Optimal Risk Sharing in a Collective Defined Contribution Pension System

Abstract

We analyze a collective defined contribution pension fund which aims at intergenerational risk sharing among different age cohorts using a return smoothing mechanism. Using a utility based framework, we find that approximately one third of unexpected return shocks should be directly passed on to all the cohorts in the year the shock occurs by means of the smoothing mechanism. We demonstrate that risk sharing implemented in this way is welfare improving compared to a plan with no risk sharing and more sustainable compared to defined benefit pension fund plans. Additionally, we show that the asset allocation of such a pension fund automatically corresponds to the life-cycle portfolio choice theory.