The Equity Risk Premium and Pension Ambition: The Effect of Parameter Uncertainty

Abstract

We model uncertainty of financial parameters and examine its impact on the replacement rate in a DC pension contract. To this end, we develop a novel Bayesian framework that reveals substantial reduction in the lower percentiles for the replacement rate at retirement. We identify that the key factor driving our results is the uncertainty of the equity risk premium. Our model shows that a time-varying contribution scheme based on observed interest rates and previous equity return can partially compensate for the effect of parameter uncertainty.

Keywords: Pension contracts, model uncertainty, equity risk premium

JEL Classification: D91, H55