Netspar Brief 19: Interest-Rate Risk, the Life Cycle, and the Pension Agreement

The low interest rates and resulting impending cuts are an indication of how important interest-rate risk is for pensions. While a great deal is known about the distribution of equity risk over the life cycle, many questions remain regarding interest rate risk. How much do we need to hedge against interest rate risk? Who is in a better position to bear interest rate risks: young people or older people? What about the distribution of interest rate risk in the existing pension contracts? And what lessons for the future might be derived from that?

This Netspar Brief by Roel Mehlkopf (Tilburg University) and Servaas van Bilsen (University of Amsterdam) reveals that under the current pension contracts, the pension benefits of participants age 60 and older are inadequately protected against interest rate fluctuations. The current defined benefits agreement, moreover, offers insufficient possibilities for distributing interest rate risk between young and old in a desirable manner. An important lesson for the future is that interest rate risk differs from equity risk and should therefore also be distributed differently over the lifetime of participants. An “ideal” pension contract would treat different types of risks differently and include enough “switches” for properly distributing risks among participants, young and old.

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Download the Netspar Brief
Review the background paper and calculations of Netspar Brief 19 Illustratie Optimaal Lifecycle Beleid of Servaas van Bilsen, Roel J. Mehlkopf, Netspar Occasional paper, 2020 (in Dutch).