Default investment strategies in a defined contribution pension system: a pension risk model application for the chilean case

Abstract

AbstractIn a defined contribution pension system, one of the main risks faced by members refers to the investment of funds. In this context, we discuss which is the most suitable risk measurement for the affiliates to the pension system. Different life-cycle investment strategies are evaluated under this measure for different types of workers. We point out the importance of designing well-suited default investment options in light of the economic behavior of members, characterized by low financial knowledge, inertia and myopia in decision-making. We calibrate a pension risk model for the Chilean economy, including measures of life-cycle income, human capital risk, investment and annuitization risks. Our results suggest that affiliates can gain (loss) around 0.85 percentage points in terms of average replacement rates in return for an increase (decrease) of 1 percentage point in risk, measured as standard deviation of replacement rates. Using a stochastic dominance analysis, we find that there are no dominated strategies when subsidies from the Solidarity Pillar are excluded. When the Solidarity Pillar is considered, the most appropriate investment strategies for affiliates that receive these subsidies are concentrated on the riskier funds. However, this also means that there could be increased pressure on Government spending in order to grant additional benefits to affiliates. Our model has a wide range of practical applications that go from informing affiliates about the degree of uncertainty associated to their expected replacement rate to a guide to evaluate how different investment strategies affect the expected values of affiliates' pensions and their associated risk.