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 compared to pension schemes based on individual retirement accounts, because current risks can be shared with future generations. We setup a continuous time overlapping generations model with labor income risk and show that this idea may be misguided. For the empirical range of parameter values reported in the literature, 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.