March 16, 2010

Macroeconomic Risks and Pension Returns

This paper assesses the risk factors associated with the return to both funded and unfunded social security. The paper distinguishes productivity risk (as a proxy for wage risk), demographic risk, and asset return risk in its various forms.

It provides a survey of the literature that discusses these risk factors, and it quantifies these risks by means of a VAR models that generates a joint distribution of these risk factors.

It appears that there is only limited mean reversion in both productivity growth and asset returns, so that risks continue to grow with the length of the horizon. As a result, the level of pension benefits becomes progressively more uncertain over longer time horizons. For PAYG systems, the main source of uncertainty in benefits is productivity risk.

The long-run annual benefit growth risk is 2%, about the same size as the long-run expected growth rate. In a PAYG DC scheme expected benefit growth rates are slightly negative over the next few decades.

Equity-funded pensions are substantially more risky than PAYG pensions, with a long-term annual standard deviation of returns of 14%, but they offer substantially larger expected returns as well.

The contribution of demographic risk factors to pension return risk appears to be limited, because the effect of demographic changes on dependency ratios can be predicted several decades ahead.