent of
people currently age 65 will use nursing home care.24 If boomers are
confronted with higher than expected health care costs in retirement, they
would have a greater need to spend down their assets.

22 See GAO, Older Workers: Labor Can Help Employees and Employers Better
Plan for the Future, GAO-06-80 (Washington, D.C.: December 2005).

23 Countering this potential effect is that the move away from DB plans
would mean that plan sponsors might have less of a need to sell assets to
pay current retirees.

24 The majority of nursing home care and home health care costs are not
paid by private insurance or Medicare. In many cases, the burden of these
expenses are borne by the patient receiving care, until they have spent
down nearly all of their assets and become eligible for Medicaid, which
does cover these costs. Peter Kemper, Harriet L Komisar, and Lisa Alecxih,
"Long-Term Care Over an Uncertain Future: What Can Current Retirees
Expect?" Inquiry, Vol. 42, No. 4, Mar. 2006, pp. 335-350.

Defined Benefit Pension Plans Unlikely to Sell Off Large Amounts of Stocks
Solely as a Response to Boomer Retirement

Households are not the only holders of financial assets that might shift
or draw down their holdings as the baby boomers age. DB pension plans,
which promise to provide a benefit that is generally based on an
employee's salary and years of service, hold assets to pay current and
future benefits promised to plan participants, which are either current
employees or separated or retired former employees. According to Federal
Reserve Flow of Funds Accounts data, private-sector plans as a whole owned
$1.8 trillion in assets in 2005. Of this amount, plans held approximately
half in stocks.25 According to the Employee Benefit Research Institute
(EBRI), federal government DB plans contained an additional $815 billion
in assets as of 2004. However, most of these DB plans invest in special
Treasury securities that are non-marketable. State and local plans held an
additional $2.6 trillion in assets; however, the data do not separate DB
and DC assets for these plans. If DB plans hold approximately 85 percent
of state and local plan assets, as is the case for federal government
plans, and if DB plans held approximately half of their assets as
equities, this would mean state and local plans held an estimated $1.1
trillion in equities. Thus, public and private DB plans held an estimated
approximate value of $2 trillion in stocks. Because of the number of
boomers, we would expect that, as they retire, DB plans would pay out an
increasing amount of benefits. This demographic shift could cause plans to
sell some of their holdings to provide current benefits. Indeed, a 1994
study projected that the pension system would cease to be a source of
saving for the economy roughly in 2024.26 We would also expect plans to
convert some stocks to less volatile assets, such as cash and bonds, to
better ensure that plans have sufficient money to pay current benefits.27

25 The Flow of Funds Accounts data report amounts held in mutual fund
shares but do not report the proportion of these shares that represent
stock holdings. We assume that all assets listed in mutual fund shares are
held in stocks to show the maximum amount of assets that could be held as
stock.

26 The study also noted that when the pension system begins to be a net
seller of financial assets, it could depress asset prices, including
stocks, bonds, and real estate. See Sylvester J. Schieber and John B.
Shoven, "The Consequences of Population Aging on Private Pension Fund
Saving and Asset Markets," Working Paper No. 4665 (Cambridge, MA: National
Bureau of Economic Research, 1994).

While DB plans may shift their assets in response to demographic changes,
it is unclear whether they would cause major variations in stock and bond
prices. First, even though DB plans hold about $2 trillion in stocks, this
sum still represents a relatively small fraction of total U.S. stock
wealth ($16.1 trillion, as of 2004). Further, there are reasons why DB
plans may not appreciably shift their investments away from stocks. While
the baby boom retirement may increase the number of persons receiving
benefits, the DB participant pool has been aging long before the baby boom
approached retirement. The percentage of private-sector DB participants
made up of retirees has climbed steadily for the past 2 decades, from 16
percent in 1980 to over 25 percent in 2002. Over this time, we have
observed little evidence of a shift in investments by private DB plans
away from stocks and toward fixed-income assets. In 1993, private DB plans
held just below half of their assets in stocks, about the same proportion
as today; in 1999, at the recent stock market's peak, plans held about 58
percent of assets in stocks.

Gradual Entry into Retirement and Subsequent Employment Plans Suggest a
Cumulative Rather Than Sudden Effect on Markets

The gradual transition of the baby boomers into retirement suggests that
the sale of their financial assets will be spread out over a long period
of time, which mitigates the risk of a shock to financial markets. The
baby boom generation spans a 19-year time period-the oldest baby boomers
will turn age 62 in 2008, becoming eligible for Social Security benefits,
but the youngest baby boomers will not reach age 62 until 2026. Among
boomers in the U.S. population in 2004, the peak birth year was 1960, as
seen in figure 5, and these boomers will turn age 62 in 2022.

27 Other factors might also cause DB plans to sell stocks in the near
future. The number of plans, which has been in decline since the
mid-1980s, continues to shrink, and as plans terminate, they use their
assets to pay lump sum benefits or turn their assets over to insurance
companies or the Pension Benefit Guaranty Corporation, entities that tend
to hold more bonds than stocks. As DB plans continue to terminate, this
trend would likely cause a decline in the level of stocks in the DB
system. Also, pending pension reform legislation in Congress may create
incentives for plan sponsors to shift their asset allocation from stocks
toward bonds and other less volatile assets.

Figure 5: 2004 U.S. Resident Population, by Birth Year

As boomers gradually enter retirement, the share of the population age 65
and older is projected to continue increasing until about 2040, at which
point it is expected to plateau, as seen in figure 6. Thus, the aging of
the baby boom generation, in conjunction with the aging of the overall
U.S. population, is a cumulative development rather than a sudden change.

Figure 6: Share of the U.S. Population Age 65 and Older, Projected to 2050

In addition, the expected increase in the number of baby boomers working
past age 62 may also reduce the likelihood of a dramatic decline in
financial asset prices. An increase in employment at older ages could
facilitate the accumulation of financial assets over a longer period of
time than was typical for earlier generations (albeit also needing to
cover consumption over a longer life expectancy).28 Furthermore,
continuing to work for pay in retirement, often called partial or phased
retirement, would reduce the need to sell assets to provide income.29 In
fact, some degree of extended employment has already been evident since
the late 1990s, as seen in figure 7. From 1998 to 2005, the labor force
participation rate of men and women age 65 and older increased by 20
percent and 34 percent, respectively. Survey data show that such a trend
is expected to continue: Data from the 2004 SCF indicate that the majority
of boomers intend to work past age 62, with boomers most commonly
reporting they expect to work full time until age 65. Almost 32 percent of
boomers said they never intend to stop working for pay. Another study by
the AARP in 2004 found that many baby boomers expect to go back to work
after they formally retire-approximately 79 percent of boomers said they
intend to work for pay in retirement.30 Other research has shown that
about one-third of those who return to work from retirement do so out of
financial necessity.31 These developments suggest that baby boomers may be
less inclined to take retirement at age 62. However, some boomers may not
be able to work as long as they expect because of health problems or
limited employment opportunities.32 To the extent that these boomers
follow through on their expressed plans to continue paid work, their
income from earnings would offset some of their need to spend down assets.

28 From the perspective of the overall economy, increased employment at
older ages would also support continued growth of the labor supply, which
may improve the productivity of and financial returns to capital.

29 In general, partial retirement refers to someone who classifies himself
or herself as partially or fully retired but is still working for pay on a
part-time basis.

30 AARP, Baby Boomers Envision Retirement II: Survey of Baby Boomers'
Expectations for Retirement, Prepared for AARP Environmental Analysis by
Roper ASW, 2004.

31 Putnam Investments, Retirement Only a Breather: 7 Million Go Back to
Work. (Research conducted by Brightwork Partners, 2005).

32 In prior work, we found that, although the majority of full-time
workers age 55 or older indicate they would like to gradually reduce their
work hours in transition to full retirement, many are constrained by
health problems or perceive limited employment opportunities. See: GAO,
Older Workers: Labor Can Help Employers and Employees Plan Better for the
Future, GAO-06-80 (Washington, D.C.: Dec. 5, 2005).

Figure 7: Labor Force Participation Rates for Americans, Ages 55 and Older

The Role of Housing, a Key Asset for Baby Boomers in Retirement Security,
Continues to Evolve

Housing represents a large portion of most baby boomers' wealth and their
management and use of this asset may have some effect on their decisions
to sell assets in the financial markets. For a majority of boomers, the
primary residence accounts for their largest source of wealth-outstripping
DC pensions, personal savings, vehicles, and other nonfinancial assets.
Home ownership rates among boomers exceed 75 percent, and recent years of
appreciation in many housing markets have increased the net wealth of many
boomers. This suggests that a price decline in housing, a prospect that
many analysts appear to be concerned about, could have a much greater
impact on the overall wealth of boomers than a financial market meltdown.
While research has suggested that baby boomers have influenced housing
demand and, in turn, prices, assessing the potential impact of the baby
boom retirement on the housing market is beyond the scope of our work.

Interestingly, according to experts we interviewed, equity in the primary
residence has not historically been viewed by retirees as a source of
consumable wealth, except in the case of financial emergencies. Reverse
mortgages, which do not require repayment until the owner moves from the
residence or dies, could grow more attractive for financing portions of
retirement spending, particularly for those baby boomers who are "house
rich but cash poor" and have few other assets or sources of income.33 For
boomers who do own financial assets, an expansion of the reverse mortgage
market might reduce their need to sell financial assets rapidly. However,
boomers also appear to be carrying more debt than did previous
generations. Our analysis of the SCF data shows that the mean
debt-to-asset ratio for people aged 52 to 58 rose from 24.5 percent in
1992 to 70.9 percent in 2004.34 To the extent that baby boomers continue
to be willing to carry debt into retirement, they may require more income
in retirement to make payments on this debt.

Researchers and Financial Industry Representatives Largely Foresee Little to No
             Impact on Financial Markets as the Baby Boomers Retire

Researchers and financial industry representatives largely expect the U.S.
baby boom's retirement to have little or no impact on the stock and bond
markets. A wide range of studies, both simulation-based and empirical,
either predicted a small, negative impact or found little to no
association between the population's age structure and the performance of
financial markets. Financial industry representatives whom we interviewed
also generally expect the baby boom retirement not to have a significant
impact on financial asset returns because of the concentration of assets
among a minority of boomers, the possibility of increased global demand
for U.S. assets, and other reasons. Broadly consistent with the literature
and views of financial industry representatives, our statistical analysis
indicates that past changes in macroeconomic and financial factors have
explained more of the variation in historical stock returns than
demographic changes. Variables such as industrial production and dividends
explained close to half of the variation in stock returns, but changes in
the population's age structure explained on average less than 6 percent.
If the pattern holds, our findings indicate that such factors could
outweigh any future demographic effect on stock returns.

33 Reverse mortgages allow those aged 62 and older to access equity in
their homes through lump-sum payments, structured monthly payments, or
lines of credit to the homeowner based on the value of the home. Once the
borrower moves from the residence or dies, the principal, interest, and
all fees immediately come due.

34 The debt-to-value ratio measures total debt in relation to total
assets. The percentage of debt to assets increases as a person takes on
more debt relative to the underlying asset, such as a home or an
automobile.

