Time bomb

The European Commission's 2012 Ageing Report states that the ratio of pensioners to workers will increase from 39 per cent in 2010 to 71 per cent by 2060. The UK, Denmark and Ireland have the lowest rate, with 55 per cent, while Hungary, Romania, Slovakia and Poland will have a rate of over 90 per cent in 2060.

How the swelling ranks of the elderly will be able to adequately heat, feed and medicate themselves is a significant problem, especially since it's taken as a given that state provision throughout Europe will invariably fall in real terms over coming decades. Invariably, any discussion of this subject will tend to focus on the fiscal challenge facing governments. Of course, UK pensioners have been feeling the pinch since the early 1980s, although the prospect of an indigent old age doesn't seem to have precipitated a wave of retirement planning. According to the Pension Policy Institute, only 40 per cent of men and 37 per cent of women of working age in the UK are accruing a non-state pension. The time bomb is ticking ever louder.

Demographic effect on fixed income

An ageing population poses considerable challenges for a developed society when it comes to securing a stable level of income. In most developed countries, the working population is retiring at an accelerating rate as the baby boomer generation collectively puts its feet up. Pension planning orthodoxy says that the percentage of bonds that make up a retirement portfolio should correspond to the age at which you wish to retire. Unfortunately, the immense strain on the fixed-income market caused by a combination of money printing and an ageing population has turned the search for yield into a game of cat and mouse. Indeed, it is worth noting that bond prices started rising before the start of the financial crisis as the first cohort of the post-war baby boomer generation came up for retirement and more pension schemes adopted the practice of 'lifestyling' - the gradual shift from equities into bonds as pension holders move towards retirement, designed to shield them from stock market volatility.

The structural problems that have forced up the prices of AAA bonds are unlikely to abate (see 'The dilemma facing pension fund managers ' in the box below). Pension funds are required by their own rules to invest in the highest quality assets available, whether government or corporate bonds, and safe assets are used extensively in portfolio management to balance off riskier investments. A recent survey by the UK's pensions regulator and Pension Protection Fund (PPF) found that pension funds have shifted their funds decisively into bonds. The PPF revealed that about 43 per cent of available funds were invested in bonds, compared with an average of 38.5 per cent in equities, when a year ago the proportion was roughly equal. Some of this may be risk aversion on the part of company pension schemes, understandable given the terrible returns from equities over the past 10 years, but it also shows that pension schemes are starting to mature.

The rate at which this is happening is a matter of some debate. The United States, for example, has seen its demographic profile benefit from an influx of young, mainly Hispanic, workers from Central and South America. This had a definite impact on the last presidential election, where a younger, more mixed electorate decisively voted in President Obama. That has consequences for bonds as well. If the US can delay the ageing of its workforce by at least two decades, then this should put a floor underneath US Treasuries for the medium term.

High yield and emerging market debt

One of the side effects of a shift in age-related investing habits is that assets offering diversification or better yields are priced up in consequence. Emerging market and high-yielding corporate assets have been moving higher over the past couple of years. High-yield fixed-income assets are particularly interesting as the narrowing of spreads is linked in part to how easy the companies that issue such bonds have found it to refinance their existing debt. That isn't such a surprise as US companies, which make up most of the available high-yield market, have exited the recession with much improved balance sheets - some estimates put the total cash pile at $2 trillion (£1.25 trillion). With such financial stability the risk of default on high yielding bonds is at a structural low, which is why pension funds and individual investors have piled into the asset class.

Emerging market debt has also seen an infusion of funds from developed nations. For example, JP Morgan's widely followed emerging market bond index recently reached an all time high of 659 as spreads tightened significantly over the past few months, meaning a return of more than 13 per cent for investors. Some emerging market debt is yielding up to 350 basis points above the benchmark 10-year US Treasury. Indeed, some analysts have started to openly question whether or not emerging market debt now represents a new kind of safe haven. Countries such as Brazil, Turkey, Indonesia and India have decisively better demographics compared with developed nations and benefit from positive trade balances with the developed world.

