Long Term Risk Assessment in a Defined Contribution Pension System

Castaneda, Pablo (2006): Long Term Risk Assessment in a Defined Contribution Pension System.

Abstract

One of the most important consequences of the Chilean pension reform undertaken in the early 1980s was to transfer a significant portion of the risk associated to the financing of pensions, from the State, to the pension fund participants of the newly established compulsory pension system. This paper is concerned with the risk embedded in the portfolio strategies of pension fund portfolio managers. We develop an analytic framework that permits to incorporate the behavior of a pension fund manager in the long-term risk assessment of its investment strategy, where the latter is conducted from the point of view of the pension fund participant, who has preferences over his/her final pension. The pension fund manager’s problem is cast as a dynamic portfolio choice problem, and its solution is used afterwards to quantify the risk exposure of the pension fund participant. Our results from a simulation exercise show that the lower is the risk aversion of the participant, the higher is his/her Wealth-at-Risk —defined as the monetary compensation that leaves the participant indifferent with respect to his/her outside option— a result that is due to the fact that the outside option increases relatively more than the benefit derived from the pension provided by the fund manager. The same logic is behind the negative relationship between stock return volatility and pension risk.

• Item Type: MPRA Paper
• Institution: Superintendencia de AFP (Chile)
• Language: English
• Keywords: Dynamic convex risk measure; Pension system; Portfolio selection
• Subjects: H - Public Economics > H5 - National Government Expenditures and Related Policies > H55 - Social Security and Public Pensions; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions

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