Hello, welcome back. I am Ian McDonald, and this is the second video in the sequence on the Economics of Ageing. And in this video I'm going to talk about the risky world in which we age. In the first video I explained the economic challenge of ageing. That is, how can a reasonable level of consumption be supported when one's old? And this is a proper challenge, because when one's old, one's income from work decreases, usually to zero. As I have explained there is two sources of support, from saving when you were younger, and also from taxpayer-financed consumption. Now let us think about the risky world that we live in. And there are significant risks, and I will focus on three categories of risks. Financial risks, Longevity risks, and Health risks. And all these risks are important. They all affect how one, they all make it more difficult to plan for one's old age. First, the financial risks. Financial risks got to do with the fluctuations in the, especially in the stock market, in the price of shares. And we observe, on a daily basis, share prices going up and down. And we observe also periodically, crashes in the share market, like for example the crash that caused the global financial crisis back in 2008. We see these, we see huge fluctuations. Now, this is obviously an important issue for people who are accumulating wealth in financial assets either directly or indirectly through superannuation schemes. Secondly, longevity risks, this is to do with how long you're going to live? So you might think to describe extra life as a risk is a little bit of a peculiar use of the language. But that in terms of financing consumption that is exactly what it is. If you live a long time then you've got many years of consumption that need to be supported. The interesting thing is as we will see in a few moments life expectancy varies a lot across people, so therefore it is a very risky calculation. Thirdly, there's health risks. And so, old people, obviously, suffer from varying degrees of ill health. And it's the varying degrees, which are important. And if there's, and so, for any particular individual, that individual is uncertain as to where that individual is going to suffer a major health cost or minor health cost. Now let's just then focus on the financial risks and to introduce that I want to point out three financial facts of life. Firstly, higher returns usually come with higher risks. Financial planners will tell people making decisions about their financial planning, that's often the first thing they'll say to them, look, you've got to realise, if you go for something with a high rate of return, then you're going to, then you're going to go for an asset, which is more risky. So you can think of like a very risk-free asset as government bonds. Government bonds lending the government is very safe. It's rare for a government to to renege on their, on their bonds. And so therefore you don't face much risk on government bonds. Hence they are they return relatively low rates of interest. On the other hand, if you think of start up companies, new companies, well like say for example, in IT well then the risk is enormous. They might be the next Google or they might crash. They'll get nowhere. And obviously, many of them crash relative to the numbers that become the next Google. And so you, and so those companies, if they want to get money, venture capital in order to start up, they're going to have to offer very high rates of return to compensate people for taking on higher risks. So that's an important financial fact of life to bear in mind. Higher returns come with higher risks. Secondly, a rule of the financial markets is that you can't beat the market. You might think that you have knowledge of a project that's going to be particularly profitable. But if you reflect for a moment you will, you realise that there's lots of people in the financial market. And they're all thinking about what are good projects. And so it's all very well for you to think, I know of a good project. But your next thought should be but then other people will also know this good project. What's so special about my knowledge? If you've got inside knowledge, then that's a different thing, but insider trading using inside knowledge is illegal. So, the general rule is, you can't beat the market. If there's some really good project out there, some project that's offering a high flow of profits then, the value of that project will go up, and it will cost a lot of money in, to buy the shares in that project. The third important financial factor of life is that there's a desirable level of regulation of financial institutions. To have no regulation at all is not a very sensible thing for financial institutions. Banks, for example, they suffer from a problem that depositors may suddenly take it into their minds to draw out money form a bank and leave a bank in a liquidity strapped position. Banks lacking in liquidity they might, the banks might be solvent in the sense of having very sensible long term investments. On the one hand, but on the other hand, overnight they might find it very difficult to cover the withdrawals if suddenly the public take it into their mind to start a run on that bank. And in as far as the public see this they will be either increased incentive to take out their money from the banks, and so it's a vicious circle. So there's various regulations that try to address this, like reserve requirements liquidity requirements, where banks are required to hold a certain amount of liquidity, and there's also governments in many countries offer deposit insurance. So that if banks do fail depositors are reimbursed through government money and the very fact of this deposit insurance makes people more confident that their money will not go down the drain and therefore there is less likelihood of a run on the bank. Let me talk then a little bit about superannuation. Superannuation is obviously an important asset that people accumulate for their old age. We can make a broad distinction between defined benefit and defined contribution plans. Defined benefit plans are where you pay into a superannuation plan. And then when you retire, the benefit, your income stream is determined in advance. So you know that you will get so many dollars per year for the rest of your life until you die, that's a defined benefit scheme. Those schemes were very popular when I was young, however, in recent years, there's been quite a shift towards defined contribution scheme because financial