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Personal pension plans and stock market volatility

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  • Alier, Max
  • Vittas, Dimitri
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    Abstract

    One of the strongest objections to personal pension plans is that they transfer investment risk to individual workers, who are then exposed to the vagaries of equity and bond markets. Using historical United States data, the authors investigate the impact of the volatility of investment returns on replacement rates in the context of personal pension plans. They find large fluctuations in replacement rates across different cohorts of workers, if undiversified portfolios are used. They then explore a number of simple financial strategies for coping with this problem, including: a) portfolio diversification; b) a late, gradual shift to bonds; c) a gradual purchase of nominal or real annuities; d) a purchase of variable annuities. The first three strategies lower the volatility of replacement rates, but at significant cost in terms of lower replacement rates. The purchase of variable annuities reduces the dispersion of replacementrates across generations without lowering their level - because of the persistence of the equity premium and the fact that the volatility of equity returns is lower, the longer the holding period. Sophisticated financial engineering promises more efficient solutions to this problem, but it may not be feasible to apply it in developing countries (or in developing financial markets). Neither authors'approach nor the more sophisticated financial engineering solutions would be able to deal effectively with persistent deviations of investment returns from long trends. But the authors'findings suggest that overconcern about the impact on replacement rates of short-term volatility in stock markets may not be warranted.

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    Bibliographic Info

    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2463.

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    Date of creation: 31 Oct 2000
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    Handle: RePEc:wbk:wbrwps:2463

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    Related research

    Keywords: International Terrorism&Counterterrorism; Payment Systems&Infrastructure; Non Bank Financial Institutions; Pensions&Retirement Systems; Economic Theory&Research; Banks&Banking Reform; International Terrorism&Counterterrorism; Pensions&Retirement Systems; Non Bank Financial Institutions; Economic Theory&Research;

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    1. William N. Goetzmann & Philippe Jorion, 2004. "A Century of Global Stock Markets," Yale School of Management Working Papers, Yale School of Management ysm16, Yale School of Management.
    2. Jeffrey R. Brown, 1999. "Private Pensions, Mortality Risk, and the Decision to Annuitize," NBER Working Papers 7191, National Bureau of Economic Research, Inc.
    3. Zvi Bodie, 2001. "Financial Engineering and Social Security Reform," NBER Chapters, in: Risk Aspects of Investment-Based Social Security Reform, pages 291-320 National Bureau of Economic Research, Inc.
    4. Salvador Valdés & Gonzalo Edwards, . "Jubilación en los Sistemas Pensionales Privados," Documentos de Trabajo, Instituto de Economia. Pontificia Universidad Católica de Chile. 182, Instituto de Economia. Pontificia Universidad Católica de Chile..
    5. Ravi Jagannathan & Narayana R. Kocherlakota, 1996. "Why should older people invest less in stock than younger people?," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Sum, pages 11-23.
    6. Valdes-Prieto, Salvador, 1998. "Risks in pensions and annuities : efficient designs," Social Protection Discussion Papers 20847, The World Bank.
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