Hostname: page-component-cd9895bd7-gvvz8 Total loading time: 0 Render date: 2024-12-27T09:39:03.107Z Has data issue: false hasContentIssue false
  • English
  • Français

Background Risk and Pensions

Published online by Cambridge University Press:  10 June 2011

M. Cardinale ,
G. Katz ,
J. Kumar  and
J. M. Orszag
M. Cardinale
Affiliation:
Watson Wyatt Ltd, Watson House, London Road, Reigate RH2 9PQ, U.K., Email: michael.orszag@watsonwyatt.com
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper explores the effect of unhedgeable background risks such as mortality and labour risks (such as wages and turnover) on pension funding and finance. We explore the literature on the economics and finance of background risk, and discuss its applicability to pensions. Most of the results in economics apply to the special case of additive background risk, which is part of, but not all of, the background risk faced by pension funds. We develop three illustrative models and show the impact of background risk on pension funding and asset allocation. We find that the asset allocation and funding decisions of pension plans in general change with the introduction of background risk, in some cases significantly. We also explore implications of background risk for fair value calculations.

Keywords

PensionBackground RiskEquity Allocation
Type
Sessional meetings: papers and abstracts of discussions
Information
British Actuarial Journal , Volume 12 , Issue 1 , 01 March 2006 , pp. 79 - 134
Copyright
Copyright © Institute and Faculty of Actuaries 2006

