Optimal risk-sharing in pension funds when stock and labor markets are co-integrated

A well established believe in the pension industry is that collective pension funds should take  more stock market risk (compared to individual retirement  accounts)  since risk may be shared with future generations. We extend the OLG model of Gollier (2008) by adding labor income risk in the spirit of Benzoni, Collin-Dufresne, and Goldstein (2007) and show that this idea may be misguided. For the empirical range of parameter values reported by Benzoni et. al., we find that optimal risk-sharing actually implies that collective pension funds should take less stock market risk, not more. If labor income and dividend income are co-integrated, efficient risk-sharing policies should transfer risk from future generations to current generations instead of the other way around. Furthermore, we find that the potential welfare gains from intergenerational risk-sharing are significantly lowered.
 
Keywords: Dynamic portfolio choice; Labor income risk;  Pension; Retirement; Intergenerational risk-sharing; Funded pension systems.
JEL classifications: H55, G11, G23, J26, J32.

Working paper no. 595