Optimal Intergenerational Risk-Sharing When Stock and Labor Markets Are Co-integrated

A well-established belief in the pension industry is that collective pension funds with mandatory participation can take more stock market risk in comparison to a system with individual retirement accounts, since current risks may be shared with future generations. We setup a continuous time OLG model with labor income risk in the spirit of Benzoni, Collin- Dufresne, and Goldstein (2007) and show that this idea may be misguided. For the empirical range of parameter values reported by Benzoni et. al., we find that optimal risk-sharing actually implies that collective pension funds should take less stock market risk, not more. If stock and labor markets move together in the long run, it is no longer efficient to shift risk from current to future generations, because their human wealth becomes correlated with current financial shocks. Furthermore, we find that the potential welfare gains from intergenerational risk-sharing are significantly reduced.