Academic Studies Largely Foresee Little to No Baby Boom Retirement Effect on the
Financial Markets

With few exceptions, the academic studies we reviewed indicated that the
retirement of U.S. baby boomers will have little to no effect on the
financial markets. Studies that used models to simulate the market effects
of a baby boom followed by a decline in the birth rate generally showed a
small, negative effect on financial asset returns. Similarly, most of the
empirical studies, which statistically examined the impact of past changes
in the U.S. population's age structure on rates of return, suggested that
the baby boom retirement will have a minimal, if any, effect on financial
asset returns.35

  Simulation-Based Studies

Thirteen studies that we reviewed used models of the economy to simulate
how a hypothetical baby boom followed by a baby bust would affect
financial asset returns.36 The simulation models generally found that such
demographic shifts can affect returns through changes in the saving,
investment, and workforce decisions made by the different generations over
their lifetime. For example, baby boomers cause changes in the labor
supply and aggregate saving as they progress through life, influencing the
demand for assets and productivity of capital and, thus, the rates of
return. Specifically, the models predicted that baby boomers cause
financial asset returns to increase as they enter the labor force and save
for retirement and then cause returns to decline as they enter retirement
and spend their savings. According to a recent study surveying the
literature, such simulation models suggest, on the whole, that U.S. baby
boomers can expect to earn on their financial assets around half a
percentage point less each year over their lifetime than the generation
would have earned absent a baby boom.37 In effect, for two investors-one
of whom earns 7 percent and the other earns 6.5 percent annually over a
30-year period-the former investor would earn $6.61 for every dollar saved
at the beginning of the period and latter investor would earn $5.61 for
every dollar saved.38

35 In the studies that we reviewed some researchers measured changes in
the stock market based on annual price changes, while others used annual
rates of return. The two measures are highly correlated, with rates of
return taking into account dividends paid to shareholders as well as price
changes. For bonds, some researchers measured changes in the market by
annual prices changes, while others used yields or returns. Bond prices
and yields are inversely related, with an increase in the price of a bond
reducing its yield. When discussing the results of the individual studies,
we used the market-performance measure used by the researchers.

36 See appendix II for a list of the studies we reviewed.

37 James M. Poterba, "Impact of Population Aging on Financial Markets in
Developed Countries," Economic Review (Kansas City: Federal Reserve Bank
of Kansas City, 2004).

None of the simulation-based studies concluded that the U.S. baby boom
retirement will precipitate a sudden and sharp decline in asset prices,
and some studies presented their results in quantitative terms. One of the
studies, for example, predicted that the baby boom's retirement would at
worst lower stock prices below what they would otherwise be by roughly 16
percent over a 20-year period starting around 2012.39 This decline,
however, is equivalent to around 0.87 percent each year-somewhat small in
comparison to real annual U.S. stock returns, which have averaged about
8.7 percent annually since 1948. The study therefore concluded that the
size of the decline is much too small to justify the term "meltdown."
Moreover, another study predicted that baby boomers can expect the returns
on their retirement savings to be about 1 percentage point below their
current annual returns.40 The study's lower returns reflect the decline in
the productivity of capital that results from fewer workers being
available (due to the baby boom retirement) to put the capital to
productive use. A third study's results suggest that fluctuations in the
size of the different generations induce substantial changes in equity
prices, but the study does not conclude that the baby boom's retirement
will lead to a sharp and sudden decline in asset prices.41

The simulation models we reviewed, by design, excluded or simplified some
factors that were difficult to quantify or involved uncertainty that may
cause the models to overstate the baby boom's impact on the markets. For
example, some models assumed that baby boomers will sell their assets
solely to a relatively smaller generation of U.S. investors when they
retire. Some researchers have noted that if China and India were to
continue their rapid economic growth, they may spur demand for the assets
that baby boomers will sell in retirement.42 Supporting this view, other
research suggests that global factors may be more important than domestic
factors in explaining stock returns in developed countries.43 Some models
assumed that individuals in the same generation enter the labor force at
the same time, work a fixed amount, and retire at the same time. In
reality, some may work full or part-time after reaching retirement age.44
Likewise, the baby boomers' children, rather than working a fixed amount,
may delay their entry into the labor force and take advantage of job
opportunities created by retiring baby boomers. These factors could dampen
the effect of the baby boomer retirement on the markets.45 A few of the
models neglect that some investors may be forward-looking and anticipate
the potential effect of the aging baby boomers on the markets. To the
extent that such investors do so, current financial asset prices would
reflect, at least partially, the future effect of the baby boom's
retirement and thus dampen the event's effect on asset prices when it
actually occurs.46 Finally, the models typically do not include a
significant increase in immigration, but such an outcome would increase
the labor force and be expected to raise the productivity of capital and,
thus, the return on financial assets.47

38 The proportional effect of a 0.5 percent decline in annual return would
be smaller if the baseline level of the return was higher, but the
absolute effect in terms of dollars would be larger.

39 K. M. Lim and D. N. Weil, "The Baby Boom and the Stock Market Boom,"
Scandinavian Journal of Economics, vol. 105, no. 3 (2003).

40 The study concludes that baby boomers will be better off than their
parents and children in terms of their lifetime consumption, because asset
returns rise during their working years and because they have relatively
fewer children, boosting their ability to save early on. Robin Brooks,
"Asset-Market Effects of the Baby Boom and Social-Security Reform,"
American Economic Review, vol. 92, no. 2 (2002).

41 The study's simulation model predicted that demographic changes
accounted for around half of the variation between the highest and lowest
stock prices. John Geanakoplos, Michael Magill, and Martine Quinzii,
"Demography and the Long-Run Predictability of the Stock Market," Cowles
Foundation Paper No. 1099 (New Haven, Conn.: Cowles Foundation for
Research in Economics, Yale University, 2004).

42 A study exploring the implications of the assumption found that
financial asset returns in Germany would fall by about 1.4 percentage
points if baby boomers were only allowed to buy and sell assets
domestically, but would fall by about 1 percentage point if the country's
economy were open to international financial flows. See Axel
Bo:rsch-Supan, "Global Aging: Issues, Answers, More Questions," Working
Paper WP 2004-084, University of Michigan Retirement Research Center
(2004).

43 Swee Sum Lam and William Wee-Lian Ang "Globalization and Stock Market
Returns," Global Economy Journal, vol. 6, no. 1 (2006).

44 For example, a recent study estimated based on a survey that about 7
million previously retired U.S. individuals have returned to work for pay,
representing almost one-third of the retirees. See Brightwork Partners,
LLC, The Working Retired, a study prepared for Putnam Investments (Boston:
2005).

45 See, for example, Monika Bu:tler and Philipp Harms, "Old Folks and
Spoiled Brats: Why the Baby-Boomers' Savings Crisis Need Not Be That Bad,"
Discussion Paper No. 2001-42, CentER (2001). The researchers found that
the effect of a baby boom on asset prices could be dampened, in part by
the early retirement of baby-boom parents and the late entry of the
baby-boom children into the labor force.

46 Although the extent to which investors are forward-looking is an
important factor in determining the current and future impact of
demographic change on financial asset prices, the degree of foresight is
open to question. See, for example, Stefano DellaVigna and Joshua M.
Pollet, Attention, Demographics, and the Stock Market (Department of
Economics, University of California, Berkeley: 2003 mimeographed).

  Empirical Studies

Seven empirical studies of the U.S. financial markets we reviewed
suggested, on average, that the retirement of U.S. baby boomers will have
a minimal, if any, impact on financial asset returns.48 These studies
specifically tested whether changes in the U.S. population's age structure
have affected stock returns or bond yields or both over different periods,
ranging from 1910 to 2003. These studies focused primarily on changes in
the size of the U.S. middle age population (roughly age 40 to 64) or its
proportion to other age segments of the population. People in this age
group are presumably in their peak earning and saving years and, thus,
expected to have the most significant impact on financial asset returns.

These empirical studies are inherently retrospective. Therefore, care must
be taken in drawing conclusions about a future relationship between
demographics and asset performance, especially given that the historical
data do not feature an increase in the retired population of the magnitude
that will occur when the U.S. baby boomers retire. However, the
significant shift in the structure of the population that occurred as the
boomers entered the labor force and later their peak earning years should
provide an indication of how demographic change influences financial asset
returns.

For stocks, four of the seven studies found statistical evidence implying
that the past increases in the relative size of the U.S. middle age
population have increased stock returns.49 This finding supports the
simulation-model predictions that a relative decrease in the middle age
population-as is expected to occur when baby boomers begin to retire-will
lower stock returns. In contrast, two of the studies found little evidence
that past changes in the U.S. middle age population have had any
measurable effect on stock returns.50 Finally, the remaining study found
evidence implying that a relative decrease in the U.S. middle age
population in the future would increase, rather than decrease, stock
returns.51

47 The overall impact of immigration becomes more ambiguous when
considering the federal government's budget. Immigration will boost tax
revenues but also can increase outlays for transfer programs related to
health, education, and welfare if the immigrating cohort is less-skilled.
See, for example, Ronald Lee and Timothy Miller, "Immigration, Social
Security, and Broader Fiscal Impacts," The American Economic Review, vol.
90, no. 2 (2000).

48 See appendix II for a list of the studies that we reviewed.

49 See, Steven M. Bergantino, "Life Cycle Investment Behavior,
Demographics, and Asset Prices," (Ph.D diss., Massachusetts Institute of
Technology, 1998); Robin J. Brooks, "Asset Market and Savings Effects of
Demographic Transitions" (Ph.D diss., Yale University, 1998); E. Phillip
Davis and Christine Li, "Demographics and Financial Asset Prices in the
Major Industrial Economies," Working Paper (Brunel University, West
London: 2003); and Geanakoplos, Magill, and Quinzii (2004).

For the four studies whose statistical results implied that the baby boom
retirement will cause stock returns to decline, we determined that the
magnitude of their demographic effect, on balance, was relatively small.
Using U.S. Census Bureau data, we extrapolated from three of the four
studies' results to estimate the average annual change in returns of the
Standard and Poor's (S&P) 500 Index that the studies would have attributed
to demographic changes from 1986 to 2004. During this period, baby boomers
first began to turn age 40 and the proportion of individuals age 40 to 64
went from about 24.5 percent of the population to about 32 percent.52 We
found two of the studies' results show that the increase in the middle age
population from 1986 to 2004 led stock returns, on average, to increase by
0.19 and 0.10 percentage points each year, respectively. We found that the
third study's results showed a much larger average annual increase of
about 6.7 percentage points from 1986 to 2004. To put these three
estimates into context, the average annual real return of the S&P 500
Index during this period was around 10 percent. The last estimate,
however, may exaggerate the probable impact of the baby boom retirement on
stock returns.53 The fourth study's methodology did not allow us to use
U.S. census data to estimate the effect of its results on stock returns
from 1986 to 2004. Nonetheless, the study estimated that demographically
driven changes in the demand for stocks can account for about 77 percent
of the annual increase in real stock prices between 1986 and 1997 and
predicted that stock prices will begin to fall around 2015 as a result of
falling demographic demand.

50 Peter S. Yoo, "Age Distributions and Returns of Financial Assets,"
Working Paper 1994-002A (St. Louis: Federal Reserve Bank of St. Louis,
1994), and James M. Poterba, "The Impact of Population Aging on Financial
Markets," Working Paper No. 10851 (Cambridge, Mass.: National Bureau of
Economic Research, 2004).

51 Diane Macunovich, "Discussion of Social Security: How Social and Secure
Should It Be?", Social Security Reform: Links to Saving, Investment, and
Growth, Steven Sass and Robert Triest, eds. (Boston: Federal Reserve Bank
of Boston, 1997). While the study found evidence that a decrease in the
45-year olds increased stock returns, it also found evidence that an
increase in the 66-year old population reduced stock returns, leaving the
aggregate effect of the baby boom retirement on stock returns unclear.

52 We arrived at our estimates in several stages. First, we used U.S.
Census Bureau data to calculate the demographic variables in each study
from 1948 to 2004. Second, we multiplied the demographic regression
coefficients in each study by their appropriate demographic variables for
the period from 1948 to 2004. Third, to estimate the relative impact of
the baby boomers on stock returns from 1986 to 2004, we subtracted the
average annual impact on stock returns from 1948 to 1985 (a period of
relative stability in the middle age population) from the average annual
impact on stock returns from 1986 to 2004 (a period of rapid growth in the
middle age population).

