| There is increasing interest in whether changes in the age distribution have effects on financial markets. However, it remains unclear how slow-moving, easily predicted demographic change can have significant effects on markets that are rational and forward-looking. This paper addresses this question. It presents an overlapping generations model in which agents save for retirement and make a portfolio decision over risky equity and riskless bonds that are in zero net supply. The model is solved numerically and yields portfolio behavior in which agents shift from stocks to bonds as they age. Agents behave in this manner because of a non-traded asset, human capital, which they implicitly hold. Using the model to simulate a baby boom-baby bust shows that the difference between the return on stocks and bonds increases substantially when boom turns to bust. At this point a large cohorts of old boomers must trade with a smaller cohort of young investors, and the return on bonds falls substantially relative to the return on equity to clear the bond market. As a result the return on baby boomers' retirement savings is significantly below the steady state return, an effect baby boomers cannot diversify away. From a policy point of view, this result is important because much of the debate over reform of public pension systems takes the historical distribution of asset returns as given. The paper also demonstrates that a pay-as-you-go pension scheme fails to insure agents against the risk of being born into a large cohort, because the same demographic forces that depress asset returns also reduce the retirement benefit of baby boomers. The paper concludes that government as an infinitely-lived agent can insure agents against this risk, by making transfers of wealth across generations. |