Pension saving schemes with return smoothing mechanism
The smoothing of capital market returns is possible if the pension plan allows for some kind of intergenerational risk transfer. This can be realized if the total of assets of the pension fund is not fully allocated to individual saving accounts but part of the assets is allocated to a collective reserve (unallocated fund). High capital returns are then used to feed the collective reserve while poor capital market returns (or even losses) are compensated by withdrawals from the collective reserve. Traditional with-profit (or participation) life insurance contracts are basically designed in this way; however in most cases the smoothing process is quite opaque and leaves room for opportunistic management decisions. We introduce a continuous time model to discuss two questions: firstly, what kind of benefit do pension savers draw from a return smoothing mechanism and secondly, how should the smoothing mechanism be steered in order to maximize the benefit for the savers. We will derive limit distributions for the smoothed return process and discuss the risk return profile of smoothed pension schemes.
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