Risk Sharing and Stand-Alone Pension Schemes

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Risk Sharing and Stand-Alone Pension Schemes Arij Lans Bovenberg Netspar, Tilburg University, P.O. Box 90153, Tilburg, 5000 LE, The Netherlands. E-mail: [email protected]

Pension schemes increasingly are stand alone, in the sense that they lack a risk-absorbing sponsor in the form of the government or corporations. This paper describes various principles for how stand-alone pension schemes should optimally share risks among participants and trade risks on capital markets. In this connection, it discusses the optimal liability structure of pension funds, the optimal link between retirement and longevity and the role of longevity bonds in sharing demographic risks across generations. The paper also highlights the need for labor-market reforms that enhance the accumulation and maintenance of human capital and allow the speed and time of retirement to act as a way to buffer risk. The Geneva Papers (2007) 32, 447–457. doi:10.1057/palgrave.gpp.2510143 Keywords: pension schemes; risk; labor market; human capital

Introduction All over the world retirement systems are under severe pressure. Public pay-as-you-go (PAYG) schemes in continental European countries are especially vulnerable to lower fertility because they rely on human capital of the young to finance the pensions of older generations. As generations invest less in the human capital of the next generations by reducing fertility, they should invest more in financial capital. Hence, lower fertility calls for gradually shifting from PAYG financing to funded pension schemes.1 Several countries with large PAYG systems are thus focusing the public scheme more on poverty alleviation by gradually reducing earnings-related PAYG benefits for those earning higher incomes. At the same time, several developments have led to the demise of corporate definedbenefit plans in which companies guarantee fixed pension benefits by absorbing all financial market and demographic risks. First of all, ageing of the members of the schemes has expanded the obligations of the schemes compared to the premium base (see Figure 1). With the financial and actuarial risks of pension obligations thus starting to dominate the risks of their core business, companies no longer want to underwrite the risks of their pension schemes. Moreover, in an increasingly competitive and dynamic world economy, firms are able to offer less security to their employees. Indeed, the increased bankruptcy risk of sponsoring companies implies that workers with defined-benefit claims are saddled with the substantial credit risk of the company for which they work. Finally, new accounting rules force companies to

1

See Sinn (2000).

The Geneva Papers on Risk and Insurance — Issues and Practice

448

1400 1200 Pension liabilities

Wages

1000 800 600 400 200 0 1990

2001

2030

Figure 1. Liabilities and premium base of Dutch pension funds in millions of euros, 1990–2030. Source: Westerhout et al. (2004).

disclose their pension obligations on a market basis. This is another stimulus for companies to get out of the pensi