Optimal Investment for Retirement with Intergenerational Benchmarking
By Luke Servat & Antoon Pelsser
Countries have demonstrated a tendency to switch their second pillar toward defined contribution plans, increasing the market-sensitivity of pensions. This can lead to large differences across generations within a pension fund, as otherwise similar cohorts may experience different market conditions during accumulation. In this paper, we investigate how each cohort should invest if the goal is to reduce the likelihood of unlucky generations, in the presence of equity, interest-rate and annuity-conversion risk. We do so without risk-sharing between cohorts, such that differences are reduced purely through the investment strategy. We introduce an intergenerational benchmark based on the pension income of the immediately preceding cohort and derive a closed-form solution for the optimal life-cycle investment strategy. We find that intergenerational benchmarking changes the timing of risk exposure: the optimal strategy reduces exposure in the non-overlapping parts of consecutive cohorts’ accumulation phases and shifts risk-taking toward periods shared across cohorts. This substantially reduces differences in retirement income between nearby generations while maintaining comparable expected pension outcomes. Finally, welfare losses from underestimating intergenerational preferences are much larger than those from overestimating them.
Source SSRN
