Intergenerational Risk Sharing in Individual Retirement Schemes

Abstract

Individual retirement savings schemes could benefit from risk-sharing mechanisms between generations that take behavioral aspects into account. We introduce a novel risk-sharing mechanism that incorporates nominal loss-aversion in two ways. First, the system avoids out-of-pocket wealth transfers by sharing only a fraction of positive returns over a high-water mark of pension assets. Secondly, payments from a generation insurance fund are targeted at nominal pension shortfalls below a reference point, which mitigates the loss experience at retirement. From a simulation of overlapping generations with stochastic asset returns and interest rates we find that the generation insurance scheme outperforms a pure individual retirement scheme by a significant margin: a similar risk of pension shortfall can be achieved with a contribution rate that is up to 20% lower. The efficiency gains vary with the extent of risk sharing over generations but remain large for sensible parameter values.