From Defined-Contribution Towards Target-Income Retirement Systems

Abstract

The current trend towards Defined Contribution (DC) retirement systems around the world has rendered the risk management of pension funds crucial for the financial health of millions of people. Severe market downturns have put in evidence the need for more effective practices to control losses of retirement income for pension funds' investors. Although the move from the static allocation of policy portfolios toward target-date funds (TDFs) encouraged by regulators features significant improvements, the latter strategies completely ignore the variations in the cost of financing future consumption, which lessens the strategies' ability to control losses in retirement income. While optimal long-term portfolio selection literature emphasizes the importance of hedging against changes in the discount rates that determine the cost of financing future consumption, TDFs strategies, regulatory incentives, and reporting to pension funds' investors disregard the variations in long-term discount rates by focusing in absolute returns. We address these shortcomings by (i) developing performance metrics, such as DC funding-ratios, that foster appropriate incentives for pension fund managers and more sensible and simple reporting to their investors, (ii) introducing a series of asset allocation rules designed to secure a minimum level of target-income in retirement regardless of the returns of the risky assets in the portfolio. The strategies are consistent with insights from long-term portfolio theory and have the critical advantage of being free of any model or parameter estimation risks. We illustrate its advantages relative to a standard TDF strategy in terms of retirement security.

Keywords: Asset Allocation, Pension Fund Regulation, Portfolio Insurance, Risk Management

JEL Classification: G11, G18, J26