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Analysis of the Pension Risk in Defined Contribution Plan Members
Journal of Insurance and Finance
2009, 20(2),
pp.33-78
Publisher : Korea Insurance Research Institute
Research Area : Business Management
Publisher : Korea Insurance Research Institute
Research Area : Business Management
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In this paper, we investigate the pension risk in defined contribution pension schemes in view of asset allocation strategy and wage growth rate. To measure the downside risk faced by the retiring member of the DC schemes, we adopt the (lump-sum) benefit ratio concept. Benefit ratio is defined as the ratio of the DC to a hypothetical benchmark DB benefit which is equal to final monthly wage multiplied by 30 years. We estimate various risk measures such as shortfall probability, shortfall expectation, VaR, and TVaR and find some conclusions from our analysis. First, the distribution of benefit ratio is very sensitive to the choice of investment strategy. Investment strategy with a low equity weighting gives better results than aggressive investment viewed from downside risk. Second, the member of DC plans can be extremely risky relative to the DB benchmark for the higher rate of wage increase i.e. 8.5%. Third, the trade-off between probability of failing the target benefit ratio and shortfall expectation is important factor when determining the choice of investment strategies for the higher wage growth rate. Fourth, we consider the sensitivity of the equity risk premium. When equity returns are increased by 2 percentage points critical confidence level which accept DC schemes is increased by 19 percentage points. Finally, we adjust the contribution rate for the higher rate of wage increase (8.5%) until we achieve the 95% VaR confidence. The aggressive equity-based asset allocation strategies require substantially higher contribution rates than more conservative bond-based strategies if the same pension benefit is to be achieved.
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