In July 2006, the GAO issued a seventy page report on the Baby Boom Generation, with the headline conclusion, “Retirement of Baby Boomers Is Unlikely To Precipitate Dramatic Declines in Market Returns, But Broader Risks Threaten Market Security“.

A careful reading of this report shows that the conclusions were based on the following studies and observations by the Government Accountability Office:

1. Many people on Wall Street who were interviewed said that there was nothing to worry about.

2. Two-thirds of Baby Boomer assets are held by 10% of the population who the study concluded are so rich that they won’t need to sell stocks when they retire.

3. One-third of Baby Boomers don’t have any stocks at all, so they won’t be able to influence the market by selling.

4. Many economists performed regression analyses on past market data, while others developed simulation models of how they expected the market to operate over the next generation, and none of these experts could seem to find any provable relationship between the impending retirement of the Baby Boomers and stock market returns — with half of their results correlating to ‘unknown factors’.

5. The Baby Boomers will retire gradually over a generation, so the impact of their retirement on the market will never be sudden.

6. If the Baby Boomers think they are running out of money, they will just postpone retirement, get a job, or spend less, rather than sell stocks.

Thus the government has entered to fray about the Baby Boom Bomb, already noted in a previous article covering the debate between Professor Jeremy Siegel and Michael Milkin.

The GAO’s conclusion seems to be: Don’t Worry, Be Happy (Maybe).

Flaws in the Government’s Argument

Perhaps the greatest error in the GAO study is the underlying assumption that without a massive sell-off by Baby Boomers, there can be no ‘melt-down’ in equity prices.

Everyone realizes that Baby Boomers are not going to retire all at once, nor are they going to be forced to liquidate all their assets suddenly.

However, to jump from this obvious truth to the conclusion that stock prices will at no time in the coming decade suffer a sudden readjustment, runs contrary to the way markets work.

There is also the hidden assumption that the Efficient Market Hypothesis is operating and that current prices reflect intrinsic value and therefore are not over-priced. If stocks are fairly valued , why would prices fall, without panic selling? Or so the argument goes.

Markets Crash Without Dumping Stocks

Contrary to a common misperception, millions of investors do not need to suddenly dump stocks in order to crash a market.

All that is required to drive stock prices down is a cessation of buying.

Stock prices are determined by a tiny percentage of investors who trade on a particular day. Their decisions may trigger involuntary reactions from speculators who hold large short or margin positions. Once prices begin to fall, other potential buyers become cautious and decide to hold off for a while, and the rout is on.

For example, in the Crash of 2000 — the largest loss of stock market value in US history — there was no panic selling or sudden ‘dumping’ of equities. (See the study on the US Market in 2000.)

A Market On The Edge

The US equity market today is supported primarily by corporate buybacks and purchases of mutual funds, while individual direct investors have been net sellers of stocks for over a decade.

Other players (foreign issuers, foreign investors, pension funds, and insurance companies), move in and out of equities — each for their own reasons that change over time.

When the forces are aligned just right, as occurred in mid-2000, buying dries up and the market crashes.

The threat from the retirement of the Baby Boomers is not that this generation will all rush to the stock market at once and sell out, but rather that, in the larger scheme of things, buying pressure through mutual funds will tend to diminish and that, sooner or later, the forces will be aligned for a crash.

The ‘Too Rich To Sell Fallacy’

The GAO study also concluded that since two-thirds of financial assets are held by only 10% of the population, these people were too rich to need to sell stocks during retirement.

Even if this were true, it takes buyers to keep stock prices up, not passive coupon clippers.

No one should be comforted by the idea that ‘only’ one-third of Baby Boomers will need to sell equities to make it through their retirement years.

According to the GAO study, these ‘poor’ Baby Boomers are nonetheless holding $2.5 trillion in financial assets, which, if liquidated over twenty years, would put $125 billion of securities onto the market each year.

However, the assumption that the upper 10% of the population is so rich that these people can live well just on dividends is false. This may be true of the ‘Super-Rich’ who are in the top 1% of the population, but the other 9% are just ‘Rich’ and have to budget their spending to live a comfortable retirement.

The study ‘Rich and Poor‘ shows that in 1998 (before the Crash), the ‘Rich’ cohort had family assets of only $475,000 to $3,350,000 and did not feel rich at all. Since part of their assets were tied up in the family home, yielding no income, the remaining financial assets are not so great that they might live comfortably off the 1.5% annual dividend now paid on common stock.

Obviously, not only the ‘Non-Rich’, but also most of the ‘Rich’ Baby Boomers will need to sell financial assets to make it through retirement, which accounts for about one-half to two-thirds of the assets of Baby Boomers.

The GAO assumption of ‘too rich to sell’ does not ring true.

The Total Return Trap

Perhaps the biggest mistake in the GAO analysis is to confound the 8% historical ‘total returns’ on equities with dividend yield.

Most of the ‘total return’ figure is made up of capital gains.

The only way to live off ‘total returns’ is to sell stock and convert paper gains into cash. You cannot pay doctor’s bills with unrealized capital gains.

It is also exceedingly hopeful to assume that the historical 8% total return number will persist.

Unlike the coupons on bonds, the ‘total return’ number is not a legal obligation of corporations. To realize this return, the investor must sell stock.

From capital flow analysis of the Federal Reserve flow of funds accounts, we know that most of this historical ‘total return’ figure for equities has been due to buying pressure exerted by over $1 trillion in stock buybacks since the 1980s.

There is no assurance that companies will be able to keep this up, especially if the Baby Boomers need to sell stock to live off ‘total return’ income during retirement.

The ‘My Broker Told Me So’ Argument

Now, the GAO has a motto beneath its symbol that reads, “Accountability - Integrity - Reliability“, so we have a right to expect conclusions based on information from unbiased sources.

Therefore, pardon me if I raise an eyebrow at this argument advanced so prominently in the GAO study:

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.

I would be surprised, indeed, if stockbrokers and equity fund salespersons were to say anything else but this.

‘Financial industry representatives’ are in the business of selling stocks. For them to declare to the government that Baby Boomers might indeed crash the price of equities over the coming years would definitely not be good for business.

Indeed, it may be that Baby Boomer retirement does not crash to market, but the arguments advance by the GAO fail to convince me, especially the argument that ‘My Broker Told Me So.’

There are a lot of things that I would like to have seen in the GAO study that were not there. For example, what would be the projected amounts that Baby Boomers must, by law, withdraw from their tax-deferred savings plans each year over the next twenty years? Presumably, the GAO is in a position to get estimates of these figures, which would be relevant to a serious study of the impact of Baby Boomer retirement.

This entry was posted on Wednesday, August 2nd, 2006 at 2:37 pm and is filed under Equities, Individual Investors. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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