Lecture Notes: The Economics and Finance of Pensions
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Cours
The Economics and Finance of Pensions
Établissement
Tilburg University (UVT)
All and full lecture notes of the course The Economics and Finance of Pensions. Written in year 2022/2023 for the Master Finance at Tilburg University.
Lecture 1
D D
The agent has to maximize Max ∑ U (Ct ) subject to ∑ C t =wT and U ( C t ) =C t
1−γ
t =1 t =1
Subject to the Cashflow t * (1+r)^-t.
Wage weight * Number of years of work (T)
wT/D = smoothing consumption.
D = years to live
Let op het percentage aan consumption of wage and what amount is set aside for pension.
At the age of 20: 45 years of labour income left. AT age 65 there’s no human capital left (wage).
Financial capital increases if t<T
W*(D-T)/D.
At retirement age maximum wealth is reached.
Polls
In US most people don’t set aside much for their pension. There it’s not mandated, individual choice.
In Netherlands you don’t choose, employer decides. At least 20% but probably even more.
Free choice: people hardly save for later.
Either all money is invested in risky assets or even more (borrow money). For young active workers.
(= accumulation phase, only get money out after the retirement age).
In most pension products, there is risk-taking, but less. Approximately 20% is invested in risky assets.
Example from earlier is far too simple.
- Interest rates are non-zero
Risks are ignored
- Longevity risk: Uncertainty about time of death (save or insure?)
- Labor market risk: Will one work fulltime, with fixed wage?
- Risk in financial markets: Risky investment opportunities available and potentially attractive
Individual preferences and choices are ignored
- Retirement date does not have to be set in advance, partial retirement ..
- Partners, children, bequest motives
- Agents are irrational (few people pay adequate pension contributions voluntarily, e.g. self
employed NL)
,Pension systems vary across the world, different in all countries.
- Funded systems = Netherlands
- Unfunded system (paying for your parents)
- Defined benefit: you get a promise, if the risks are against you, someone else pays for you
(employer, future participants)
- Defined contribution: your amount of money is invested
Video’s on Canvas, before next lecture.
DB = Defined Benefit.
State county or government will pay.
Pension agreement June 2019 (dutch)
Possible to take partial lumpsum at retirement date for maximum of 10%. Was not possible before.
Uniform contribution and uniform accrual system (not entirely fair)
Decumulation phase: you take the money out of the pension (after retirement)
How to divide current wealth into parts that belong to each person?
Exam:
Lecture material, main arguments from papers
Book is more a framework.
Trying to understand main concepts of the chapters in the book.
- Book not really up to date on some subjects
Heterogeneity
Different setting from where most pension systems were built on.
Can is be tuned to these differences between individuals?
People used to stay for 40 years at 1 employer. Now we have flexible labour careers.
Uniform accrual etc: paying too much when you’re too young. You get it back when you’re old, but
now in the Netherlands you get it back when you’re still an employee.
Do you want to have a choice? What will be your choice? In US, of course people want to have a
choice. In other countries they want to protect people from wrong choices.
Nowadays, the pension funds are larger than the companies (like Philips).
Why do we have pension funds?
1. Consumption smoothing over time (to counter depreciation human capital, even if no risks
involved) (“Piggybank function”)
- Accumulation phase: transform human capital into pension capital (saving)
- Decumulation phase: transform pension capital in consumption (dissaving)
- Compare simplest example before
2. Provide insurance idiosynchratic shocks (risk pooling)
- Idiosyncratic shocks: Long life (in unproductive phase) and short life or depreciation human
capital (if you get disabled) (in productive phase)
- Insurance = risk can be pooled
, o Old-age pensions are life-long payments (annuities): protect against longer than
expected retired life
o Survivor benefits protect against short life in active phase
o Disability insurance and pensions insure risk of too rapid depreciation of human
capital
If you don’t pass away before certain age: no income, this is provided by others.
3. Risk sharing/trading
- Macro-economic financial risks (good and bad times in the economy and/or stock market):
these risks cannot be pooled: shift risks to whom is most able (willing) to bear them given
the reward to take this risk (e.g. equity premium)
- Increases in overall life expectancy likewise macro factor to be shared or traded
- Pension systems can potentially help to share risks (trade them internally in the collective)
where markets are incomplete and/or distortions are sizable (e.g. macro-longevity risk,
Dutch inflation (no ILB market), …) (Index-…-Bonds)
Risks that hit everyone at the same time: trade or share them.
4. Incorporate individual preferences and circumstances adequately
- Individuals best know their own preferences and characteristics (e.g. retirement timing,
consumption plans, health status, external assets (house)): argument in favor of choice
- Individuals often make ‘behavioral mistakes’, Should one “nudge” them? E.g. not saving
enough, not insuring longevity risk, overconfidence in investment decisions
- If choices are not actuarily fair (i.e. do not require same capital) offering choice options could
be costly for the pension provider or other participants (option for participants to choose A
or B). = disadvantage of offering choices.
If there’s no public market, the pension fund can still trade internally.
People are overconfident.
Public policy purposes of pensions
- Social purposes
o Poverty relief
o Redistribution of income and wealth across and within generations
o Sources of heterogeneity
o Company/Sectoral pension systems (healthcare, horeca etc)
To obtain the AOW: you have to live in the Netherlands, if you worked outside of NL for 10 years,
you only obtain 80% if it.
- Well-functioning labour markets
- Pension arrangements can stimulate saving and thereby economic growth and development
of capital markets.
Some companies only offer pension after worked there for more than 1 year.
, Lecture 2
Germany, France: PAYG. Left side of the graph. Right: funded systems.
Accumulated pension wealth per individual is larger in Netherlands than Germany.
What if stock prices drop? In funded pension countries, the pension wealth drops.
Burden on future generations? Germany: burden is much larger in PAYG countries.
Ownership rights. In funded system: some property rights
DB & DC
All risks with the employer = DC. DB is risk for individual.
Individual choice with respect to asset allocation? DC. Cannot in DB.
Pension income linked to final salary: DB 70% of salary a month before retirement. DC = depends on
the amount of money of return on investments.
Real life: all systems are somewhere between DB and DC!
DB and DC are extremes.
Lawyers see clear differences between DB and DC.
Legally the Dutch pension reform implies that all plans will become DC.
In many countries there’s quite some freedom in choosing retirement date. Actuarially fair choice.
Lot of heterogeneity in preferences: more preference for choice.
Prefer mandating over choice:
- Choice dimension is susceptible (gevoelig) for moral hazard spending all and then
applying for government support.
- Vulnerable for over-estimating once abilities investment decision for example.
- Substantial risks but not expensive to insure partner pension (before 60’s impact is huge,
even if you both have an income. Probability is low so cheap to insure)
Actuarially fair = capital needed for choice 1 and for choice 2 is the same.
AOW you cannot choose your retirement date, you get it as of the specified age.
Not factor dependent: communication and you don’t want to change the system every year,
discrimination also, not allowed.
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