A structural switch away from equities

As we explain in the panel in the box below, 'The heyday of equities', the hunt for lower-risk yield has worrying implications for equity markets. However, while a shift into bonds makes some sense in terms of risk management, yields for sovereign debt rated at, or above, AA+ have become so anaemic that managers might be inclined to persist with a higher weighting of equities in their portfolios for longer than originally envisaged, particularly given that UK public companies have been returning a higher proportion of cash to shareholders.

During the second quarter of 2012, they paid a record £22.6bn in dividends, as companies baulked at allocating capital for investment purposes due to the global economic slowdown. The figure was boosted by special dividends from the likes of GlaxoSmithKline, Old Mutual and Antofagasta, and represented the sixth consecutive quarter of growth. Share buy-backs have also been much in evidence and pension fund managers might reasonably expect this largesse to persist given that UK public companies are now sitting on around £754bn in cash.

One may also logically conclude that the ever-increasing proportion of government bonds held by pension funds is contributing to a potential 'bond bubble'. Although viewed as lower risk, the irony is that any significant correction in bond prices will have devastating implications for pensions, given the high exposure to bonds driven by the adoption of lifestyling. Blue-chip equities could, counter-intuitively, be a lower risk option.

And while the effects of an ageing population are introducing some challenging variables for savers to consider, it is also creating opportunity in some sectors. Perhaps the best retirement insurance of all could be to invest in the sectors that stand to profit from this inexorable demographic shift.

SECTORS TO WATCH…

Pharmaceuticals

There is no doubt that, as a population ages, the demand for medication and treatment of all kinds increase. Spending on healthcare rises with age; the US department of labor estimates that spending for the 65+ age group averages over 13 per cent of after-tax income, or about $4,700 on average. So it would seem logical to pour money into pharma companies and sit back while rising demand for medicines does the rest. Unfortunately, the situation isn't quite as simple as the scenario suggests. Higher spending pressures are forcing patients to be savvy about the medicines they buy, while investors have to be very careful about the shares they pick.

The US generates the most comprehensive data for the prescription of medicines available. According to IMS Healthcare, these show that prescription trends do not necessarily favour the big pharma companies. To begin with, IMS says the absolute amount of medicines spending has risen by only 0.5 per cent to $320bn (£200bn), but the proportion of spending on branded medicines has fallen, with generics taking an 80 per cent share of all prescriptions. Also, a third of spending is concentrated on only five disease areas: diabetes, dislipidaemia (high blood cholesterol), cancer, neurological disorders and heart disease.

The best strategy for investors to play the trends, therefore, is to concentrate on areas that are growing. For example, investors can buy into the trends towards generic prescription by buying the shares of companies such as Teva (US:TEVA), the Israeli company with a listing in New York. Even buying Novartis (VX:NOVN) shares is a significant diversification as the company owns Sandoz, one of Europe's largest generic medicines suppliers. Other companies with highly developed demographic niches include Novo Nordisk (DC:NOVOB) and Abbott Laboratories (US:ABT) in diabetes management, with Novo the particularly dominant player in the global insulin market.

Healthcare equipment & services

The healthcare equipment market is dominated by the big US medical equipment firms such as Zimmer (US:ZMH) and Medtronic (US:MDT), with an honourable mention for the UK's own Smith & Nephew (SN.). The demand for replacement of hips and knees is an obvious growth market for a progressively ageing population. Companies that offer testing services to detect diseases, for example, also benefit. Large players such as Siemens (GY:SIE) and Diasorin (IM:DIA) are complemented by a host of smaller companies specialising in niche diagnostics tests, or so-called biomarkers - Immunodiagnostic Systems (IDH) and Cyprotex (CRX) are two UK-listed examples.

