“Human wealth is risky – even among similar individuals, lifetime earnings vary widely”

What is the focus of the paper?

While much attention has been given to measuring the risk preferences of pension participants, there remains a need for a reliable way to measure their risk capacity – that is, their ability to bear investment risk in their pensions. This paper aims to address that gap by developing a comprehensive measure of risk capacity across the full work-life cycle for different groups of pension participants.

What are the key findings?

Risk capacity is defined as the ratio of risk-free to risk-bearing components within an individual’s total wealth portfolio, which includes financial wealth, pension entitlements, social security, and human capital. Focusing solely on financial wealth provides a limited perspective, especially since, for most individuals, human capital or human wealth, the present value of future labor income, is the largest component of total wealth. This paper presents an empirical measure of risk capacity based on individuals’ total lifetime wealth, using long-term Dutch registry data that span the full working lives of a recently retired cohort. We focus specifically on human wealth and its associated risks. Human wealth varies substantially over the life course, particularly by initial income at age 30. While part of this variation reflects stable characteristics such as educational level, considerable differences remain even after accounting for initial income. This underscores the riskiness of human wealth across all groups, segmented by gender, income level, and employment sector.

What are the implications?

  • Human wealth and its associated risks must be carefully measured to assess an individual’s ability to bear investment risk in their pensions.
  • Administrative data are preferable to surveys for measuring risk capacity, capturing the total wealth portfolio of participants, and allowing for breakdowns by age, gender, income, and sector.
  • The Dutch state pension (AOW) serves as a crucial safety net, particularly for women and individuals with low initial incomes.