By Edmund Cannon and Ian Tonks, Pensions Institute  
We use historical data on investment returns and labour income from sixteen countries to quantify the value and risk of defined contribution pension plans, building frequency distributions of pension fund and pension replacement ratios for each country. We show that pension risk is substantial, and find that pension fund ratios are lower and less variable than when the correlation between wage growth and investment returns is ignored: typically halving the median pension fund ratio. We also show that an all-equity fund is the dominant investment strategy across all countries, although sometimes a life-cycle strategy insures against downside risk.
Introduction
The primary purpose of a pension is to ensure that an individual’s consumption does not fall after the retiring from work: ideally the pension achieves this by providing an income in retirement which is similar to previous labour income. Indeed the pension replacement ratio should be close to unity if the pension is to smooth consumption effectively. The determinants of the pension replacement ratio are the returns on investment – in both the accumulation and decumulation phases of the pension – as well as the determinants of labour income. Importantly, investment returns and labour income are both risky and correlated. In this paper we use a large data set of both variables to measure the overall effect on the riskiness of a personal pension. We find that DC pension fund ratio are lower on average and less variable than they appear to be when the correlation between wage growth and investment returns is ignored. Using the realised wage growth rate and implementing its correlation with investment returns, instead of assuming a constant growth rate, halves the median DC fund ratio.
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