The problem with the healthcare services sector is that so much of what it offers is dependent on the personal choice of the patient, ie elective surgery. If economic conditions spook insurers and patients into holding off on a procedure, then equipment companies tend to suffer. Real growth in medical devices comes less from big capital spending budgets and one-off operations and more from the operational costs involved in performing surgery.

Surgical Innovations (SUN), for example, makes partly disposable parts for use in key-hole surgery as the consumable items ensure a recurring stream of revenue. Investors should always remember that rising healthcare costs mean strained public budgets, so any innovation that mitigates this is more likely to find favour. That makes diversification within the sector important as companies will have access to different types of market. Zimmer or Stryker (US:SYK) shares would give investors exposure to the dominant US players for bog-standard hip replacement and knee operations. That could be combined with big German companies such as Fresenius and its spin-off Fresenius Medical Care (GY:FME), which offers a nice package of service-based hospital management expertise and high-end dialysis technology.

Residential care

Investing in residential care in the UK has been a terribly bitter experience after one of the biggest care home providers in the country, Southern Cross, sank with all hands, taking £425m of investors' capital with it. In retrospect, the private equity owner's decision, made prior to the credit crunch and austerity drive, to saddle the company with massive debts before floating it played a major part in its downfall, but the broader question of whether it is possible to make a profit out of rising demand in the sector is highly relevant.

The problem is that the residential care industry, quite rightly, has to provide minimum standards of care backed by legislation and consequently has little room for the kind of cost savings and economies of scale that "normal" businesses might be able to generate. Attempts to parse costs by employing cheaper labour, for example, often lead to the kind of nursing home care scandals that plagued Southern Cross towards the end of its existence. In addition, a care home’s costs are subject to inflation, whereas the fees that can be charged to councils and other public bodies aren't, which means an immediate structural squeeze on companies that have high central costs. This is not a problem for small 'mom and pop' outfits, who can compensate by simply putting in a few more hours, which is probably why the sector in the UK is largely private and unconsolidated.

In fact, getting a decent return might involve simply buying a care home. A quick trawl through property-for-sale websites reveals that owning a care home might be a better use of capital than buying shares in one. Just as an example, a typical return for investors who pay around double a home's annual turnover, on average, will generate a net return on capital of approximately 12.5 per cent.

If buying a care home is beyond your reach then using the bond market to access other parts of social provision might be more realistic. Bonds are offered by social housing providers such as Places for People, which issued a 5 per cent bond for retail investors earlier this year. Backed by an implicit government guarantee and high demand for social housing, the bond has proved popular. If more older people means more visits to the doctor, then Primary Healthcare Properties' 5.375 per cent bond is also a good choice.

Life assurers

Life assurers have plenty to worry about with Solvency 11 regulations and the Retail Distribution Review, and the changes in demography have to a large extent been addressed. In short, the big life assurers are simply concentrating on areas of the world where pension provision is in its infancy. Prudential (PRU), for example, is the UK's largest life assurer by market capitalisation and already Asia is the biggest single contributor to group profits. And the growth potential is enormous, with Prudential aiming to double 2010 new business profits there by 2013. Urbanisation and longevity are increasing in emerging countries at a much faster rate than in developed ones, and while a shift in the ratio between old and young will at some stage become more of an issue, at the moment it is not because there is so much untapped business as emerging nations play catch-up.

As for more mature markets like the UK, the changing ratio between the young and the old is just one problem. The biggest challenge is apathy, with recent research suggesting that more than half of those covered by the new auto-enrolment pension scheme would either opt out altogether or not contribute more than 5 per cent of their salary, a level that may not provide an adequate level of income. Colin Williams, managing director of corporate benefits at Friends Life, summed up the problem thus: "The easiest way to prevent retirement poverty is to encourage employees to start saving early. If auto-enrolment fails to kick-start the fight against retirement poverty, the government will have to consider other options, which may include compelling people to save rather than just nudging them along." Meanwhile, the life assurers are looking elsewhere. JC