Measuring risk capacity
In the recently concluded pension agreement, arrangements have been made about, among other things, a new pension contract (see Ministry of Social Affairs and Welfare, 2020). The aim is to ensure that participants will be able to achieve the same pension level as they can now. Obligation of pension schemes is retained and pension funds will continue to carry out and invest pension schemes collectively. In principle, pension income will depend on the return on contributions and will therefore move more directly with the development of the economy. Excessive fluctuations in the pension result will be absorbed by means of a collective solidarity reserve, which will be filled from contributions and excess return. The new pension therefore involves intergenerational risk sharing.
It has been agreed in the pension agreement that older people will be assigned less risk than younger people. A key question is how to organize the investment policy (WVP) or the allocation of excess returns (new pension contract) per group of participants. If one assumes a steady income from work that is constant during the working life, and abstracts from other income (from, among other things, a partner and from the free (house) capital that is built up by households themselves), the pension fund must, according to standard investment theory, follow the strategy of ‘life cycle investing’: compared to older people, the pension assets of younger participants should be invested relatively more in ‘risky assets’, because the present value of the remaining income from work (Human Capital) is greater than that of older participants. In other words, young people have more “risk capacity” than the elderly do. The risk tolerance will then determine how much extra investment risk a pension fund should take on behalf of the young people (see, for example, Bovenberg et al., 2007; and Teulings and de Vries, 2006). This project is not about measuring risk tolerance (see the Topicality project by Riedl et al.), but about differences in risk capacity as a result of age differences, based on assumptions other than risk-free constant future income from work, and about differences other than in labor incomes. This includes free assets, home ownership, income and pension of the partner. We will investigate the following questions:
- What other characteristics of risk capacity of the residual labor income of that participant are conceivable and relevant, if the assumption of risk-free constant labor income is abandoned? For example, we can think of career effects, part-time work, sleepers and uncertain income from work.
- What characteristics of risk capacity, other than the value of labor income, are conceivable and relevant? For example, we can think of the value of the free financial assets of households, the net value of the house (after deduction of the mortgage debt), other income of the household (the present value of the remaining income from work or pension income of the partner of the participant).
- What welfare effects does an incorrect estimate of the risk capacity have?
Read the paper here.