Replicating intergenerational longevity risk sharing in collective defined contribution pension plans using financial markets

Abstract

Intergenerational risk sharing is often seen as a strong point of the Dutch pension system. The ability to absorb financial and actuarial shocks through the funding ratio allows for the smoothing of returns over generations. Nevertheless, it implicitly means that generations subsidize each other, which has its disadvantages, especially in the light of incomplete contracts and situations of hard regulation constraints. This paper highlights the advantages of intergenerational risk sharing as a main characteristic in certain collective pension plans, investigating if and how much of this can be replicated by individual participation in the market. Using a stylized model based on different pension plans such as “hard”/“soft” defined benefit, collective/“pure” defined contribution, this paper identifies the effects of an increase in life-expectancy as one of the most important actual demographic shocks. The existence of regulatory constraints modifies agents’ behavior so that they tend to choose individual investment to ensure their retirement savings. In the absence of regulatory constraints, individual investment under-performs and highly replicates pension fund performance. Thus, choosing collective participation is more rational. Moreover, as the effect of the shock is decomposed, a discussion of the absorption heterogeneity by different plans is presented.