Besides testing for the effect of demographic shifts on stock returns,
five of the seven studies included bonds in their analyses and largely
found that the baby boom retirement will have a small effect or no effect
on bond yields. Three studies found statistical evidence indicating that
the past increase in the relative size of the U.S. middle age population
reduced long-term bond yields. In turn, the finding suggests that the
projected decrease in the middle age population in the future would raise
yields. Extrapolating the results of one study, we find its estimates
imply that the increase in the U.S. middle age population from 1986 to
2004 reduced long-term bond yields by about 0.42 percentage points each
year, compared to actual real yields that averaged 3.41 percent over the
same time period. The other two studies tested how the demographic shift
affected long-term bond prices rather than yields, but an increase in
prices would, in effect, reduce yields.54 We found that the results of one
of the studies showed that the demographic shift from 1986 to 2004 raised
bond prices by only about 0.05 percentage points each year. The other
study's methodology did not allow us to estimate the effect, but the study
estimated that demographically driven changes in the demand for bonds can
account for at least 81 percent of the annual increase in real bond prices
between 1986 and 1997 and predicted that bond prices will begin to fall
around 2015 as a result of falling demographic demand. In contrast to
these studies, two studies found little statistical evidence to indicate
that past changes in the middle age population have had any measurable
effect on long-term bond returns.55

53 In their simulation-based model, the researchers used as their
demographic variable the ratio of the U.S. population age 40 to 59 to the
U.S. population age 20 to 39. In their empirical analyses, they modified
their demographic variable, in our view, without an economic rationale to
capture more of the variation in stock returns, switching to the ratio of
the population age 40 to 49 to the population age 20 to 29. By choosing
the demographic variable purely on the basis of statistical association,
the change likely biased their estimated effect upward. Also, the study's
demographic variable is projected to fluctuate much less in the future,
suggesting that upcoming demographic changes will have less of an impact
on stock returns. A researcher estimated that the projected changes in the
study's demographic variable from 2000 to 2050 would result in a 0.60
percentage point decline in annual real returns.

54 The interest payment a borrower makes on a bond is typically fixed, so
an increase in the bond's price reduces the fixed payment as a proportion
of the bond's price and, thus, reduces the bond's yield.

Financial Industry Representatives Do Not Expect Baby Boom Retirement to Have a
Significant Financial Market Impact

The financial industry representatives with whom we met generally told us
that they do not expect U.S. baby boomers to have a significant impact on
the financial markets when they retire. They cited a number of factors
that could mitigate a baby boom induced market decline, many of which we
discussed earlier.56 For example, some mentioned the concentration of
assets among a minority of households, the long time span over which
boomers will be retiring, and the possibility for many boomers to continue
working past traditional retirement ages. Some also noted that baby
boomers will continue to need to hold stocks well into retirement to hedge
inflation and to earn a higher rate of return to hedge the risk of
outliving their savings, reducing the likelihood of a sharp sell-off of
stock. A number of representatives cited developments that could increase
the demand for U.S. assets in the future, such as the continued economic
growth of developing countries and an increase in immigration. Finally,
several commented that interest rates, business cycles, and other factors
that have played the primary role in influencing financial asset returns
are likely to overwhelm any future demographic effect from changes in the
labor force or life cycle savings behavior.

55 These studies, however, found statistical evidence suggesting that the
past increase in the middle age population has decreased returns on
"Treasury bills," or short-term bonds. This finding suggests that the
projected decrease in the middle age population will increase Treasury
bill returns.

56 While it may not be in the interest of the financial industry to make
alarming projections about the baby boom retirement, mutual fund companies
and broker-dealers we interviewed offer stock funds, bond funds,
annuities, and international stock funds. As a result, they have a broad
range of products to offer workers and retirees in the event that they
become concerned about the risks of a particular asset class or country.

Broad Economic Factors Will Likely Have a Greater Impact on Financial Markets
Than Will Demographics

Our statistical analysis indicates that macroeconomic and financial
factors explain more of the variation in historical stock returns than
population shifts and suggests that such factors could outweigh any future
demographic effect on stock returns. In addition, factors not captured by
our model were also larger sources of stock return variation than the
demographic variables we selected. We undertook our own statistical
analysis, because many of the empirical studies we reviewed either did not
include relevant variables that influence stock returns in their models or
included them but did not discuss the importance of these variables
relative to the demographic variables.57 To broaden the analysis, we
developed a statistical model of stock returns based on the S&P 500 Index
to compare the effects of changes in demographic, macroeconomic, and
financial variables on returns from 1948 to 2004.58 As shown in figure 8,
fluctuations in the macroeconomic and financial variables that we selected
collectively explain about 47 percent of the variation in stock returns
over the period. These variables are the growth rate of industrial
production,59 the dividend yield, the difference between interest rates on
long- and short-term bonds, and the difference between interest rates on
risky and safe corporate bonds-all found in previous studies to be
significant determinants of stock returns. These variables are likely to
contain information about current or future corporate profits. In
contrast, our four demographic variables explained only between 1 percent
and 8 percent of the variation in the annual stock returns over the
period. These variables were based on population measures found to be
statistically significant in the empirical studies we reviewed: the
proportion of the U.S. population age 40 to 64, the ratio of the
population age 40 to 49 to the population age 20 to 29, and annual changes
in the two. Note, however, that almost half of the variation in stock
returns was explained by neither the macroeconomic and financial variables
nor the demographic factors we tested, a finding that is comparable to
similar studies. Hence, some determinants of stock returns remain unknown
or difficult to quantify.

57 These studies include, for example, Geanakoplos, Magill, and Quinzii
(2004), Poterba (2004), and Davis and Li (2003).

58 See appendix IV for a complete description of our statistical model and
results.

59 Industrial production is the output of U.S. manufactured goods, mines,
and utilities. Its growth rate is highly correlated with gross domestic
product, a broader measure of the economy's output. While labor force
growth should influence growth of the overall economy, including
industrial production, we believe that the significance of industrial
production in our model is driven primarily by changes in industrial
production related to business cycle fluctuations.

Figure 8: Sources of Stock Market Return Variation

The statistical model shows that financial markets are subject to a
considerable amount of uncertainty and are affected by a multitude of
known and unknown factors. However, of those known factors, the majority
of the explanatory power stems from developments other than domestic
demographic change. Simply put, demographic variables do not vary enough
from year to year to explain the stock market ups and downs seen in the
data. This makes it unlikely that demographic changes, alone, could induce
a sudden and sharp change in stock prices, but leaves open the possibility
for such changes to lead to a sustained reduction in returns. At the same
time, fluctuations in dividends and industrial production, which are much
more variable than demographic changes, may obscure any demographic effect
in future stock market performance. For example, a large recession or a
significant reduction in dividends would have a negative effect on annual
returns that would likely overwhelm any reduction in returns resulting
from the baby boom retirement. Conversely, an unanticipated increase in
productivity or economic growth would be expected to increase returns
substantially and likely dwarf the effect of year-over-year changes in the
relative size of the retired population.

  Baby Boomers and Future Generations Likely to Increasingly Rely on Their Own
Savings, Placing Greater Importance on Rates of Return and Financial Management
                                     Skills

While the baby boom retirement is not likely to cause a sharp decline in
asset prices or returns, the retirement security of boomers and future
generations will likely depend increasingly on individual saving and rates
of return as guaranteed sources of income become less available. This
reflects the decline of coverage by traditional DB pension plans, which
typically pay a regular income throughout retirement, and the rise of
account-based DC plans. Uncertainties about the future level of Social
Security benefits, including the possible replacement of some defined
benefits by private accounts, and the projected increases in medical and
long-term care costs add to the trend toward individuals taking on more
responsibility and risk for their retirement. All of these developments
magnify the importance of achieving rates of return on savings high enough
to produce sufficient income for a secure retirement. In this environment,
individuals will need to become more educated about financial issues, both
in accumulating sufficient assets as well as learning to draw them down
effectively during a potentially long retirement.

As Baby Boomers Retire, Fewer May Receive Income from Traditional Pensions

Changes in pension design will require many baby boomers and others to
take greater responsibility in providing for their retirement income,
increasing the importance of rates of return for them. The past few
decades have witnessed a dramatic shift from DB plans to DC plans. From
1985 to 2004, the number of private sector DB plans has shrunk from about
114,000 to 31,000. From 1985 to 2002 (the latest year for which complete
data are available), the number of DC plans almost doubled, increasing
from 346,000 to 686,000. Furthermore, the percentage of full-time
employees participating in a DB plan (at medium and large firms) declined
from 80 to 33 percent from 1985 to 2003, while DC coverage increased from
41 to 51 percent over the period.60 The shift in pension design has
affected many boomers. According to the 2004 SCF, about 50 percent of
people older than the baby boomers reported receiving benefits from a DB
plan, but fewer than 44 percent of baby boomers have such coverage.
However, within the baby boom generation, there is a noticeable
difference: 46 percent of older boomers (born between 1946 and 1955)
reported having a DB plan, while only 39 percent of young boomers (born
between 1956 and 1964) had a DB plan (see table 1).61 According to the
SCF, the percentage of households age 35 to 44 with a DC plan increased
from 18 percent in 1992 to 42 percent in 2001.

60 Participation in DB plans is typically much higher in the public
sector. For 1998, the latest year for which data are available, 90 percent
of state and local government workers participated in a DB plan.

Table 1: Pension Coverage by Plan Design, 2004, as Percentage of Birth
Cohort

Birth years DB plan only DC plan only Both DB and DC 
1956-1964           16.8         21.6           22.1 
1946-1955           23.5         18.6           22.2 
1936-1945           34.1         10.7           16.5 

Source: GAO Analysis of 2004 SCF.

The shift from DB to DC plans places greater financial management
responsibility on a growing number of baby boomers and makes their
retirement savings more dependent on financial market performance. Unlike
DB plans, DC plans do not promise a specified benefit for life. Rather, DC
plan benefits depend on the amount of contributions, if any, made to the
DC plan by the employee and the employer, and the returns earned on assets
held in the plan. Because there is no guaranteed benefit, the
responsibility to manage these assets and the risk of having insufficient
pension benefits at retirement falls on the individual. Similar to DB
plans, some DC plans offer their participants the option of converting
their balance into an annuity upon retirement, but DC plan participants
typically take or keep their benefits in lump-sum format.62

Small changes in average rates of return can affect the amount accumulated
by retirement and income generated during retirement. For example, if a
boomer saved $500 each year from 1964 until retirement in 2008 and earned
8 percent each year, he or she would accumulate almost $209,000 at
retirement. The same worker earning 7 percent each year over the same
period would accumulate only $153,000 at retirement, a difference in total
saving of 27 percent. Moreover, rates of return can have a similar affect
on retirement income. With $209,000 at retirement, the retiree could spend
$19,683 each year for 20 years if he or she continued to earn 8 percent
each year in retirement. If the annual rate of return dropped one
percentage point to 7 percent, the same amount of retirement savings would
generate only about $18,412 each year for 20 years, a difference of 6.5
percent in annual retirement income. Retirees depending on converting
savings to income are particularly dependent on rates of return, since
they may have limited employment options. Similarly, workers nearing
retirement may be more affected by fluctuations in rates of return than
younger workers, who would have more working years to make up any declines
or losses.

61 While this trend may partially reflect that older workers are more
likely to have pension coverage than younger workers, the shrinking of DB
plans and the aging of its participant pool are well-established and
likely to continue.

62 One study by the Investment Company Institute found that 32 percent of
DC participants chose an annuity upon taking benefits. See Investment
Company Institute, Defined Contribution Plan Distribution Choices at
Retirement: A Survey of Employees Retiring Between 1995 and 2000
(Washington, D.C.: Fall 2000). A 2003 GAO study found a much lower
incidence, with fewer than 10 percent of DC participants choosing to
annuitize upon retirement (see GAO-03-810 ). As of 2000, about 38 percent
of DC plans offered the option of receiving benefits as an annuity.

