The Allocation of Financial Risks During the Life Cycle in Individual and Collective DC Pension Contracts

Abstract

This paper measures how financial shocks - equity market, interest rate or inflation shocks - affect different generations of participants in pension schemes. We show that an individual scheme, by using a life cycle investment strategy, can largely replicate the allocation of traded risks across generations of a collective pension scheme that gradually adjusts pensions after financial shocks. Collective schemes can shift financial risk to generations that will participate in the future, whereas individual accounts cannot. In the current institutional setting this shift of traded risk in collective contracts to future generations is limited. Collective pension schemes are able to reallocate nontraded risks among the participants to obtain a more efficient distribution of risk across generations. In schemes with individual accounts, risk sharing is limited to risks traded on financial markets.