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RESEARCH PRODUCT

Subjective Economic Risk to Beneficiaries in Notional Defined Contribution Accounts

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ABSTRACT This article aims to quantify the aggregate subjective economic risk to which beneficiaries would be exposed if a retirement pension system based on notional account philosophy were introduced. We use scenario generation techniques to make projections of the factors that determine the real expected internal rate of return (IRR) and the expected replacement rate (RR) for the beneficiary according to six retirement formulae based on the most widely accepted rates or indices. We then apply the model to the case of Spain. Our projections are based on Herce and Alonso's macroeconomic scenario 2000-2050 (2000) and include information about the past performance of the indices and the time period the forecast is to cover. The results of the IRR calculation-average value, standard deviation, and value-at-risk (VaR)-are analyzed both in objective terms and for different degrees of participants' risk aversion. INTRODUCTION According to Hoskins (2003), we are indeed living in a "pension reform era," and there is no evidence that the pension reform debate is diminishing. On the contrary, it is only just beginning to heat up in certain parts of the world, for example the Caribbean, the Gulf States, and parts of Asia and Africa. The race to reform pension systems in many countries over the last few years has been such that, as Valdes-Prieto (2002) points out, the problems of pension reform have begun to dominate economic policy. The main pension reforms1 proposed and applied can be summarized as parametric reforms of the pay-as-you-go (PAYG) system, changes to other (mainly capitalization) systems, and systems combining capitalization and PAYG, as proposed chiefly by the World Bank. Reform trends championed by the main international organizations can be found in articles by Gillion (2000), Holzmann (2000), and Queisser (2000). One of the most important recent innovations in public pension reform has been the introduction of so-called notional defined contribution accounts (NDCs) in some countries, namely Brazil2 (1999), Italy (1995), Latvia (1996), Mongolia (2000), the Kyrgyz Republic (1997),3 Poland (1999), and Sweden (1999). Other countries such as China, Russia, Austria, and the Czech Republic are also seriously thinking about introducing them. This type of retirement formulation is considered suitable for those countries where, due to special demographic or political conditions, it is difficult to introduce an at least partial accumulation of funds. The system establishes an analogy between the PAYG and capitalization systems by incorporating into the PAYG system actuarial and financial instruments used in the capitalization system. According to Valdes-Prieto (2000), this strengthens the long-term financial solvency of the PAYG system but increases the uncertainty surrounding the pension to be received by the beneficiary.4 This article will concern itself with estimating the aggregate subjective economic risk the beneficiary would be exposed to if a retirement pension system based on NDCs were to be introduced. We will not be measuring the political risk of NDCs, and although the demographic risk will not be analyzed directly either, it is taken into account implicitly when considering a number of indices used to calculate the formula for obtaining the retirement pension. The estimated aggregate subjective economic risk to the beneficiary is applied to the case of Spain, though the model put forward is equally valid for any country. The European Union, the World Bank, and the OECD along with various researchers5 have all strongly recommended an in-depth revision of the Spanish public pension system. All are agreed that, at least in the long term, the financial sustainability of the system is seriously at risk. One valid possibility could be the introduction of notional accounts, as suggested by Vidal-Melia and Dominguez-Febian (2006) and DevesaCarpio and Vidal-Melia (2004). The latter have studied the effect that the introduction of various notional retirement formulae similar to those actually applied in some countries would have had in Spain. …