Although DC plans place greater responsibility on individuals for their
retirement security, statistics indicate that so far at least some have
yet to fully accept it. First, many workers who are covered by a DC plan
do not participate in the plan. Recent data indicate that only about 78
percent of workers covered by a DC plan actually participate in the plan.
Second, even among baby boom participants, many have not saved much in
these accounts. Figure 9 shows the percentage of boomers with account
balances in their DC pensions and IRAs, which are personal accounts where
individuals can accumulate retirement savings. Over one-half of households
headed by someone born from 1946 to 1955 did not have a DC pension; for
those that did have a DC pension, their median balance was $58,490, an
amount that would generate just a $438 monthly annuity starting at age 65.
Similarly, only 38 percent reported having an IRA, and the median IRA
balance among those participating was only $37,000, an amount that would
generate a monthly annuity of only $277.63

63 We calculated annuity equivalents using the annuity calculator from the
Thrift Savings Plan (www.tsp.gov), assuming an interest rate of 5.5
percent, single life benefits beginning at age 65, no joint survivor
benefits, and level payments.

Figure 9: Individual Retirement Account and Defined Contribution Pension
Balances for Older and Younger Baby Boomers, 2003

These statistics may not provide a complete picture for some individuals
and households, since those with a small DC plan account balance also may
have a DB plan and thus may not have the same need to contribute to their
account. However, EBRI found that, as of 2004, median savings in 401(k)
accounts, a type of DC plan, were higher for every age group up to age 64
for those with a DB plan than those with only a 401(k). Also, the median
balances for those with only 401(k) plans may not be enough to support
them in retirement. For families with the head of family age 55 to 64 in
2004 with only a 401(k), EBRI estimated that their median balance was
$50,000; for those age 45 to 54, the median was $40,000. While many in
these age groups could continue to work for several years before reaching
retirement age, without substantially higher savings, these households may
be primarily dependent on income from Social Security during retirement.

Extending our analysis of the allocation of baby boomer assets generally
reveals that financial assets are, in general, a small portion of boomers'
asset portfolios. Among all boomers, housing is the largest asset for the
majority of households, with vehicles making up the second largest portion
of wealth. Figure 10 shows the allocation of baby boomer assets among
housing, cash, savings, pensions, vehicles, and other assets.64 Not
including the top quartile by wealth, savings and pensions, the portions
of wealth that are invested in stocks and bonds are a small portion of
overall wealth, constituting no more than 20 percent of total gross assets
per household. Among the bottom two quartiles by wealth, on average
boomers have more of their wealth invested in their personal vehicle
(automobile or truck), which depreciates over time, than in either savings
or pensions, assets that generally appreciate over time. Overall, the
finding that most boomers do not hold a significant amount of financial
assets, measured both by account balance and by percentage of total
assets, mitigates this generation's potential effect on the asset markets
as boomers retire and highlights the fact that many boomers may enter
retirement without adequate personal savings.

64 Cash consists of assets in checking, savings, and money market
accounts, certificates of deposit, and U.S. Savings Bonds. Savings
consists of assets held outside of an employer-sponsored retirement plan
and invested in IRAs, Keogh plans, mutual funds, annuities, trusts,
managed accounts, and publicly traded stocks and bonds. Pensions consist
of assets held in an employer sponsored account type pension plan, such as
a 401(k) or 403(b) plan; defined benefit pensions are not included. Other
assets not falling within the categories defined above include business
and investment real estate interests, collectibles of value, and jewelry.

Figure 10: Allocation of Assets of Baby Boomers, by Wealth Quartiles

Note: Q1 refers to the bottom 25 percent of the population by wealth,
while Q4 refers to the top 25 percent of the population by wealth.

Financial Stress on Social Security, Medicare, and Health Expenditures May
Create Uncertainties for Some Baby Boomers and Future Generations

The uncertainties surrounding the future financial status of Social
Security, the program which provides the foundation of retirement income
for most retirees, also presents risks to baby boomers' retirement
security.65 These benefits are particularly valuable because they provide
a regular monthly income, adjusted each year for inflation, to the
recipient and his survivors until death. Thus, Social Security benefits
provide some insurance against outliving one's savings and against
inflation eroding the purchasing power of a retiree's income and savings.
Such benefits provide a unique retirement income source for many American
households.

Social Security, however, faces long-term structural financing challenges
that, if unaddressed, could lead to the exhaustion of its trust funds.
According to the intermediate assumption projections of Social Security's
2006 Board of Trustees' Report, annual Social Security payouts will begin
to exceed payroll taxes by 2017, and the Social Security trust fund is
projected to be exhausted in 2040. Under these projections, without
counterbalancing changes to benefits or taxes, tax income would be enough
to pay only 74 percent of currently scheduled benefits as of 2040, with
additional, smaller benefit reductions in subsequent years.

These uncertainties are paralleled, if not more pronounced, with Medicare,
the primary social insurance program that provides health insurance to
Americans over age 65. Medicare also faces very large long-term financial
deficits. According to the 2006 Trustees report, the Hospital Insurance
Trust Fund is projected to exhaust itself by 2018. The challenges stem
from concurrent demographic trends-people are living longer, spending more
years in retirement, and have had fewer children-and from costs for health
care rising faster than growth in the gross domestic product. These
changes increase benefits paid to retirees and reduce the number of
people, relative to previous generations, available to pay to support
these benefits.

These financial imbalances have important implications for future
retirees' retirement security. While future changes to either program are
uncertain, addressing the financial challenges facing Social Security and
Medicare may require retirees to receive reduced benefits, relative to
scheduled future benefits, while workers might face higher taxes to
finance current benefits. In addition, some proposals to reform Social
Security incorporate a system of individual accounts into the current
program that would reduce scheduled benefits under the current system,
perhaps with protections for retirees, older workers, and low-wage
workers, and make up for those reductions to some degree with income from
the individual accounts.66 Like DC plans generally, these accounts would
give the individual not only the prospect for higher rates of return but
also the risk of loss, placing additional responsibility and risk on
individuals to provide for their own retirement security. Similarly,
tax-preferred health savings accounts are a type of personal account to
allow enrollees to pay for certain health-related expenditures.

65 According to the 2004 SCF, about half of retirees receive at least half
of their income from Social Security. For those in the lowest 60 percent
of the income distribution, these benefits make up over three-quarters of
their total income. For all retirees, Social Security accounts for about
40 percent of their total retirement income. See GAO-05-193SP .

The worsening budget deficits that are expected to result if fiscal
imbalances in Social Security and Medicare are not addressed could have
important effects on the macroeconomy. By increasing the demand for
credit, federal deficits tend to raise interest rates, which are mitigated
to the extent that foreign savings flow into the United States to
supplement scarce domestic savings. If foreigners do not fully finance
growing budget deficits, upward pressure on interest rates can reduce
domestic investment in productive capacity. All else equal, these higher
borrowing costs could discourage new investment and reduce the value of
capital already owned by firms, which should be reflected in reduced stock
prices as well.

The fiscal challenges facing Medicare underscore the issue of rising
retiree health costs generally. Rising health care costs have made health
insurance and anticipated medical expenses increasingly important issues
for older Americans. Although the long-term decline in the percentage of
employers offering retiree health coverage has appeared to have leveled
off in recent years, retirees continue to face an increasing share of
costs, eligibility restrictions, and benefit changes that contribute to an
overall erosion in the value and availability of coverage. A recent study
estimated that the percentage of after-tax income spent on health care
will almost double for older individuals by 2030 and that after taxes and
health care spending incomes may be no higher in 2030 than in 2000 for a
typical older married couple. People with lower incomes will be the most
adversely affected. The study projected that by 2030, those in the bottom
20 percent of the income distribution would spend more than 50 percent of
their after-tax income on insurance premiums and out-of-pocket health care
expenses, an increase of 30 percentage points from 2000.67 The costs of
healthcare in retirement, especially long-term and end-of-life care, are a
large source of uncertainty for baby boomers in planning their retirement
financing, as typical private and public insurance generally does not
cover these services. Nursing home and long-term care are generally not
covered under Medicare but by Medicaid, which is the program that provides
health insurance for low-income Americans. Medicaid eligibility varies
from state to state, but generally requires that a patient expend most of
their financial assets before they can be deemed eligible for benefits.
Most private long-term care insurance policies pay for nursing home and
at-home care services, but these benefits may be limited, and few elderly
actually purchase this type of coverage, with a little over 9 million
policies purchased in the United States by 2002. Thus, health care costs
may cause some baby boomers without long-term care insurance to rapidly
spend retirement savings.

66 Individual accounts would also try to increase revenues, in effect, by
providing the potential for higher rates of return on account investments
than the trust funds would earn under the current system, but this exposes
workers to a greater degree of risk. Some proposals would create
individual accounts without reducing promised benefits or increasing
payroll taxes, relying instead on compensating decreased government
spending, increased revenues, or increased borrowing from the public. Note
that individual accounts would generally not by themselves achieve
solvency for the Social Security system. Achieving solvency requires more
revenue, lower benefits, or both. See GAO, Social Security Reform:
Considerations for Individual Account Design, GAO-05-847T (Washington,
D.C.: June 23, 2005).

Baby Boomers and Future Generations May Increasingly Rely on Their Own
Investment Decisions, Highlighting Importance of Financial Literacy

With more individuals being asked to take responsibility for saving for
their own retirement in a DC pension plan or IRA, financial literacy and
skills are becoming increasingly important in helping to ensure that
retirees can enjoy a comfortable standard of living. However, studies have
found that many individuals have low financial literacy.68 A recent study
of HRS respondents over age 50 found that only half could answer two
simple questions regarding compound interest and inflation correctly, and
one-third could answer these two questions and another on risk
diversification correctly. Other research by AARP of consumers age 45 and
older found that they often lacked knowledge of basic financial and
investment terms. Similarly, a survey of high school students found that
they answered questions on basic personal finance correctly only about
half of the time.

67 See Richard W. Johnson and Rudolph G. Penner, "Will Health Care Costs
Erode Retirement Security?" Issue in Brief (Boston: Center for Retirement
Research at Boston College, 2004, No. 23.)

68 GAO, Highlights of a GAO Forum: The Federal Government's Role in
Improving Financial Literacy, GAO-05-93SP (Washington, D.C.: Nov. 15,
2004). At this forum, experts suggested that the federal government should
not make financial literacy a national priority but should play a
supportive role, given that a wide array of state, local, nonprofit, and
private organizations provide financial education.

Baby boomers approaching retirement and fortunate enough to have savings
may still face risks from failing to diversify their stock holdings. In
one recent survey, participants perceived a lower level of risk for their
company stock than for domestic, diversified stock funds.69 However,
investors are more likely to lose their principal when investing in a
single stock as opposed to a diversified portfolio of stocks, because
below average performance by one firm may be offset by above average
performance by the others in the portfolio. In addition, holding stock
issued by one's employer in a pension account is even more risky because
if the company has poor financial performance, it could result in both the
stock losing value and the person losing his job. One consequence of this
poor financial literacy may be investors holding a substantial part of
their retirement portfolio in employer stock. EBRI reported that the
average 401(k) investor age 40 to 49 had 15.4 percent of her portfolio in
company stock in 2004; the average investor in his 60's still had 12.6
percent of her assets in company stock.70 Perhaps of greater concern, the
Vanguard Group found that, among plans actively offering company stock, 15
percent of participants had more than 80 percent of their account balance
in company stock in 2004.71

                            Concluding Observations

Our findings largely suggest that baby boomers' retirement is unlikely to
have a dramatic impact on financial asset prices. However, there appear to
be other significant retirement risks facing the baby boom and future
generations. The long-term financial weaknesses of Social Security and
Medicare, coupled with the uncertain future policy changes to these
programs' benefits, and the continued decline of the traditional DB
pension system indicate a shift toward individual responsibility for
retirement. These trends mean that rates of return will play an
increasingly important role in individuals' retirement security. For those
with sufficient income streams, this new responsibility for retirement
will entail a lifetime of financial management decisions-from saving
enough to managing such savings to generate an adequate stream of income
during retirement, the success of which will directly or indirectly be
dependent on rates of return. Given the potential impact of even a modest
decline in returns over the long run on savings and income, market
volatility, and uncertainties about pensions, Social Security, and
Medicare, the onset of the baby boom retirement poses many questions for
future retirement security.

