Risk Pooling and the Market Crash: Lessons From Canada's Pension Plan
by Ashby H.B. Monk and Steven A. Sass
June 2009
IB#9-12
Introduction
Defined contribution plans are now the nation’s primary private retirement income program and repository of retirement savings. About two thirds of the assets held in such plans are invested in equities, as is the case in the defined benefit plans they largely replaced. Equities can dramatically reduce the cost of providing retirement incomes, given their high expected returns. But, as illustrated by the recent market crash, equities are also risky. The resulting losses (and gains) in retirement income are also distributed very unevenly in the nation’s 401(k)-IRA system. The crash hardly affected the retirement prospects of the young: the bulk of the retirement income they will draw from 401(k)s and IRAs will come from future contributions and future returns. Those at the cusp of retirement, by contrast, are heavily exposed: retirement savings are then at their peak and there is little time to adjust work, saving, and retirement plans in response to the market crash.
This concentration of risk is highly troubling, as the 401(k)-IRA system has become the nation’s primary private retirement income program, and has led to calls to reform. The challenge is to capture the higher expected returns equities offer in a way that provides reasonably secure and reliable incomes in retirement. One approach would make individual retirement accounts more secure and reliable through the use of mandates, defaults, guarantees, or risk-sharing arrangements. This brief offers a different approach, examining the Canada Pension Plan (CPP) and how it manages the risk that comes with investing retirement savings in equities...
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Ashby H. B. Monk is a Research Fellow at the Center for Retirement Research at Boston College (CRR) and the University of Oxford. Steven A. Sass is Associate Director for Research at the CRR. The authors would like to thank the staff of the Canada Pension Plan Investment Board and the Office of the Chief Actuary of Canada for responding to queries and reviewing early drafts. Anthony Webb, our colleague at the CRR, was an able guide to various subtleties in the analysis of risk. All judgments and any errors in the brief, however, are those of the authors alone.