Hear from a Researcher: Damiaan Chen “Retirement offers some nice challenges”

“Retirement offers some nice challenges”

The retirement landscape is in flux, and there are always new questions in need of answers. Science plays an important role in this, as do young, new researchers who approach pension and retirement research with a fresh eye. In this series, we ask them about their motivations and findings. This time, we hear from Damiaan Chen (UvA and DNB). He worked with Roel Beetsma and Sweder van Wijnbergen to quantify the wealth loss derived from unprotected inflation risk: “an international problem.” 

“Retirement and pensions is not an obvious direction to choose, but it does contain a great many elements that make it interesting. The field has big policy implications and is subject to a great deal of political debate. Plus, there are huge sums involved, and it is complicated, with risks that play out over extremely long terms. Modeling that is a fun challenge. So, it was a great opportunity to be awarded this individual research grant.”

Economic Gains
“My research at Netspar was on the impact of unprotected inflation risk on the wealth of retirees. That is the risk that the price index will climb without the retirees being appropriately compensated. There currently exist no financial instruments in the Netherlands for hedging against such specific risk. What is more, younger and older pension participants have different consumption demands and thus essentially face different rates of inflation. In our study, we attempted to quantify the impact on wealth of these two sources of unprotected inflation risk. Depending on the assumptions you use, such as the risk preferences, we estimated that this problem could result in a 1% to 8% wealth loss during retirement. If you could better hedge against that risk, it would lead to economic gains.”

Consumption Patterns
“The problem of unhedged inflation risk is to some extent specific to the Netherlands. One solution would be to offer safe government bonds indexed to inflation. For example, there are some European inflation swaps out there, and some European countries offer those sorts of bonds with inflation protection.[1] There is another source of the problem that pertains to all countries, however: retirees might not be interested in general insurance against price increases because it doesn’t work with their consumption patterns. For instance, elderly people spend more money on health care and younger ones on education. It is more effective, then, to base indexation on the consumption demands of a particular target group, but that is also currently not possible because we lack the necessary price index.”

Inter-generational Solidarity
“Although we didn’t model any solution paths, we do describe how governments could offer so-called index-linked bonds that would offer inflation protection to pension funds. In addition, we need to acquire a better understanding of the different consumption bundles of older and younger people. The first step in that is to collect data, based upon which you can index the change in pension value for older people. That would require a certain level of inter-generational solidarity. Since spending patterns probably differ considerably, young people would be subsidizing the inflation insurance for older people or vice versa. This could only occur in a collective pension fund, where working together leads to a win–win situation, even in cases where a fund may not have an entirely balanced membership base. A grayer fund will have fewer younger members to provide security, but this could be compensated for by higher fees.”

Want to know more?

Dr. Damiaan Chen graduated from the Economics and Business Faculty of the University of Amsterdam (UvA) and is currently working as a regulatory specialist at the Dutch central bank (DNB). As a postdoc at UvA, Dr. Chen conducted a Netspar study of unprotected inflation risk with Roel Beetsma and Sweder van Wijnbergen.

Read the paper Unhedgeable Inflation Risk within Pension Schemes by Damiaan Chen, Roel Beetsma, and Sweder van Wijnbergen.

You can also read the ESB article “Hogere welvaart als inflatierisico van pensioen beter kan worden afgedekt” (Greater Prosperity through Better Hedging of Inflation Risk in Pensions) by Damiaan Chen, Roel Beetsma, and Sweder van Wijnbergen (in Dutch).

[1]Such as Great Britain, Germany, France, Italy, Spain, Denmark, and Sweden.