Getting Feedback on Defined Contribution Pension Plans

Article excerpt

ABSTRACT

With the growth of private and public defined contribution (DC) pension plans around the world, market rates of return should increasingly play a large role in the retirement patterns of individuals. The reverse could, however, also be true--i.e., a country's population demographics could influence the financial markets. In this article, we model the potential impact of aggregate retirement patterns on macroeconomic variables with the goal of further understanding the implications of a traditional DC pension becoming the predominant source of retirement income for an entire society. We find that the economic-system feedback dampens fluctuations in the size of the working population.

INTRODUCTION

With the growth of defined contribution (DC) pension plans around the world, in both the private pensions and public systems, market rates of return are increasingly likely to play a large role in the retirement patterns of individuals; however, the reverse could also be true (MacDonald and Cairns, in press). A variety of existing theoretical economic models claim that "demographics matter" (Poterba, 2004); i.e., the demographic structure of a population could affect financial markets. The benefit of this article is that we model, for a populationwide DC pension system, the dynamic interaction among the retirement patterns of the population, aggregate demand for assets and financial market returns, as well as between the aggregate supply of workers and general wage growth. We refer to this as "modeling feedback."

This is a companion article to MacDonald and Cairns (in press), which examined the labor force implications of a nationwide pure DC pension system. Using the simulated output from a modeled society populated by DC plan participants, they found that market performance plays an important role in the retirement pattern of workers and creates instability in the ratio of retirees to workers (dependency ratio) from one year to the next. The objective of this article was to incorporate a simple macroeconomic feedback feature into the stochastic simulation model of MacDonald (2007) and investigate its effects. If the population's retirement patterns do indeed impact the financial rates of return and wages, this feedback could potentially dampen or exacerbate the swings in the dependency ratio.

There has been a growing interest in the relationship between changing demographics and the impact on financial market returns. The focus of the majority of the literature has been the response of the financial market to the baby-boom; more precisely, it has explored how changing age cohort sizes create a change in asset demand and the associated impact on the financial returns. Such studies are motivated by the demographic transition occurring in the United States and in many other developed countries.

Unlike these previous studies, we assume a stationary and stable population model. Rather than the age structure, it is the level of labor force participation in our population that varies and affects the financial asset demand, which could then affect the equilibrium of the financial market. Although modeling changes in the population size and age structure distribution is an interesting topic for future work, this article examines only a stationary population model in order to clarify the implications of a pure DC pension system on interaction between the workforce demographics and economic variables, and to distinguish this impact from the effects of shifts in the demographic age structure.

Despite the constant age structure in our model, previous age structure studies have provided several insights that have contributed to our feedback model and our general analysis. In the coming section, we provide a brief review of the findings that have helped us in our investigation.

We divide our article into four parts. "Previous Literature on the Aggregate Impact of Asset Demand on Financial Markets" discusses past research on the relationship between financial market returns, demographics, and asset demand in the context of our analysis. …