69 See John Hancock Financial Services, Defined Contribution Plan Survey:
Insight into Participant Investment Knowledge and Behavior, 2002.

70 Sarah Holden and Jack VanDerhei, "401(k) Plan Asset Allocation, Account
Balances, and Loan Activity in 2004," EBRI Issue Brief #285 (September
2005.)

71 This figure includes only those plans in which Vanguard serves as the
manager. Vanguard Corporation, How America Saves 2005: A Report on
Vanguard 2004 Defined Contribution Plan Data (Valley Forge, Penn.: October
2005).

The performance of financial and other asset markets provides just one
source of risk that will affect the retirement income security of baby
boomers and ensuing generations. For those with financial assets, choices
they make about investments play a critical role not just in having
adequate savings at retirement but also in making sure their wealth lasts
throughout retirement. That Americans are being asked to assume more
responsibility for their retirement security highlights the importance of
financial literacy, including basic financial concepts, investment
knowledge, retirement age determination, and asset management in
retirement. Government policy can help, policies that encourage
individuals to save more and work longer (for those who are able) and that
promote greater education about investing and retirement planning that can
help ensure higher and more stable retirement incomes in the future.

Although individual choices about saving and working will continue to play
a primary role in determining retirement security, the high percentage of
boomers who have virtually no savings, assets, or pensions will face
greater difficulties in responding to the new retirement challenges. For
this group, the federal government will play an especially key role in
retirement security through its retirement and fiscal policies. The
challenges facing Social Security and Medicare are large and will only
grow as our population ages. Legislative reforms to place Social Security
and Medicare on a path towards sustainable long-term solvency would not
only reduce uncertainty about retiree benefits, particularly for those
Americans who own few or no assets, but also help address the federal
government's long-term budget imbalances that could affect the economy and
asset markets. Ultimately, retirement security depends on how much society
and workers are willing to set aside for savings and retirement benefits
and on the distribution of retirement risks and responsibilities among
government, employers, and individuals. One of Congress's greatest
challenges will be to balance this distribution in a manner that achieves
a national consensus and helps Americans keep the promise of adequate
retirement security alive in the 21st century.

                                Agency Comments

We provided a draft of this report to the Department of Labor, the
Department of the Treasury, the Department of Housing and Urban
Development, and the Social Security Administration, as well as several
outside reviewers, including one from the Board of Governors of the
Federal Reserve System. Labor, Treasury, and SSA and the outside reviewers
provided technical comments, which we incorporated as appropriate. We are
sending copies of this report to the Secretary of Labor, the Secretary of
the Treasury, the Secretary of the Housing and Urban Development
Department, and the Commissioner of the Social Security Administration,
appropriate congressional committees, and other interested parties. We
will also make copies available to others on request. In addition, the
report will be available at no charge on GAO's Web site at
http://www.gao.gov.

If you have any questions concerning this report, please contact Barbara
Bovbjerg at (202) 512-7215 or George Scott at (202) 512-5932. Contact
points for our Office of Congressional Relations and Public Affairs may be
found on the last page of this report. GAO staff who made contributions
are listed in appendix VI.

Barbara D. Bovbjerg, Director Education, Workforce, and Income Security
Issues

George A. Scott, Acting Director Financial Markets and Community
Investment Issues

List of Congressional Committees

The Honorable Richard C. Shelby

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking, Housing, and Urban Affairs

United States Senate

The Honorable Charles E. Grassley

Chairman

The Honorable Max Baucus

Ranking Minority Member

Committee on Finance

United States Senate

The Honorable Susan M. Collins

Chairman

The Honorable Joseph I. Lieberman

Ranking Minority Member

Committee on Homeland Security and Governmental Affairs

United States Senate

The Honorable Gordon H. Smith

Chairman

The Honorable Herb Kohl

Ranking Minority Member

Special Committee on Aging

United States Senate

The Honorable George Miller Ranking Minority Member Committee on Education
and the Workforce House of Representatives

The Honorable Michael G. Oxley

Chairman

The Honorable Barney Frank

Ranking Minority Member

Committee on Financial Services

House of Representatives

The Honorable Tom Davis

Chairman

The Honorable Henry A. Waxman

Ranking Minority Member

Committee on Government Reform

House of Representatives

The Honorable William M. Thomas

Chairman

The Honorable Charles B. Rangel

Ranking Minority Member

Committee on Ways and Means

House of Representatives

The Honorable Jim McCrery

Chairman

The Honorable Sander M. Levin

Ranking Member

Subcommittee on Social Security

House Committee on Ways and Means

Appendix I: Scope and Methodology Appendix I: Scope and Methodology

To analyze whether the retirement of the baby boom generation is likely to
precipitate a dramatic drop in financial asset prices, we relied primarily
on information from two large survey data sets. We calculated the
distribution of assets and wealth among baby boomers and existing retirees
and bequest and work expectations of baby boomers from data from various
waves of the Federal Reserve's Survey of Consumer Finances (SCF). This
triennial survey asks extensive questions about household income and
wealth components; we used the latest available survey from 2004 and
previous surveys back to 1992. The SCF is widely used by the research
community, is continually vetted by the Federal Reserve, and is considered
to be a reliable data source. The SCF is believed by many to be the best
source of publicly available information on U.S. household finances.

Some caveats about the data should be kept in mind. Because some assets
are held very disproportionately by relatively wealthy families, the SCF
uses a two part sample design, one of which is used to select a sample
with disproportionate representation of families more likely to be
relatively wealthy. The two parts of the sample are adjusted for sample
nonresponse and combined using weights to provide a representation of
families overall. In addition, the SCF excludes one small set of families
by design. People who are listed in the October issue of Forbes as being
among the 400 wealthiest in the United States are excluded. To enable the
calculation of statistical hypothesis tests, the SCF uses a replication
scheme.1 A set of replicate samples is selected by applying the key
dimensions of the original sample stratification to the actual set of
completed SCF cases and then applying the full weighting algorithm to each
of the replicate samples. To estimate the variability of an estimate from
the SCF, independent estimates are made with each replicate and with each
of the multiple imputations; a simple rule is used to combine the two
sources of variability into a single estimate of the standard error.

We also analyzed recent asset sales by retirees and work and bequest
expectations of baby boomers, as well as gathered further financial
information on baby boomers and older generations, from data from the
Health and Retirement Study (HRS) from 1994 to 2004. The University of
Michigan administers the HRS every 2 years as a panel data set, surveying
respondents every two years starting in 1992 about health, finances,
family situation, and many other topics. Like the SCF, the HRS is widely
used by academics and continually updated and improved by administrators.
We also received expert opinions on the likely impact of the baby boom
retirement on asset and housing markets from interviews with various
financial management companies, public policy organizations, and
government agencies, particularly those agencies dealing with housing.

1 See Arthur B. Kennickell, "Currents and Undercurrents: Changes in the
Distribution of Wealth, 1989-2004," SCF Working Papers, June 22, 2006.

To assess the conclusions of academics researchers and outside experts on
the financial impacts of the baby boom retirement, we read, analyzed, and
summarized theoretical and empirical academic studies on the subject.
Based on our selection criteria, we determined that these studies were
sufficient for our purposes but not that their results were necessarily
conclusive. We also interviewed financial industry representatives from
mutual fund companies, pension funds, life insurance companies,
broker-dealers, and financial industry trade associations. We also did our
own analysis of the historical importance of demographics and other
variables on stock returns by collecting demographic, financial, and
macroeconomic data and running a regression analysis. We performed data
reliability assessments on all data used in this analysis.

To assess the role rates of return will play in providing retirement
income in the future, we synthesized findings from the analysis of
financial asset holdings to draw conclusions about the risk implications
for different subpopulations of the baby boom and younger generations. We
also used facts and findings on pensions and Social Security (from past
GAO reports and the academic literature) and insights from interviews with
outside experts to extend and support our conclusions.

We conducted our work between August 2005 and June 2006 in accordance with
generally accepted government auditing standards.

Appendix II: Bibliography of Simulation-Based and Empirical Studies

Abel, Andrew B. "Will Bequests Attenuate the Predicted Meltdown in Stock
Prices When Baby Boomers Retire?" The Review of Economics and Statistics,
vol. 83, no. 4 (2001): 589-595.

Abel, Andrew B. "The Effects of a Baby Boom on Stock Prices and Capital
Accumulation in the Presence of Social Security." Econometrica, vol. 71,
no. 2 (2003): 551-578.

Ang, Andrew and Angela Maddaloni. "Do Demographic Changes Affect Risk
Premiums? Evidence from International Data." Journal of Business, vol. 78,
no. 1 (2005): 341-379.

Bakshi, Gurdip S. and Zhiwu Chen. "Baby Boom, Population Aging, and
Capital Markets." Journal of Business, vol. 67, no. 2 (1994): 165-202.

Bergantino, Steven M. "Life Cycle Investment Behavior, Demographics, and
Asset Prices." Ph.D diss., Massachusetts Institute of Technology, 1998.

Bo:rsch-Supan, Axel. "Global Aging: Issues, Answers, More Questions."
Working Paper WP 2004-084. University of Michigan Retirement Research
Center (2004).

Bo:rsch-Supan, Axel, Alexander Ludwig, and Joachim Winter. "Aging, Pension
Reform, and Capital Flows: A Multi-Country Simulation Model." Working
Paper No. 04-65. Mannheim Research Institute for the Economics of Aging
(2004).

Brooks, Robin J. "Asset Market and Savings Effects of Demographic
Transitions." Ph.D diss., Yale University, 1998.

Brooks, Robin. "What Will Happen to Financial Markets When the Baby
Boomers Retire?" IMF Working Paper WP/00/18, International Monetary Fund
(2000).

Brooks, Robin. "Asset-Market Effects of the Baby Boom and Social-Security
Reform." American Economic Review, vol. 92, no. 2 (2002): 402-406.

Brooks, Robin. "The Equity Premium and the Baby Boom." Working Paper,
International Monetary Fund, 2003.

Bu:tler, Monika, and Philipp Harms. "Old Folks and Spoiled Brats: Why the
Baby-Boomers' Savings Crisis Need Not Be That Bad." Discussion Paper No.
2001-42. CentER, 2001.

Davis, E. Phillip and Christine Li. "Demographics and Financial Asset
Prices in the Major Industrial Economies." Working Paper. Brunel
University, West London: 2003.

Erb, Claude B., Campbell R. Harvey, and Tadas E. Viskanta. "Demographics
and International Investments." Financial Analysis Journal, vol. 53, no. 4
(1997): 14-28.

Geanakoplos, John, Michael Magill, and Martine Quinzii. "Demography and
the Long-Run Predictability of the Stock Market." Cowles Foundation Paper
No. 1099. Cowles Foundation for Research in Economics, Yale University:
2004.

Goyal, Amit. "Demographics, Stock Market Flows, and Stock Returns."
Journal of Financial and Quantitative Analysis, vol. 39, no. 1 (2004):
115-142.

