Intergenerational risk sharing in collective DC
The purpose of the proposed research is to develop the analysis of Pareto efficient financially fair contracts further, in order to arrive at CDC plan designs to be implemented in products that could be offered to collectives by a PPI or a similar institution. Specific research questions include the following.
- What are the characteristics of collectives that enhance the attractiveness of risk sharing agreements? It may be expected that a suitably defined notion of heterogeneity will play an important role in answering this question. Risk sharing may not have much of an added value for groups of households who are all more or less the same in terms of positions and exposures. If agents are different (in a financial sense), we can expect that it will be more interesting for them to form risk sharing collectives. Propensity for risk sharing must be analyzed in relation to the nature of the risk involved (investment risk, longevity risk, and so on), and must also be considered in relation to the opportunities for risk sharing offered by financial markets at large, as discussed below.
- Financial markets provide an important source of risk sharing potential. This potential can be used by a collective in order to provide desired exposure to its participants which can be allocated through an internal risk sharing mechanism. The collective then acts as a “syndicate” in the sense of Wilson. Of course, participants additionally have access to financial markets on an individual basis. As a result of market frictions (transaction costs, credit concerns), it may be more attractive for participants in a collective to share risks among each other than to make use of instruments that are offered on the financial markets. On the other hand, external markets may offer more flexibility to meet individual needs. The design of a CDC product must take this into account and has to strike a balance between the three forms of risk sharing that are available to participants in a collective: internally, externally through the collective, and externally on an individual basis. The element of collective choice (i.e. asset mix as a fund decision in view of risk sharing mechanisms that are in place) has not been covered yet in the work of Cui and Ponds on swap design.
- A collective with internal risk sharing may be viewed in game-theoretic terms as a coalition. Even when there are incentives for internal trading due to the presence of frictions in the external markets, the relative positions of partners in the coalition are likely to change over time, which may threaten the stability of the coalition. The question needs to be investigated how internal risk sharing can be designed so as to assure the stability of the coalition over time. Financial fairness is likely to be important in defining proper rules for entry to and exit from the collective at times other than at career start or end.
- In relation to the previous items, an important question that should be addressed is how elements of individual choice can be built into an internal risk sharing system. Theoretically speaking, it is always better to provide households with more elements of choice, but behavioral economics suggests that actually a limited choice might be preferable in practice, and that it is important to provide sensible defaults. The heterogeneity that was discussed in item 1. above is likely to be expressed through a classification of participants into categories,for instance based on age. One possibility that may be investigated is to allow participants to choose the category they want to belong to; the default choice would naturally follow the participant’s own characteristics, but deviation is allowed. This also may provide a mechanism for participants to exert influence on collective risk-taking.
- In a large part of the literature on portfolio optimization, preferences are specified in terms of expected utility, and frequently even more specifically in terms of a power utility function. This specification of preferences often leads to relatively tractable results and provides insights in the effects of changing levels of risk aversion. For purposes of product design however it is important to take into account features that are prominent in participants’ evaluations of pension plan design, such as the notions of “guaranteed level” and “aspiration level”, and (to the extent that the retirement phase is part of the design) the variability of paid benefits. An investigation is needed into the formalization of such criteria and their use in the design of risk sharing systems.