institutions have been worried about all the risk they bear from defined benefit schemes. A defined contribution scheme is where you put in a defined amount during your life, your working life, but then when you retire, you have a capital sum, and it's up to you to manage that capital sum for the rest of your life. So that's a defined contribution scheme. Now, managing those funds is not easy. And so you have to worry about exactly how how you should do that. Another feature of superannuation sorry another division of superannuation is active-managed funds versus passive funds. So some funds, are actively managed. That is to say they are run by funds managers who on a day to day basis are reconsidering how to hold the assets of the fund. Shifting the assets from one, from shifting the, the wealth of the fund from one asset to another asset. Maybe it's mining assets this week, and then next month, it might be retail assets, and so on. And so that's an actively managed fund. Passive funds take a longer view. In a passive fund, what happens is that there's much less shifting around of the wealth of the fund between different assets. Now, the interesting thing is that for the actively managed funds, they have to employ more financial planners, more people to make these decisions. And it seems that these financial planners perhaps earn quite a lot of money. In any event active funds, active managed funds tend to have a much higher cost. And many, several studies have found in fact that once you take into account the higher costs incurred by the active managed funds. The net returns to the, the person who's putting the money in, that's you the superannuation person who's buying superannuation, the net return is actually lower. One person who did a study on this said the best rule of thumb in terms of choosing superannuation is to choose a lower cost rather than a higher cost fund. So that's the view of one particular person. Finally there is capital sums versus lifetime annuities. A capital sum is, you retire, you got so many thousand dollars. A lifetime annuity is where you have some agreement with a financial institution, such that they'll pay you a certain amount per year for the rest of your life. A defined benefit superannuation fund is a lifetime annuity. Lifetime annuities have a, a great attraction in that they insure you against longevity risk and they also give you some guidance about how fast to spend your wealth. Whereas capital sums, you got a real problem of how fast to run down the capital sum, especially given that you don't know when you're going to die, and so that obviously makes things very complicated. Longevity risk is quite an important challenge for old people. People we just don't know when we're going to die, in general. I mentioned in the previous video that the average woman in the US say 65 years, may expect to live a further 20 years. Well, that's the average person. However, of 65-year-old women in the US 25% will live more than another 25 years. So, that's not the average of 20 years. Well, instead of that, they're looking at least another other five years. And obviously significant numbers of people will live into their late 90s and this is an increasing trend. So, this, this risk of having a very long lifetime to support is becoming very important, is very important. Another 25% will live less than 13 years, so that's a relatively short time. And basically when you're 65, seems like you can die pretty much any time, and so that makes longevity risk a serious issue. As I suggested just now, annuities and defined benefit superannuation are ways in which to handle this longevity risk. Then there is health care risk. There is considerable variation in health care costs across people. And to give you an idea of that sort of variation, there's consider a study of total health care costs, public versus private in Australia. And so these people, they, they study, they looked at health care costs by age. And to take one of their results for women in Australia in their 75th year 5% will have health costs greater than $21,000 which is a lot and 5% will have health costs less than $1,000 which is not very much. So you can see there's a high variation and when you're say 65, how do you know which group you're going to be in. Those numbers are health costs, they're public plus private. So there are the cost borne by the government, plus the cost borne by the, by the individual directly, and, but let me make it clear that the government bear the majority of health costs. So taxpayer support of health care plays a major role in spreading the risk of high health care costs across the general population. We all pay taxes, and then those of us unfortunate enough to suffer from bad health and from requiring high health care costs. Those will then get supported by the rest of us. It's a way of spreading the risk of high healthcare costs. So, as you see, people's wellbeing when old is subject to considerable risks. The risks I've emphasised are financial risks, longevity risks and health care cost risks. Now, dealing with these, well the financial markets are very helpful in dealing with financial risks. In that what they allow individuals to do is to spread their wealth over many different assets. And then, what one is doing there is, one is saying, well, some assets will do badly, but some assets will do well, and on average, things might work out too bad. And financial markets, that's a big benefit of financial markets, that they allow one to do this. Government intervention clearly helps a lot in the, as you see, people who live for a long time, and they get pensions until they die, and people who suffer from high health care costs, then they get more support from the tax-payer than those people lucky enough not to have bad health problems. And so in those, those ways in which, those are ways in which the risky environment is dealt with. However, we will see in the next videos that there's other problems that we have to take into account. There are behavioural problems, which make decision making, especially coping with these risks, but just more generally in coping with this long time horizon of taking into account one's ageing years, one will see that the behavioural shortcomings may lead to problems, and lead to problems in dealing with these risks. And we'll also see in the fourth video the growing fiscal pressure maybe will exaggerate, it will exacerbate the economic challenge of ageing. Well I hope to see you in the next video. Thank you.