Helmenstein, Christian, Alexia Prskawetz, Yuri Yegorov. "Wealth and Cohort
Size: Stock Market Boom or Bust Ahead?" MPIDR Working Paper WP 2002-051.
Max-Planck Institute for Demographic Research, 2002.

Lim, Kyung-Mook and David N. Weil. "The Baby Boom and the Stock Market
Boom." Scandinavian Journal of Economics, vol. 105, no. 3 (2003): 359-378.

Macunovich, Diane. "Discussion of Social Security: How Social and Secure
Should It Be?" In Social Security Reform: Links to Saving, Investment, and
Growth. Steven Sass and Robert Triest, eds., Boston: Federal Reserve Bank
of Boston (1997): 64-74.

Poterba, James M. "Demographic Structure and Asset Returns." The Review of
Economics and Statistics, vol. 83, no. 4 (2001): 565-584.

Poterba, James M. "The Impact of Population Aging on Financial Markets."
Working Paper 10851. Cambridge, Mass.: National Bureau of Economic
Research, 2004.

Yoo, Peter S. "Age Distributions and Returns of Financial Assets." Working
Paper 1994-002A. St. Louis: Federal Reserve Bank of St. Louis, 1994.

Yoo, Peter S. "Population Growth and Asset Prices." Working Paper
1997-016A. St. Louis: Federal Reserve Bank of St. Louis, 1997.

Young, Garry. "The Implications of an Aging Population for the UK
Economy." Bank of England Working Paper no. 159. Bank of England, London:
2002.

Appendix III: Summary of the Simulation-Based and Empirical Studies
Assessing the Impact of a Baby Boom on Financial Markets Appendix
Table 2: Simulation-Based Studies Assessing the Impact of a Baby Boom on
Financial Markets

                                                                                    Channel through                
                                                                                    which baby boom   
                                                                                    affects asset     
Study          Objective     Model                   Key assumptions   Asset(s)     returns           Implications
Abel (2001 and Assess the    Overlapping-generations Model assumes a   Capital      Baby boomers      Model        
2003)          impact of a   model, with agents      closed economy,                affect the price  suggests     
               baby boom on  living for two periods: agents supply                  of capital        that baby    
               the price of  working when young but  labor                          through their     boomers will 
               capital, with not when old            inelastically,                 aggregate savings increase     
               and without a                         and a convex                   and, in turn,     stock        
               bequest                               adjustment cost                demand for        returns      
               motive                                technology for                 assets. Assuming  while in the 
                                                     converting                     a bequest motive  labor force  
                                                     consumption goods              does not          and will     
                                                     into capital                   attenuate the     reduce stock 
                                                     goods. In one                  reduction in the  returns in   
                                                     scenario, the                  price of capital  retirement.  
                                                     model assumes                  when baby boomers 
                                                     agents have no                 retire. Although  
                                                     bequest motive.                retirees do not   
                                                     In the other, it               sell all of their 
                                                     assumes agents                 capital, there is 
                                                     have a bequest                 more capital in   
                                                     motive, so they                the economy,      
                                                     do not consume                 because retirees  
                                                     all of their                   save more when    
                                                     wealth during                  working in        
                                                     retirement.                    anticipation of   
                                                                                    leaving bequests. 
Brooks (1998,  Assess the    Overlapping-generations Model assumes a   Risky        Demographic       Model        
2000, 2002,    impact of the model, with agents      closed economy,   capital and  shifts lead to    suggests     
and 2003)      baby boom on  living for four         agents supply     safe bonds   changes in        that baby    
               stock and     periods: childhood,     labor                          aggregate savings boomers will 
               bond returns, young working age, old  inelastically,                 over time,        increase     
               including the working age, and        and agents make a              causing the real  stock and    
               equity        retirement              portfolio                      interest rate to  bond returns 
               premium                               decision over                  vary and, in      while in the 
                                                     risky capital or               turn, push stock  labor force  
                                                     safe bonds. In                 and bond returns  and reduce   
                                                     one scenario,                  in the same       stock and    
                                                     model assumes                  direction.        bond returns 
                                                     agents do not                  Changes in stock  but increase 
                                                     receive social                 returns mirror    the equity   
                                                     security                       wage income,      premium in   
                                                     benefits; in                   which moves       retirement.  
                                                     another scenario,              inversely with    
                                                     it assumes they                the size of the   
                                                     do.                            labor force and   
                                                                                    reflects changes  
                                                                                    in the            
                                                                                    capital-labor     
                                                                                    ratio.            
Bo:rsch-Supan, Assess the    Multi-country           Model assumes     Capital      Changes in        Model        
Ludwig, and    effects of    overlapping generations countries and                  aggregate savings suggests     
Winter (2004)  population    model                   regions are                    and labor supply  that baby    
               aging and                             modeled                        affect the ratio  boomers will 
               pension                               symmetrically as               of capital to     increase     
               reform on                             open economies;                labor and capital stock        
               international                         demographic                    to output and     returns      
               capital                               changes capture                hence the rate of while in the 
               markets                               survival rates,                return, where the labor force  
                                                     immigration, and               rate of return to and reduce   
                                                     fertility rates;               capital moves     stock        
                                                     variable labor                 negatively with   returns in   
                                                     supply in some                 the               retirement.  
                                                     scenarios; and                 capital-to-output 
                                                     bequests are                   ratio.            
                                                     accidental.                                      
Bu:tler and    Assess the    Overlapping-generations Model assumes a   Bonds and    Due to their      Model        
Harms (2001)   impact of a   model, with three       closed economy,   physical     large size and    suggests     
               baby boom on  living generations      agents have       capital that impact on the     that baby    
               the price of                          perfect foresight provides     capital-to-labor  boomers will 
               capital                               and leave no      rent         ratio, baby       increase     
                                                     bequests, economy              boomers depress   stock        
                                                     produces a                     the wage rate but returns      
                                                     consumption good               prop up the       while in the 
                                                     and physical                   return to capital labor force  
                                                     capital, agents                when working. In  and reduce   
                                                     can transfer                   retirement, they  stock        
                                                     income across                  contribute to a   returns in   
                                                     periods by buying              rise in the wage  retirement.  
                                                     bonds or physical              rate and depress  The swing in 
                                                     capital that is                the return to     returns can  
                                                     safe, labor                    capital.          be           
                                                     supply is                      Endogenous labor  attenuated   
                                                     endogenous in                  supply dampens    by the       
                                                     some scenarios,                factor price      working and  
                                                     and no social                  fluctuations by   saving       
                                                     security exists.               allowing          behavior of  
                                                                                    baby-boom parents the          
                                                                                    and children to   generations  
                                                                                    shift their labor preceding    
                                                                                    supply to take    and          
                                                                                    advantage of the  following    
                                                                                    baby boomers'     the baby     
                                                                                    impact on the     boomers.     
                                                                                    returns to        
                                                                                    capital and       
                                                                                    labor.            
Geanakoplos,   Assess the    Overlapping-generations Model assumes a   Safe bonds   In the basic      Model        
Magill, and    impact of the model, with agents      closed economy,   and, in      model,            suggests     
Quinzii (2004) combination   living for three        agents supply     later        demographic       that baby    
               of life-cycle periods: young adult,   labor             versions of  shifts lead to    boomers will 
               behavior and  middle age, and         inelastically,    the model,   excess demand for increase     
               changing      retirement              and a large       equity       consumption or    stock and    
               demographic                           cohort is         contract     saving, requiring bond returns 
               structure on                          deterministically representing interest rates to while in the 
               stock prices                          followed by a     claims on    change and, in    labor force  
               and the                               smaller cohort.   capital      turn, bond and    and reduce   
               equity                                It then adds                   equity prices to  stock and    
               premium                               other                          move inversely    bond returns 
                                                     assumptions,                   with such change. but increase 
                                                     including                      Model also shows  the equity   
                                                     children, social               that large        premium in   
                                                     security,                      cohorts drive the retirement.  
                                                     bequests,                      terms of trade    
                                                     uncertainty with               against           
                                                     wages and                      themselves by     
                                                     dividends, and                 being so          
                                                     capital stock                  numerous,         
                                                     with adjustment                favoring the      
                                                     costs.                         small cohorts on  
                                                                                    the other side of 
                                                                                    the market that   
                                                                                    follow or precede 
                                                                                    them.             
Helmenstein,   Assess the    Theoretical model, with Model assumes     Safe bonds   In the model      Model        
Prskawetz, and effect of     economic behaviors      wealth accrues    and stock    where wealth is   suggests     
Yegorov (2002) population    assumed rather than     from bequests and that is also uniformly         that baby    
               aging on the  derived from optimizing savings, which    safe         distributed among boomers will 
               financial     agents                  are accumulated                high-wealth       increase     
               markets when                          as a fraction of               individuals, the  stock and    
               wealth is                             wage income; and               increase in       bond returns 
               unevenly                              the population is              demand for stocks while in the 
               distributed                           divided into                   and bonds by baby labor force  
                                                     different                      boomers when in   and reduce   
                                                     generations, each              the work force    stock and    
                                                     of which has                   causes prices to  bond returns 
                                                     equal amount of                rise. Likewise,   in           
                                                     wealth but is                  the spending of   retirement.  
                                                     composed of low                savings by baby   The decline  
                                                     and high-wealth                boomers in        in returns,  
                                                     individuals.                   retirement causes however,     
                                                     High-wealth                    prices to         could be     
                                                     individuals                    decline.          attenuated   
                                                     receive a bequest                                if wealth is 
                                                     at age 20, hold                                  not evenly   
                                                     their wealth in                                  distributed. 
                                                     stocks, consume                                  
                                                     only labor                                       
                                                     income, and work                                 
                                                     their entire                                     
                                                     lives; low-wealth                                
                                                     individuals                                      
                                                     follow the                                       
                                                     life-cycle                                       
                                                     hypothesis.                                      
Lim and Weil   Assess the    Macro-demographic model Model assumes     Capital      Demographics      Model        
(2003)         impact of the of linked dynasties     production and                 affect stock      suggests     
               baby boom on                          investment are                 prices through    that baby    
               stock prices                          carried out by                 the installation  boomers will 
                                                     identically                    cost of capital.  increase     
                                                     competitive firms              As capital is the stock        
                                                     that maximize the              only savings      returns      
                                                     present                        vehicle, greater  while in the 
                                                     discounted values              savings drives up labor force  
                                                     of their cash                  the price of      and reduce   
                                                     flows; firms                   capital. The      stock        
                                                     making                         larger the        returns in   
                                                     investments face               adjustment costs, retirement.  
                                                     installation                   the larger are    
                                                     costs that are a               the movements in  
                                                     positive function              stock prices.     
                                                     of the ratio of                                  
                                                     investment to                                    
                                                     capital; closed                                  
                                                     economy; and                                     
                                                     labor supply is                                  
                                                     exogenous.                                       
Yoo (1997)     Assess the    Overlapping-generations Model assumes a   Capital      Variation in a    Model        
               impact of a   model, with agents      closed economy,                population's age  suggests     
               baby boom on  living for 55 periods   an agent's demand              distribution      that baby    
               asset prices  and receiving an        for an asset does              affects the       boomers will 
                             age-dependent endowment not respond to                 aggregate demand  increase     
                             during the first 45     expectations of                for an asset by   stock        
                             periods                 future prices,                 changing the      returns      
                                                     supply of capital              distribution of   while in the 
                                                     is fixed, and                  asset holders.    labor force  
                                                     agents supply                  This variation in and reduce   
                                                     labor                          aggregate demand  stock        
                                                     inelastically.                 for an asset      returns in   
                                                     The model later                produces the      retirement.  
                                                     relaxes                        relationship      The effect   
                                                     assumptions about              between a         is           
                                                     expectations of                population's age  attenuated   
                                                     future prices and              distribution and  if the       
                                                     the fixed supply               asset prices.     supply of    
                                                     of capital.                                      capital      
                                                                                                      varies.      
Young (2002)   Assess the    Overlapping-generations Model assumes     Capital      The baby boom     Model        
               impact of a   model                   agents will save               increases labor   suggests     
               baby boom and                         for old age, but               supply and lowers that baby    
               other                                 some will die                  the               boomers will 
               demographics                          before old age,                capital-to-labor  increase     
               shocks on                             with their                     ratio, raising    stock        
               asset prices                          savings being                  the marginal      returns      
                                                     bequeathed to the              product of        while in the 
                                                     next generation;               capital and       labor force  
                                                     agents supply                  interest rate and and reduce   
                                                     labor exogenously              reducing the      stock        
                                                     in varying                     marginal product  returns in   
                                                     amounts and                    of labor and wage retirement.  
                                                     degrees of                     rate. When baby   
                                                     effectiveness                  boomers are in    
                                                     over their                     the work force,   
                                                     lifetime; agents               aggregate savings 
                                                     can hold assets                is raised; thus,  
                                                     that pay a rate                when boomers      
                                                     of return, and                 retire, the       
                                                     receive bequests;              raised capital    
                                                     agents live up to              drives down the   
                                                     five periods and               interest rate on  
                                                     consume a                      retirement.       
                                                     decreasing amount                                
                                                     of their wage                                    
                                                     income in each                                   
                                                     period.                                          

Source: GAO summary of studies.

