Journal of Risk

Paul Cox

Birmingham Business School

The way in which pensions are provided is changing. Countries around the world are responding to demographic change by shifting pension policies toward funded and individual investment schemes (in Ireland, France and New Zealand, for example), auto-enrolling workers into schemes (in countries such as the UK) and requiring contributions by employers and/or employee members (this occurs in both Australia and the UK).

and requiring contributions by employers and/or employee members (this occurs in both Australia and the UK). Membership of defined benefit (DB) schemes is also in long-term decline as employers close DB schemes to new members, and sometimes even to existing ones. In the UK, active membership of private-sector DB schemes halved between 2000 and 2005, and halved again between 2005 and 2007. In 2008, just a quarter of private-sector schemes and a third of all DB schemes were still open to new members. Pension reforms and the decline in the number of DB schemes are swelling the membership and assets of defined contribution (DC) schemes. The switch to DC schemes in many countries is now quite advanced, with more active members and more money flowing into DC schemes than is flowing into DB schemes. This has sparked interest in how the risks associated with DB and DC schemes are distributed and shared, as well as in the possibilities for risk sharing in DC schemes. The “Risk Sharing in Defined Contribution Pension Schemes” conference held in January 2010 can be seen as an attempt to address some issues of risk sharing in DC schemes. The aim was to reach out internationally. During this two-day conference (supported by NetSpar and the UK’s Department for Work and Pensions), participants from industry and from the policy making and academic spheres presented and discussed issues including, but not limited to:

The role of investment return guarantees. One proposal involved a minimum-return guarantee consisting of a swap. There was discussion of what type of third party (government, central bank or insurer, perhaps) could, or would, underwrite and intermediate the swap.A second proposal was for a DC scheme to purchase investment return guarantees in the market. There was discussion of the relatively high cost of these, the preferences and characteristics of individuals that most desire them, and the main beneficiaries. A further presentation suggested the trading of financial surpluses or deficits from cohorts of members as they retire from targetdate retirement funds. There was discussion of the need for a buyer of last resort to be available if counterparties for the surpluses or deficits cannot be found – one with a strong enough covenant and enough financial capital to hold open financial positions across generations if need be.

Construction of lifestyled target-date funds for the management of age-based risks. There was discussion that target-date funds and “lifestyling” were a possible alternative to risk sharing because they are carried out with a view to reducing the amount of inappropriate risk borne by individual members of DC schemes at different points in their age profile. Fitting investment risk more appropriately to age and/or other characteristics may reduce or remove the need for investment risk sharing.

The nature of the building blocks of DC schemes. Actuarial participants presented the case that, so long as growth assets with uncertain capital return and distributions are among the basic building blocks of DC schemes, questions of risk sharing are likely to present themselves. This has been starkly highlighted by the financial crisis. The proposed solution was a collective DC scheme and a target investment return. The collective DC scheme would provide a vehicle for both the growth stage of the fund as well as organizing the payment of pensions during retirement.

The papers in this special issue draw upon the themes discussed at the conference. The paper by Giuseppe Grande and Ignazio Visco investigates a minimum-return guarantee consisting of a swap. In the swap agreement, a third-party organization would pay a future pensioner the value of the guarantee in exchange for the portfolio of financial assets accumulated in the pension fund if the value of the fund at maturity is below the guaranteed level. The authors suggest that underwriting by the government would be both sustainable for the government and would give workers an acceptable benefit–contribution ratio.

In the second paper of the issue, Joseph Simonian describes how target-date funds could hedge financial market tail risks through risk management techniques based on market instruments. The author uses the example of acting in an anticipatory way to hedge tail risk by purchasing deep-out-of-the-money derivatives in normal times. The issue that the paper addresses is important for debates concerning the mitigation of rare and catastrophic event risk (tail risks). The paper ends by describing an indicator of tail dependence that, it is suggested, is consistent with multifactor pricing models. Laurence Booth and Bin Chang investigate target-date funds in their paper entitled “Target-date funds: good news and bad news”. Such funds are a means by which DC schemes manage age-profile risks, but their study finds that some 2010-dated funds increased their equity exposure in 2007. This resulted in significant losses for investors planning to retire in 2010. The authors question whether there is a role for regulation and oversight in order to ensure that target-date funds do manage risk as they imply.

The paper by S. G. (Fieke)Van der Lecq andAdriW. I. M.Van derWurff investigates the level of contributions into DC schemes that would be required to provide the same level of assurance of retirement outcome as that of a DB scheme. The study finds that realizing a DC pension with the same confidence level as a DB pension would require almost 2.5 times more contributions, due to individuals bearing the investment risk. The authors conclude that DC schemes without risk sharing are unaffordable for participants and employers when compared with DB schemes.

Csaba Burger and Gordon L. Clark study risk sharing between employers and employees in German supplementary occupational pensions. The results suggest that individuals themselves are not averse to riskier retirement investment vehicles. Rather, it is employers that are the more risk-averse and may consider limited-risk investment vehicles as a responsible choice for their own and their employees’ financial safety. I conclude by thanking the reviewers for their comments, which helped the authors to further improve the content of their papers. The collation of these five papers would not have been possible without the support of the Department for Work and Pensions and NetSpar. I take this opportunity to thank all of them very warmly for their involvement at various stages of these events.