Intergenerational Effects of Guaranteed Pension Contracts

Abstract

In this paper we show that there exist intergenerational cross-subsidization effects in guaranteed interest rate life and pension contracts as the different generations partially share the same reserves. Early generations build up bonus reserves, which are left with the company at expiry of the contract. These bonus reserves function partly as a subsidy of later generations, such that the latter earn a risk-adjusted return above the risk-free rate. Furthermore, we show that this subsidy may be large enough to explain why late generations buy guaranteed interest rate products, which otherwise would not have been part of the optimal portfolio allocation.

Pension Fund Design under Long-term Fairness Constraints

“…One could allow for additional, non-marketed noise in the processes A and L, but we will impose the simplification that the only source of uncertainty is B, which is hedgeable. Hence, in line with recent studies, for example Dskeland and Nordahl (2008a), we focus on the savings part of the contract, in particular we disregard mortality.…”

“…As pointed out by Dskeland and Nordahl (2008a) different, even nonoverlapping, generations in a with-profits pension fund may systematically subsidise each other because the bonus reserve does not belong to a specific subset of the collective, but to the collective as a diffuse whole. One way of partially overcoming this is to price each contract correctly by adjusting the terms to reflect the fund's financial and demographic condition at the time of underwriting.…”

The design of pension contracts: on the perspective of customers

“…Another widely used method is to find the optimal portfolio which gives the largest utility for customers. If one contract exists in the optimal portfolio while the other does not, then the former should be viewed as a more attractive product for customers (see Døskeland & Nordahl, 2008 a ).…”

Fairness versus efficiency of pension schemes

“…In a pension context intergenerational redistribution has-to our knowledgebeen addressed mainly by Døskeland and Nordahl [3]. Their model, however, is so vastly different from the one presented below that comparison is futile.…”

“…They conclude that it is unfavourable to take part in the accumulation phase of a pension fund, and vice versa. One particular distinction between [3] and the model of the present paper is that they consider overlapping generations explicitly whereas we deal with disjoint generations. Overlapping or contemporary generations can easily be studied within this paper's framework, however.…”