Table 3: Empirical Studies Assessing the Impact of a Baby Boom on
Financial Markets

                                                            Time                        
                          Demographic                       frame of  
Study        Objective    variable(s)     Asset variable(s) analysis  Key results
Ang and      Tests for    Average age of  Difference        1900-2001 Demographic       
Maddaloni    associations population      between the       for the   changes predicted 
(2003)       between      above 20 years  compounded total  United    future changes in 
             demographic  old             return of the     States,   the equity        
             variables                    stock market      France,   premium in the    
             and equity   Percentage of   index and         Germany,  international     
             premium in   the population  compounded return and       data but only     
             the United   age 65 and over on a risk-free    United    weakly in the     
             States and                   asset             Kingdom;  U.S. data.        
             other        Percentage of                     1920-2001 
             countries    the population                    for Japan 
                          in the working                              
                          ages of 20 to                               
                          64                                          
Bakshi and   Tests for    Average age of  Excess return on  1946 to   In the United     
Chen (1994)  associations population over S&P 500 stock     1990      States, increases 
             between      age 20          index                       in the average    
             demographic                                              age of persons    
             variable and                                             older than age 20 
             equity                                                   predicted a       
             premium                                                  higher risk       
                                                                      premium.          
Bergantino   Tests for    Growth in the   Average annual    1946 to   In the United     
(1998)       associations demographic     rate of real      1997      States, the       
             between      demand for      price                       increase in the   
             demographic  financial       appreciation of             demand for stocks 
             variables    assets          (1) the S&P 500             and bonds based   
             and (1)      constructed     stock index and             on demographic    
             stock and    from time       (2) long-term               changes increased 
             bond prices  series of       government bonds            stock and bond    
             and (2)      cross-sectional                             prices but had no 
             equity       profiles of                                 effect on the     
             premium in   stock and bond                              equity premium.   
             the United   holdings                                    
             States                                                   
                          Ratio of                                    
                          demographic                                 
                          demand for                                  
                          stocks to                                   
                          demographic                                 
                          demand for                                  
                          bonds                                       
Brooks       Tests for    Population age  Logged annual (1) 1950 to   The increase in   
(1998)       associations 40 to 64        stock price       1995      people age 40 to  
             between      divided by rest indices for a               64 relative to    
             demographic  of the          cross-section of            the rest of the   
             variables    population      countries and (2)           population        
             and (1)                      price indices for           increased stock   
             stock and    Population age  bonds based on              and bond prices,  
             bond prices  40 to 64        yields to                   particularly in   
             and (2)      divided by      maturity of                 the United        
             stock prices population age  long-term                   States. Also, the 
             relative to  65 and older    government bonds            increase in       
             bond prices                                              people 40 to 64   
             in the                                                   relative to       
             United                                                   people over 65    
             States and                                               increased the     
             other                                                    equity premium.   
             countries                                                
Davis and Li Tests for    Percentage of   Change in annual  1950 to   The relative      
(2003)       associations the population  average level of  1999 for  increase in       
             between      (1) age 20 to   (1) real stock    stocks;   people age 40 to  
             demographic  39 and (2) age  price index       1960 to   64 increased      
             variables    40 to 64        (excluding        1999 for  stock prices and  
             and stock                    dividends) and    bonds     decreased         
             and bond                     (2) real                    long-term bond    
             prices in                    long-term bond              yields in the     
             the United                   yield                       United States and 
             States and                                               other countries.  
             other                                                    
             countries                                                
Geanakoplos, Tests for    Ratio of        Price-to-earnings 1910 to   In the United     
Magill, and  associations population age  ratio, real       2002 for  States, the       
Quinzii      between      40 to 49 to     return on S&P 500 the       relative increase 
(2004)       demographic  population age  stock index, real United    in the population 
             variable and 20 to 29        short-term        States;   age 40 to 49      
             financial                    interest rate,    1950 to   increased stock   
             asset prices                 and real stock    2001 for  returns. The      
             and returns                  price index of    the       results for the   
             in the                       foreign countries foreign   other countries   
             United                                         countries included in the   
             States and                                               study were mixed. 
             other                                                    
             countries                                                
Goyal (2004) Tests for,   Percentage      Difference        1926 to   In the United     
             among other  change and      between logged    1998      States, the       
             things,      level of        S&P 500 stock               relative increase 
             associations population age  returns and                 in persons age 45 
             between      25 to 44, age   logged Treasury             to 64 increased   
             demographic  45 to 64, and   bill rate                   the equity        
             variables    age 65 and                                  premium.          
             and the      over.                                       
             equity                                                   
             premium      Average age of                              
                          person over age                             
                          25                                          
Macunovich   Tests for    Logged annual   3-year moving     1934 to   In the United     
(1997)       associations change in U.S.  average of the    1994      States, the       
             between      population age  annual change in            increase in       
             demographic  6, 9, 18, 27,   the Dow Jones               people age 45 and 
             variables    45, 66, and     Industrial                  66 decreased      
             and stock    total U.S.      Average                     stock returns.    
             prices       population                                  
Poterba      Tests for    Percentage of   Annual real       1926 to   In the United     
(2004)       associations population age  returns for       2003 for  States, the       
             between      40 to 64;       Treasury bills,   United    relative increase 
             demographic  percentage of   long-term         States    in people age 40  
             variables    population over government bonds,           to 64 decreased   
             and stock    age 65;         and large                   short-term        
             and bond     population age  corporate stocks            government bond   
             returns in   40 to 64        based on S&P 500            returns but had   
             the United   divided by                                  no effect on      
             States       population age                              long-term         
                          20 and older;                               government bond   
                          and population                              or stock returns. 
                          over age 65                                 
                          divided by                                  
                          population age                              
                          20 and older                                
Yoo (1994)   Tests for    Percentage of   Annual real       1926 to   In the United     
             associations population age  returns of common 1988      States, the       
             between      25 to 34, age   stock, small                relative increase 
             demographic  35 to 44, age   company stock,              in people age 45  
             variables    45 to 54, and   long-term                   to 54 decreased   
             and stock    age 65 and over corporate bonds,            annual returns of 
             and bond                     long-term                   short and         
             returns                      government bonds,           intermediate-term 
                                          intermediate-term           government bonds  
                                          government bonds,           but had no effect 
                                          and Treasury                on the annual     
                                          bills                       returns of stock  
                                                                      and long-term     
                                                                      government or     
                                                                      corporate bonds.  

Source: GAO summary of studies.

Appendix IV: Econometric Analysis of the
Impact of Demographics on Stock Market Returns

This appendix discusses our analysis of the impact of demographics and
macroeconomic and financial factors on U.S. stock market returns from 1948
to 2004. In particular, we discuss (1) the development of our model used
to estimate the relative importance of demographics and other factors in
determining stock market returns, (2) the data sources, and (3) the
specifications of our econometric model, potential limitations, and
results.

GAO's Econometric Model of the Effects of Demographic, Macroeconomic, and
Financial Factors on Stock Market Returns

We developed an econometric model to determine the effects of changes in
demographic, macroeconomic, and financial variables on stock market
returns from 1948 to 2004. Our independent empirical analysis is meant to
address two separate but related questions:

           o  Are the demographic effects on stock returns found in some of
           the empirical literature1 still apparent when additional control
           variables-macroeconomic and financial indicators known to be
           associated with stock returns-are present in the regression
           analysis?

           o  How much of the variation in stock returns is explained by
           those macroeconomic and financial indicators as compared to
           demographic variables?

Answering the first question serves to address the possibility of omitted
variable bias in simpler regression specifications. For example, studies
by Poterba;2 Geanakoplos, Magill, and Quinzii (hereafter, GMQ); and Yoo3
use only demographic variables as their independent variables. The
omission of relevant variables in regressions of this kind will result in
biased estimates of the size and significance of the effects under
investigation. Answering the second question serves to put the influence
of demographics on stock returns in perspective: How much of stock market
movements are explained by demographics as opposed to other variables? To
answer the questions we include a series of demographic variables from the
literature we reviewed in a multivariable regression model. We relied
primarily on information in a seminal study done by Eugene Fama to develop
our model.4

1 From our literature review, studies that found evidence of a
relationship between demography and stock returns include Robin J. Brooks,
"Asset Market and Savings Effects of Demographic Transitions," Ph.D diss.,
Yale University (1998); E. Phillip Davis and Christine Li, "Demographics
and Financial Asset Prices in the Major Industrial Economies," Working
Paper (Brunel University, West London: 2003); and John Geanakoplos,
Michael Magill, and Martine Quinzii, "Demography and the Long-Run
Predictability of the Stock Market," Cowles Foundation Paper No. 1099 (New
Haven, Conn.: Cowles Foundation for Research in Economics, Yale
University, 2004). While Davis and Li include a set of control variables,
Brooks' international approach captures only a global business-cycle
component. Geanakoplos, Magill, and Quinzii do not include control
variables.

2 James M. Poterba, "The Impact of Population Aging on Financial Markets,"
Working Paper No. 10851 (Cambridge, Mass.: National Bureau of Economic
Research, 2004).

3 Peter S. Yoo, "Age Distributions and Returns of Financial Assets,"
Working Paper 1994-002A (St. Louis: Federal Reserve Bank of St. Louis,
1994).

Data and Sample Selection

We analyzed the determinants of real (adjusted for inflation) total
(including both price changes and dividends) returns of the Standard and
Poor's (S&P) 500 Index from 1948 to 2004. We chose the S&P 500 Index as
our dependent variable not only because it is widely regarded as the best
single gauge of U.S. equities market and covers over 80 percent of the
value of U.S. equities but also because S&P 500 Index mutual funds are by
far the largest and most popular type of index fund. Due to changes in the
structure of financial markets over time, we chose a shorter time horizon
to minimize the likelihood of a structural break in the data.5 For our
independent variables, we selected macroeconomic and financial variables
that economic studies have found to be important in explaining stock
returns and were used in Fama's analysis to determine how much of stock
market variation they explained.6 We selected two demographic variables,
the proportion of the population age 40-64 and the ratio of the population
age 40-49 to the population age 20-29 (the middle-young or "MY" ratio),
that had statistically significant coefficients in several of the
empirical studies that we reviewed.7 Table 1 presents the independent and
dependent variables in our model and their data sources. For consistency,
we estimate the equation four times using both levels and changes in the
two demographic variables.