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Alessie, R., Hochguertel, S. & van Soest, A. (2001). Household portfolios in the Netherlands. In Guiso, L., Haliassos, M. and Japelli, T. (eds.), Household portfolios. Cambridge, MA: MIT Press.Google Scholar
Arrondel, L. & Calvo-Pardo, H. (2002). Portfolio choice with correlated background risk: theory and evidence. DELTA.Google Scholar
Artige, L. (2004). Optimal saving with additive and multiplicative background risk. Louvain: Institut de Recherches Economiques et Sociales (IRES), Universite Catholique de Louvain.Google Scholar
Bodie, Z., Merton, R.C. & Samuelson, W.F. (1992). Labor supply flexibility and portfolio choice in a life cycle model. Journal of Economic Dynamics and Control, 16, 427–449.CrossRefGoogle Scholar
Bordley, R. & LiCalzi, M. (2000). Decision analysis using targets instead of utility functions. Decisions in Economics and Finance, 23, 53–74.CrossRefGoogle Scholar
Cagetti, M. (2003). Wealth accumulation over the life cycle and precautionary savings. Journal of Business and Economic Statistics, 21(3), 339–353.CrossRefGoogle Scholar
Cahuc, P. & Zylberberg, A. (2004). Labor economics. Cambridge, MA: MIT Press.Google Scholar
Cardinale, M. (2004). The long-run relationship between pension liabilities and asset prices: a cointegration approach. Paper presented to the Staple Inn Actuarial Society.Google Scholar
Carroll, C. (2001). A theory of the consumption function, with and without liquidity constraints. Journal of Economic Perspectives, 15(3), 23–45.CrossRefGoogle Scholar
Chapman, R.J., Gordon, T. & Speed, C.A. (2001). Pensions, funding and risk. British Actuarial Journal, 7, 605–662.CrossRefGoogle Scholar
Cobb, C.W. & Douglas, P.H. (1928). A theory of production. American Economic Review, 18, 159–165.Google Scholar
Continuous Mortality Investigation Mortality Committee. (2005). Projecting future mortality: towards a proposal for a stochastic methodology. CMI.Google Scholar
Davis, S. & Willen, P. (2000a). Occupation — level income shocks and asset returns: their covariance and implications for portfolio choice. NBER.Google Scholar
Davis, S.J. & Willen, P. (2000b). Using financial assets to hedge labor income risks: estimating the benefits. Working paper, University of Chicago and Princeton.Google Scholar
Diamond, D.W. (1984). Financial intermediation and delegated monitoring. Review of Economic Studies, 60, 393–414.CrossRefGoogle Scholar
Doherty, N.A. & Schlesinger, H. (1983). Optimal insurance in incomplete markets. Journal of Political Economy, 91, 1045–1054.CrossRefGoogle Scholar
Eeckhoudt, L., Gollier, C. & Schlesinger, H. (1996). Changes in background risk and risk-taking behavior. Econometrica, 64(3), 683–689.CrossRefGoogle Scholar
Eeckhoudt, L. & Kimball, M.S. (1992). Background risk, prudence, and the demand for insurance. In Dionne, G. (ed.), Contribution to insurance economics, 239–254. London: Kluwer.CrossRefGoogle Scholar
Elmendorf, D.W. & Kimball, M.S. (2000). Taxation of labor income and the demand for risky assets. International Economic Review, 41(3), 801–833.CrossRefGoogle Scholar
Exley, J., Mehta, S. & Smith, A. (1997). The financial theory of defined benefit pension schemes. British Actuarial Journal, 3, 835–9666.CrossRefGoogle Scholar
Franke, G., Schlesinger, H. & Stapleton, R.C. (2002). Multiplicative background risk. Wissenchaftszentrum, Berlin.Google Scholar
Franke, G., Stapleton, R.C. & Subrahmanyam, M.G. (1998). Who buys and sells options: the role of options in an economy with background risk. Journal of Economic Theory, 82(1), 89–109.CrossRefGoogle Scholar
Fuchs, N. & Schundeln, M. (2005). Precautionary savings and self-selection — evidence from the German reunification ‘experiment’. Quarterly Journal of Economics, 120(3) (forthcoming).Google Scholar
Gollier, C. (2001). Economics of risk and time. Cambridge, MA.: MIT Press.CrossRefGoogle Scholar
Gollier, C. & Pratt, J. (1996). Weak proper risk aversion and the tempering effect of background risk. Econometrica, 64, 1109–1123.CrossRefGoogle Scholar
Gourinchas, P.-O. & Parker, J. (2002). Consumption over the life cycle. Econometrica, 70(1), 47–89.CrossRefGoogle Scholar
Haberman, S., Day, C., Fogarty, D., Khorsanee, Z., Nash, N., Ngwira, B., Wright, I.D. & Yakoubov, Y.H. (2003). A stochastic approach to risk management and decision making in defined benefit pension schemes. British Actuarial Journal, 9, 493–618.CrossRefGoogle Scholar
Haberman, S. & Renshaw, A.E. (2003a). Lee-Carter mortality forecasting: a parallel generalized linear modelling approach for England and Wales mortality projections. Applied Statistics, 52(1), 119–137.Google Scholar
Haberman, S. & Renshaw, A.E. (2003b). On the forecasting of mortality reduction factors. Insurance: Mathematics and Economics, 32(3), 379–401.Google Scholar
Hochguertel, S. (1998). Households' portfolio choices. Tilburg CentER.Google Scholar
Kimball, M.S. (1990). Precautionary saving in the small and the large. Econometrica, 58, 53–73.CrossRefGoogle Scholar
Kimball, M.S. (1991). Precautionary motives for holding assets. NBER.CrossRefGoogle Scholar
Kimball, M.S. (1993). Standard risk aversion. Econometrica, 61, 589–611.CrossRefGoogle Scholar
Lee, R. & Carter, L. (1992). Modeling and forecasting U.S. mortality. Journal of the American Statistical Association, 87(14), 659–671.Google Scholar
Leland, H. (1968). Saving and uncertainty: the precautionary demand for saving. Quarterly Journal of Economics, 82(3), 465–473.CrossRefGoogle Scholar
Lusardi, A. (1998). On the importance of the precautionary saving motive. American Economic Review, Papers and Proceedings, 88(2), 449–453.Google Scholar
Magill, M. & Quinzii, M. (1996). Theory of imperfect markets. MIT Press.Google Scholar
Merton, R. (1969). Lifetime portfolio selection under uncertainty. Review of Economics and Statistics, 51, 247–257.CrossRefGoogle Scholar
Merton, R. (1971). Optimum consumption and portfolio rules in a continuous time model. Journal of Economic Theory, 3, 373–413.CrossRefGoogle Scholar
Meyer, D. & Meyer, J. (1997). Changes in background risk and the demand for insurance. Paper presented at the Risk Theory Society.Google Scholar
Nachman, D. (1982). Preservation of ‘more risk averse’ under expectations. Journal of Economic Theory, 28, 361–368.CrossRefGoogle Scholar
ONS (2001). Twentieth century mortality.Google Scholar
Poon, S.-H. & Stapleton, R.C. (2005). Asset pricing in discrete time. Oxford University Press.CrossRefGoogle Scholar
Pratt, J. & Zeckhauser, R. (1987). Proper risk aversion. Econometrica, 55, 143–154.CrossRefGoogle Scholar
Quiggin, J. (2003). Background risk in generalized expected utility theory. Economic Theory, 22, 607–611.CrossRefGoogle Scholar
Redington, F.M. (1952). Review of the principles of life office valuations. Journal of the Institute of Actuaries, 78, 286–315.CrossRefGoogle Scholar
Richards, S. & Jones, G. (2004). Financial aspects of longevity risk. Paper presented to the Staple Inn Actuarial Society.Google Scholar
Ross, S.A. (1981). Some stronger measures of risk aversion in the small and in the large with applications. Econometrica, 49, 621–638.CrossRefGoogle Scholar
Sakagami, Y. (2005). The effect of FSD changes in multiplicative background risk on risk-taking attitude. Economics working paper archive.Google Scholar
Sharpe, W. (1976). Corporate pension funding policy. Journal of Financial Economics, 3(2), 183–193.CrossRefGoogle Scholar
Sherris, M. (1992). Portfolio selection and matching: a synthesis. Journal of the Institute of Actuaries, 119, 87–106.CrossRefGoogle Scholar
Shiller, R. (1979). The volatility of long-term interest rates and expectations models of the term structure. Journal of Political Economy, 87, 1190–1219.CrossRefGoogle Scholar
Shiller, R. (1994). Macro markets: creating institutions for managing society's largest economic risks. Oxford University Press.Google Scholar
Tuljapurkur, S. & Boe, C. (1998). Mortality change and forecasting: how much and how little do we know? North American Actuarial Journal, 2(4), 13–47.CrossRefGoogle Scholar
Valdés-Prieto, S. (2005). Securitization of taxes implicit in PAYG pensions. Economic Policy (forthcoming).CrossRefGoogle Scholar
Ventura, L. & Eisenhauer, J. (2005). The relevance of precautionary saving. German Economic Review, 6(1), 23–35.CrossRefGoogle Scholar
Viceira, L. (2001). Optimal portfolio choice for long-horizon investors with non-tradable labour income. Journal of Finance, 56, 433–470.CrossRefGoogle Scholar
Vissing-Jorgensen, A. (2002). Towards an explanation of household portfolio choice heterogeneity: nonfinancial income and participation cost structures. NBER.CrossRefGoogle Scholar
Weil, P. (1992). Equilibrium asset prices with undiversifiable labor income risk. Journal of Economic Dynamics and Control, 16(3-4), 769–780.CrossRefGoogle Scholar