Risk sharing under WTP
It's complicated
I had a few comments about the WTP explainer suggesting WTF might be a more suitable acronym. OK I’m making that up, but it’s true the post explains the “how” but not the “why” of the technique. That’s today’s topic: risk sharing between participants.
Now risk is already a concept that can create a lot of confusion. In different contexts it means different things depending on scope, goals and horizon. A better term might be profit sharing, as the subject is how returns of a pension fund are distributed to members in a fair and transparent manner. I’ll be ignoring the thorny question of financing: whether the plan is funded by the state, employers, or participants. Instead I’ll take the perspective of corporate finance, as we need to consider the fund’s balance sheet and at a minimum distinguish the assets it owns from the liabilities it owes. ALM or Asset-Liability Management is the process of designing an investment portoflio—allocating assets—to correspond to the liabilities and goals of the fund.
So what different kinds of liabilities are there?
The most straightforward balance sheet to consider is that of a DC (Defined Contribution) fund. Here there is no risk sharing: all risk (or profit) is for individual participants. They can manage market risk by investing in a range of funds with different profiles—typically growth vs.income—but own all the outcomes without recourse to other parties. They have an equity claim on the various investment funds. Other risks are also bourne by participants individually. Salient is longevity risk—the questionable risk of outliving your savings—for which many insurers offer a life annuity where you pay them to take that risk.
That brings us to a DB (Defined Benefit) pension, where in an idealized case the participants bear no risk at all. Their lifelong pensions are guaranteed by transferring the risk to an external sponsor, often an employer or an insurer. The pension fund balance sheet then has two types of liabilities: debt to the participants and equity to the sponsor. Any profit flows to the sponsor who may need to be compensated for bearing the risk: this makes DB on average more expensive for participants than DC.
The Netherlands in particular has seen the growth of CDC systems (Collective Defined Contribution) where the risk is bourne not by external sponsors but by active members paying premium. The contracts are DB but risks are bourne within the pool of members. Good outcomes lead to lower premia in future, bad outcomes to higher premia—intergenerational risk sharing. In our aging demographic this has turned out to be unsustainable as the increasing dependency ratio means increasingly risk needs to be bourne by a shrinking base of active members. And investment outcomes have not turned out particularly favorably either.
This longwinded backstory introduces the reforms known as WTP (Wet Toekomst Pensioen or Future Pensions Law). CDC funds may1 transition into full DC contract known as FPR (Flexible Pension) or restructure into SPR (Solidarity Pension) making the different liabilities explicit on the balance sheet. In that case it needs to be made clear upfront which participants bear risk and in what proportions so that outcomes can be realized immediately. Losses can no longer be shifted to hypothetical future generations, so excess profits do not need to be stored in a buffer either2.
The mechanics of the SPR are interesting and I discussed them previously. Participants are grouped into age cohorts—age determines the value of a life annuity—and these cohorts express their risk preferences in an exposure to growth and defensive returns (with leverage, go back to read the details). Of interest to this post is how this realizes the risk sharing: the growth return consists not only of return on growth assets, but all return after subtracting defensive returns3. Therefore a younger participant exposed to only growth return is in principle short the defensive returns promised to older participants. They are senior in both senses!
This illustrates the social value of pensions under new law. SPR funds will be able to provide life annuities which are otherwise expensive due to the scarcity of risk capital in the broader market. This is clearly a benefit for older members, who can acquire a riskless pension product. The other side of the coin is that younger members can sell these annuities for leverage, which would otherwise not be available! The market does not provide many opportunities for unsecured borrowing, that young people without financial assets can invest with capital borrowed against their future incomes is clearly a benefit to them4.
This is in a nutshell the beauty of risk-sharing. Older generations with financial assets but low risk tolerance cooperating with younger generations of their peers with high risk tolerance but less accumulated wealth. The latter can bear the risk of the former, allowing the whole to bear more risk collectively and expect to achieve better outcomes.
They can also keep going in current form, under current law.
This transition involves a tricky restructuring of the balance sheet, that has legal ramifications that I’m not qualified to comment on. Internationally this is the most surprising aspect of the reform: existing claims amounting to hundreds of billions of euros are not being grandfathered but are being restructured.
As can be seen in this formula from the original post, which I can’t link to directly.
Yes you can leverage with derivatives, but then you are short cash. There are economic as well as legal and practical limits to doing this. Here the opportunity is to short annuities and hence invest with some of your future income. Or in terms of Merton’s model: transform human capital into financial capital. The financial market does not provide many opportunities to do this.