The most difficult task for pension fund managers is to properly calibrate risk and return to make sure that pensioners earn a steady income after retirement. Today, this tradeoff is harder than ever. Since 1980, the average person’s life expectancy at retirement has increased by about four years, or one year per decade. This has resulted in greater liabilities for pension funds. In addition, bond yields have decreased to rock-bottom levels, which means that the dollars we save no longer grow as fast as they once did.

How do we ensure a sustainable retirement system in these difficult conditions? We can either force future retirees to increase their level of contributions accordingly, or we can find ways to invest capital more efficiently and take on more risk with the objective of earning higher return.

This tradeoff presents a rock-and-a-hard-place situation for pension plan managers, regulators and policymakers. Any restriction placed on pension plans to take on risk results in bigger contributions from future retirees to ensure there is sufficient capital in the pot to pay the pensions.

For example, take the case of solvency requirements in Canada. These requirements are designed to protect pensioners by requiring pension plans to always have sufficient assets to safely cover pension liabilities. If a plan experiences a sudden drop in assets resulting in a deficit, the plan must eliminate the shortfall by making a special contribution. This is costly and therefore discourages risk-taking.

Read more @Policy Options