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The central challenge for an aging society is the need to achieve acceptable real returns to fund retirement, in a world of lower returns and higher costs of living for the elderly. Unfortunately, many of the solutions to the realities of an aging society risk generating lower nominal economic returns, and thus lower nominal investment returns. Managing an aging population to maximize the productivity of the population could be one of the greatest challenges facing developed economies today.

Lower returns, higher inflation

The world has entered a period of lower nominal returns on investment. The high nominal returns that began in the 1970s are the exception rather than the rule. After the inflation spike that followed the oil price shock, nominal returns were supported first by inflation and then by the reduction of risk premiums in financial markets. The result was a relatively lengthy period of supernormal returns. With inflation low and regarded as contained in the major markets, there is little prospect of a further decline in inflation risk premiums, and returns are correspondingly lower in nominal terms. Lower income yield on specific asset classes has also been promoted by central bank policies in recent years.

The lower return environment is complicated by the fact that, while average inflation may be lower, inflation for the elderly may be higher. The elderly in society have a different consumption basket from average. They spend less on education, more on healthcare (to give one obvious example). If the things they buy persistently have an above-average inflation rate – and generally that is the case – then older people will have a personal inflation rate higher than the reported statistic. This creates a challenge in saving for retirement. Investment returns that beat the published rate of consumer price inflation may not guarantee a stable living standard for the elderly, if the inflation experience of the elderly differs markedly from the average. What appears to be a positive rate of return on pension savings may turn out to be illusionary when pension spending begins.

When do you retire

If lower investment returns reduce potential retirement income, and higher inflation raises the cost of being old, one obvious solution is to have people work longer and retire later. Indeed this strategy is being pursued by many state pension schemes around the world. In Japan it has become commonplace for employees to work beyond their official retirement age. However, simply having workers continue in employment for longer creates its own peculiar set of challenges.

An aging workforce that is insufficiently flexible may prevent younger workers from contributing as positively as they should. A highly productive worker at 50 may be less so at 70 – but if pay and position are protected (as they are in many countries today), then a worker fairly paid and promoted at 50 may be over-paid and over-promoted at 70. Moreover, the 70-year-old worker may prevent a productive 40-year-old worker from achieving the pay and promotion that the 40-year-old deserves. A workplace structure based on seniority rather than merit could rapidly become a problem for both company and economy if working longer is seen as the sole solution to financing retirement.

The complications of creating an efficient workforce structure as the workforce ages could lower investment returns (lower productivity in an economy will generate lower returns on investments overall). This then directly feeds back into the problems of funding retirement in a lower return world.

Conflict over state resources

Without significant shifts in patterns of working, an older society ultimately has fewer workers paying taxes to support those not working. Financing (though probably not repaying) the burden of government debts becomes the responsibility of a smaller and generally younger tax base. This at least raises the risk of inter-generational tensions over the allocation of national resources. Should the state concentrate on healthcare, or on education? How should infrastructure spending be directed?

Older people have traditionally been more inclined to vote, which means that (electorally speaking) they are a lot more important. If there are more older than younger voters, politicians will pay more attention to their needs than to the younger generations'. This does not mean that state assistance for the elderly is secure, however. Younger people are more mobile, generally speaking, and may react to a higher tax burden by leaving a country. This would reduce the economy's trend rate of growth (a variation of the so-called "brain drain" effect), which in turn would directly lower the return on domestic investment. There is also a trend towards single-issue politics in which the younger generation is more engaged. This means that specific initiatives favored by the older generation may meet a more focused resistance from the younger generation.

Immigration and robotics

If a society's aging population creates economic problems through a shortage of labor, either importing labor or substituting capital for it would seem to be a logical response. Immigration will increase the tax base and support productivity. Introducing robotics and other capital equipment will enable older workers to maintain productivity levels.

The problem with both of these initiatives is that they tend to alienate the same demographic in society – generally lower skilled and lower paid workers. The economic benefits of immigration tend to be broad but shallow; the economy as a whole benefits, but the shallowness of the benefits means that many people will be unaware of them. The economic boost provided by immigration exceeds the economic costs, but those costs tend to be narrow but deep; few people are negatively affected, though where there is a negative impact it tends to be severe. The least flexible members of the labor force are likely to bear the economic cost burden, and this group is generally the lower skilled demographic.

Capital-for-labor substitution (introducing robots, for instance) also tends to be skewed towards lower skilled employment, although this is not always the case. It can again generate political hostility from a demographic left behind by changes in the economy. Thus, while importing labor or increasing capital can resolve the economic challenges presented by an aging population, it can also create significant political and social problems. If these problems produce a climate of prejudice and hostility towards either migration or investment, the result will be a less-efficient economy, which, once again, means lower returns over time.