Live long and prosper. If this is society's marker for progress, we have scored only a partial success. Today’s babies can indeed be expected to live 14 years longer than those born half a century ago thanks to improved healthcare, technology and other modern day advances. Increased prosperity, though, has proved much harder to achieve: living longer costs more. 
The big challenge facing society now is to accumulate enough wealth to fund longer lives in general and longer retirements in particular.
That will require a new approach to investment. The time has come to discard the traditional theory that, as retirement nears, workers should allocate a greater proportion of that saving to lower-risk assets such as government bonds. Our research suggests such a strategy will not deliver the necessary returns to fund retirement.
In order to secure a retirement income equivalent to 50 per cent of their final salary, today’s 30-year-olds would need to generate an annual real return of at least 5.3 per cent on their pension pots. While historically such performance has been possible in a half bonds-half equities portfolio, bond yields are now extremely low. Add in modest economic growth and we expect long-term returns on a 50/50 portfolio from today’s levels to be about two percentage points short of the required rate of return.
The upshot is that investors will have to consider higher-risk investments, including developed market equities, emerging markets, illiquid assets and private equity. As longer lifespans prolong investment horizons, we believe that tolerance for liquidity risk will increase.
New models
How will asset prices react to the changing demographic landscape? To begin with, we need to dispense with the idea that asset class valuations revert to the historical mean.
If, as we expect, appetite for riskier investment grows, stocks’ price-to-earnings or price-to-book ratios could rise beyond what investors have come to accept as reasonable levels. Assets that look expensive relative to history, therefore, may yet turn out to be cheap relative to the future.
For instance, public and private companies with strong and consistent growth prospects, as well as ones with a solid dividends track record, could command bigger valuation premiums than has been the case historically. The quest for higher returns should also favour emerging markets over their slower growing developed peers, particularly euro zone and Japanese equities.
Rolling 5yr annualised return (per cent)
Source: Datastream
In fixed income, it won’t be too long before investors realise that government bonds’ capital reservation powers are diminishing. Real returns on US government bonds turned negative in 2017 for the first time since the early 1980s (see chart) and the scope for future capital gains appears limited. Central banks are shifting from net bond purchases to net sales, while government issuance is likely to rise to pay for increased costs of caring for the elderly. Buying bonds at today’s prices for the long term could prove particularly painful, and we would expect global demand for bonds to start dropping.
In short, longevity risk is looming large over the global economy in general and the investment world in particular. To adapt our portfolios for longer lives and longer retirements, we will need to take on more – not less – risk. Both individual investors and the asset management industry as a whole will need to adapt.
Supriya Menon is senior multi asset strategist at Pictet Asset Management. The views expressed above are her own and should not be used as investment advice.