4 Eugene Fama, "Stock Returns, Expected Returns, and Real Activity,"
Journal of Finance, vol. 45, no. 4 (1990).

5 A Chow test confirms that there are no structural breaks around the
midpoint (1976) in any of the regressions, but there is probably a
structural break after 1980 in the baseline (Fama) regression

6 See Fama (1990).

7 See Brooks (1998), Davis and Li (2003), and Geanakoplos, Magill, and
Quinzii (2004).

Table 4: Names, Definitions and Data Sources of Variables Used in Our
Regression Models

                               Dependent variable
Stock Returns            Real annual returns to the S&P 500 Index from     
                            Robert Shiller's calculations                     
                             Independent variables
Control Variables        
Dividend yield           Dividends paid to shares of stocks in the S&P 500 
                            Index, divided by the share price, from Moody's   
                            Economy.com (lagging)                             
Term spread              The difference between yields on Moody's AAA      
                            corporate bonds and the 3-month T-bill, from the  
                            Federal Reserve Bank of St. Louis (lagging)       
Default spread shock     Unexpected changes to the difference between      
                            Moody's BAA and AAA corporate bonds, calculated   
                            as residuals from an AR(1) regression, from the   
                            Federal Reserve Bank of St. Louis                 
Industrial production    Industrial Production Index of U.S.               
                            manufacturing, mining, and electric and gas       
                            utilities, from the Board of Governors of the     
                            Federal Reserve (leading)a                        
Demographic variables    
Middle age-to-young (MY) Ratio of individuals in the United States ages 40 
ratio                    to 49 over 20 to 29, from the U.S. Census Bureau  
Proportion 40-64         Proportion of individuals in the U.S. ages 40-64, 
                            from the Census Bureau                            

Source: GAO analysis of S&P 500 returns, 1948-2004.

aFor industrial production, because it is leading, we assume that the
causality is wholly from growth in industrial production to stock returns,
and not vice versa. This is consistent with the literature, as expressed
in Nai-Fu Chen, Richard Roll, and Stephen A. Ross, "Economic Forces and
the Stock Market," Journal of Business, vol. 59, no. 3 (1986), "stock
prices are usually considered as responding to external forces." Further,
in Paul Beaudry and Franck Portier, "Stock Prices, News and Economic
Fluctuations," Working Paper 10548 (Cambridge, Mass.: National Bureau of
Economic Research, 2004), the authors find that stock prices respond today
to news about productivity shocks that will effect the economy with a
substantial delay. This implies that higher industrial production in the
future should cause higher stock returns today.

Model Specification, Limitations, and Estimation

We estimated the following regression equation:

         rt = b0 + b1x1,t-1 + b2x2,t-1 + b3x3,t + b4x4,t+1 + thyt + et

where rt is real stock market returns during calendar year t, xi are four
control variables (the dividend yield, the term spread, shocks to the
default spread, and growth of industrial production, respectively) adapted
from Fama's study,8 yt is the demographic variable, and et is the error at
time t. The error structure is modeled assuming White's
heteroskedasticity-consistent covariance matrix. We first estimate the
equation without a demographic variable to measure the proportion of
variation explained by macroeconomic and financial indicators, followed by
estimating the regression equation four separate times to include each of
the demographic measures.9 For the benchmark model, we find no evidence of
serial autocorrelation or deviations from normality.10

Despite standard diagnostics and careful regression specification, some
limitations of our analysis remain. We cannot be certain that we have
chosen the best variables to represent the aspects of the economy that
move the stock market or the demographic variables that may influence
stock returns as well. We have attempted to choose appropriate variables
based on the existing empirical and theoretical literature on the economic
and demographic determinants of stock returns. Nevertheless, even these
variables may be measured with error. Generally, measurement errors would
cause us to underestimate the importance of those variables that have been
measured with error. This would be most problematic in the case of our
demographic variables, though measurement error in our economic and
financial control variables actually makes our estimates conservative.
Nevertheless, we assessed the reliability of all data used in this
analysis, and found all data series to be sufficiently reliable for our
purposes. As a result, we believe that the limitations mentioned here (and
related to the direction of causality in industrial production mentioned
above) do not have serious consequences for the interpretation of our
results.

8 See Fama (1990).

9 By including the variables in this order, we are measuring the
contribution of demographics to the R-squared after controlling for
macroeconomic and financial variables. We replicated the results instead
including the demographic variables first, and found that they accounted
for even less of the variation in stock returns, around 1.8 percent on
average, compared to an average of roughly 5.7 percent when macroeconomic
and financial variables were included first.

10 The presence of serial autocorrelation or deviations from normality
would imply that the methods we used to measure statistical significance
(e.g., p-values) were inappropriate, and could thus lead to incorrect
conclusions about the strength of relationships between variables.

The regression results are presented in tables 2 through 6 below. Our
results are consistent with the literature on the determinants of stock
market returns, especially Fama's study, in that several of our
macroeconomic and financial variables are statistically significant, and
they account for a substantial proportion (roughly 47 percent) of the
variation in stock returns. The coefficient of determination in Fama's
study could be higher due to the inclusion of more industrial production
leads.

The finding in Davis and Li's study that the 40-64 population had a
statistically significant impact on stock returns is not robust to
alternative specifications, as demonstrated in Table 6. The proportion of
the population 40-64 is no longer a statistically significant determinant
of stock returns, and the inclusion of the variable improves the R-squared
by less than 1.5 percent. However, changes in the 40-64 population are
significant, and account for an additional 8 percent of the variation in
stock returns.

The MY ratio and changes in the MY ratio are statistically significant, as
seen in Tables 5 and 6, and the model with changes in the MY ratio
accounts for a higher proportion of the variation in stock returns than
the model estimated with the level of the ratio.11

Table 5: Stock Market Returns Regression Results-Baseline Model

Parameter                     Estimate p-value 
Intercept                    -0.104809  0.0636 
Dividend yield                0.024963  0.0462 
Term spread                   0.012387  0.4650 
Shocks to the default spread -0.105986  0.1698 
Industrial production         2.097360 <0.0001 
R-squared                     0.465597      NA 

Source: GAO analysis of S&P 500 returns, 1948-2004.

11 Changes in the "MY" ratio were used by Geanakoplos, Magill, and Quinzii
(2004).

Table 6: Stock Market Returns Regression Results-Middle Age Model

Parameter                       Estimate p-value 
Intercept                      -0.549744  0.2546 
Dividend yield                  0.036523  0.0095 
Term spread                     0.013526  0.4516 
Shocks to the default spread   -0.109996  0.2196 
Industrial production           2.031814 <0.0001 
Proportion middle aged (40-64)  1.513299  0.3610 
Change in R-squared             0.014389      NA 

Source: GAO analysis of S&P 500 returns, 1948-2004.

Table 7: Stock Market Returns Regression Results-Change in Middle Age
Model

Parameter                                 Estimate p-value 
Intercept                                -0.201542  0.0008 
Dividend yield                            0.053588  0.0004 
Term spread                              -0.002828  0.8802 
Shocks to the default spread             -0.095472  0.2514 
Industrial production                     2.056497 <0.0001 
Change in proportion middle aged (40-64)  27.52932  0.0044 
Change in R-squared                       0.080823      NA 

Source: GAO analysis of S&P 500 returns, 1948-2004.

Table 8: Stock Market Returns Regression Results-Middle-Young Ratio Model

Parameter                        Estimate p-value 
Intercept                       -0.467783  0.0094 
Dividend yield                   0.052177  0.0003 
Term spread                      0.026824  0.2163 
Shocks to the default spread    -0.167018  0.1369 
Industrial production            1.877306 <0.0001 
MY ratio (age 40-49/ age 20-29)  0.286547  0.0409 
Change in R-squared              0.055683      NA 

Source: GAO analysis of S&P 500 returns, 1948-2004.

Table 9: Stock Market Returns Regression Results-Change in Middle-Young
Ratio Model

Parameter                                  Estimate p-value 
Intercept                                 -0.055320  0.3315 
Dividend yield                             0.017724  0.1314 
Term spread                               -0.006925  0.7323 
Shocks to the default spread              -0.102432  0.1668 
Industrial production                      2.227720 <0.0001 
Change in MY ratio (age 40-49/ age 20-29)  1.903652  0.0064 
Change in R-squared                        0.079029      NA 

Source: GAO analysis of S&P 500 returns, 1948-2004.

Appendix V: A Appendix V: GAO Contact and Staff Acknowledgments

Contacts

Barbara D. Bovbjerg (202) 512-7215

George A. Scott (202) 512-5932

Staff Acknowledgments

In addition to the contacts above, Kay Kuhlman, Charles A. Jeszeck, Joseph
A. Applebaum, Mark M. Glickman, Richard Tsuhara, Sharon Hermes, Michael
Hoffman, Danielle N. Novak, Susan Bernstein, and Marc Molino made
important contributions to this report.

(130493)

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Highlights of GAO-06-718 , a report to congressional committees

July 2006

BABY BOOM GENERATION

Retirement of Baby Boomers Is Unlikely to Precipitate Dramatic Decline in
Market Returns, but Broader Risks Threaten Retirement Security

The first wave of baby boomers(born between 1946 and 1964) will become
eligible for Social Security early retirement benefits in 2008. In
addition to concerns about how the boomers' retirement will strain the
nation's retirement and health systems, concerns also have been raised
about the possibility for boomers to sell off large amounts of financial
assets in retirement, with relatively fewer younger U.S. workers available
to purchase these assets. Some have suggested that such a sell-off could
precipitate a market "meltdown," a sharp and sudden decline in asset
prices, or reduce long-term rates of return. In view of such concerns, we
have examined (1) whether the retirement of the baby boomers is likely to
precipitate a dramatic drop in financial asset prices; (2) what
researchers and financial industry participants expect the effect of the
boomer retirement to have on financial markets; and (3) what role rates of
return will play in providing retirement income in the future. We have
prepared this report under the Comptroller General's authority to conduct
evaluations on his own initiative as part of the continued effort to
assist Congress in addressing these issues.

                                                          What GAO Recommends

GAO is not making any recommendations.

Our analysis of national survey and other data suggests that retiring
boomers are not likely to sell financial assets in such a way as to cause
a sharp and sudden decline in financial asset prices. A large majority of
boomers have few financial assets to sell. The small minority who own most
assets held by this generation will likely need to sell few assets in
retirement. Also, most current retirees spend down their assets slowly,
with many continuing to accumulate assets. If boomers behave the same way,
a rapid and large sell off of financial assets appears unlikely. Other
factors that may reduce the odds of a sharp and sudden drop in asset
prices include the increase in life expectancy that will spread asset
sales over a longer period and the expectation of many boomers to work
past traditional retirement ages.

A wide range of academic studies have predicted that the boomers'
retirement will have a small negative effect, if any, on rates of return
on assets. Similarly, financial industry representatives did not expect
the boomers' retirement to have a big impact on the financial markets, in
part because of the globalization of the markets. Our statistical analysis
shows that macroeconomic and financial factors, such as dividends and
industrial production, explained much more of the variation in stock
returns from 1948 to 2004 than did shifts in the U.S. population's age
structure, suggesting that demographics may have a small effect on stock
returns relative to the broader economy.

While the boomers' retirement is not likely to cause a sharp and sudden
decline in asset prices, the retirement security of boomers and others
will likely depend more on individual savings and returns on such savings.
This is due, in part, to the decline in traditional pensions that provide
guaranteed retirement income and the rise in account-based defined
contribution plans. Also, fiscal uncertainties surrounding Social Security
and rising health care costs will ultimately place more personal
responsibility for retirement saving on individuals. Given the need for
individuals to save and manage their savings, financial literacy will play
an important role in helping boomers and future generations achieve a
secure retirement.

Distribution of Baby Boomer Financial Assets, by Wealth Percentiles
*** End of document. ***