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 allocation of interest rate risk in the existing pension contracts? And what lessons for the future might be derived from that? This Netspar Brief attempts to provide answers to these questions based on recent scientific research and by contrasting theory and practice as seen in existing pension contracts in the Netherlands.
Distribution of interest rate risk over the life cycle can occur in various ways. One option is to vary the risk mix over the life cycle. In the world of defined contribution plans, this is known as life cycle investing. In the Netherlands, the so-called WVP contract, for Wet Verbeterde Premieregeling (Improved Defined Contribution Scheme Act), also falls into this category. That is one of the contracts that has received particular attention in the pension agreement.
Yet, risk is also distributed over the life cycle in plans with uniform collective assets, such as the well-known “FTK contract” (named for the Financial Assessment Framework at its core) that most industry pension funds and occupational pension plans now use. Under that contract, the assets are pooled, and a common investment policy is used for the fund as a whole. Setbacks and windfalls are distributed by looking at the funding ratio, which is a function of the ratio between a fund’s assets and its liabilities. Because of the central role played by the liabilities, these types of plans are also called “entitlement contracts.”
This Netspar Brief calculates the implicit life cycle pattern for both equity risk and interest rate risk for the existing FTK contract. This life cycle follows from the allocation rules in the contract, which determine which risks are allocated to which generations. In this Netspar Brief, these implicit life cycles are compared to what theory says about the desirable or “optimal” allocation of risks.
For equity risk, the implicit life cycle appears to align reasonably well on average with the recommendations from the academic literature. Young people bear relatively more equity risk than older people. This is consistent with life cycle theory, as well as professional practice in existing DC plans.
The distribution of interest rate risk in the existing collective contract, however, is much less in line with recommendations from the academic literature. In an average pension fund, participants over the age of 60, in particular, are more exposed to interest rate risk than is desirable according to theory. The interest rate risk that older age groups implicitly bear is equal to a situation in which interest rate risk remains for the most part open. Whereas, of course, according to theory, it is actually desirable for the interest rate risk to be largely covered for these older age groups. This means that the benefits of this group are insufficiently protected against interest rate risk.
Older people incur a great deal of interest rate risk in entitlement contracts because the funds’ funding ratio, in particular, is vulnerable to changes in the value of the liabilities for the younger participants. In effect, the interest rate risk of the young people falls partially on the shoulders of older people via the funding ratio. This problem is inherent to entitlement contracts, in which interest rate shocks are distributed through the funding ratio mechanism and uniform indexation and cuts to benefits.
What lessons for the future might be derived from this? First, interest rate risk is different than equity risk and should thus be allocated differently over the lifetime. Second, the “ideal” pension contract needs to be able to accommodate this difference in types of risk. A pension contract should contain enough “switches” for properly distributing risks among participants, young and old. An added complication here is that the allocation also differs per fund, according to such factors as age composition. A younger fund might need a different form of risk sharing than an older one, and the same holds true for funds with a homogenous membership base versus those with a highly diverse group of participants (in terms of age or other factors). An ideal pension contract must thus also be able to take this diversity among funds into account.