Pension systems are often treated as background institutions. Families save. Invest. And prepare for retirement. But in reality, pension structures play a central role in financial markets. Large pools of capital are collectively managed. Investment decisions are limited. And risks are redistributed across generations. This paper presents a new perspective. Pension design is not neutral. Defined benefit plans shape asset prices, risk premiums and economic outcomes. The result is a subtle but powerful mechanism. Pension funds affect both the market and the household. And changes to pension systems could reshape the entire financial balance.
Asset pricing and risk sharing implications of alternative pension plan systems
- NUNO COIMBRA, FRANCISCO GOMES, ALEXANDER MICHAELIDES, JIALU SHEN
- Journal of Finance, 2026
- A version of this paper can be found here here
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Key academic insights
Pension funds are major players in asset pricing
The paper shows that including defined benefit pension funds in asset pricing models significantly improves their ability to match real-world data. These funds are huge. Persistent. And structurally different from families. Their demand for safer assets lowers risk-free rates and increases equity premiums.
Institutional constraints matter for market outcomes
Unlike households, pension funds are not freely optimized. They follow the rules. Face the obligations. And invest more conservatively. This creates imbalances in the demand for assets that households cannot fully compensate for. The result is a direct impact on equilibrium prices.
A new channel of risk emerges through pension funding
Pension fund returns fluctuate. But the promised benefits remain fixed. This gap has to be absorbed somewhere. Either workers or firms adjust the contributions. This creates an indirect exposure to market risk, even for households that do not invest in stocks.
Risk is redistributed across generations
Defined benefit schemes provide a stable income for retirees. But this stability comes at a cost. Workers and firms absorb shocks through changing inputs. This shifts risk away from retirees and concentrates it on the working population.
Defined benefit systems increase the equity premium
Because pension funds invest conservatively and pose additional consumption risk to workers, the model generates a higher equity premium and Sharpe ratio. This helps explain the age-old conundrum of asset pricing.
The move to defined contribution changes everything
When the system moves to defined contribution plans, families must save more individually. The risk-free rate increases. The equity premium falls. And the overall structure of demand for assets varies significantly.
The risk of consumption shifts from workers to pensioners
In a defined contribution world, workers face less income volatility. But pensioners lose the insurance provided by pension funds. As a result, consumption becomes more volatile in retirement.
Practical applications for investment advisors
Understand the role of pension institutions
Asset prices are not determined by households alone. Large institutional investors, such as pension funds, play a key role. Their constraints and objectives shape market outcomes.
Interpret interest rates and risk premiums differently
Low risk-free rates and high equity premiums may partly reflect pension fund demand. Ignoring this can lead to misinterpretation of market signals.
Monitor structural changes in pension systems
The shift from defined benefit to defined contribution plans is not simply a policy change. It has direct implications for expected returns, volatility and long-term asset allocation.
Include indirect risk exposure
Even investors who do not own shares can still be exposed to market risk through income from work or pension contributions. Portfolio advice should reflect this broader perspective.
How to explain this to customers
“Pension systems do more than provide retirement income. They also affect the way financial markets work. In traditional systems, large pension funds invest conservatively and help stabilize income for retirees. But this shifts risk to workers and firms. As many countries move toward individual retirement accounts, this balance shifts. People take on more responsibility and more risk. This affects not only interest rates and the expected return on market.”
The most important chart from the paper
In Figure 2, panel A presents the average life-cycle wealth accumulation (ages 20 to 100) in the core economy and the DC-only economy, separately for type A households and type B households. Panel B presents the ratio of average lifetime wealth accumulation in the DC-only economy relative to the core economy before retirement (ages 20 to 65), separately for households of type A and type B families.
Results are hypothetical results and are NOT an indication of future results and do NOT represent returns actually achieved by any investor. Indices are not managed and do not reflect management or trading fees, and one cannot invest directly in an index.
ABSTRACT
We show that incorporating defined benefit pension funds into an incomplete market asset pricing model improves its ability to match the historical equity premium and the risk-free rate and has important implications for risk sharing. We document the importance of pension fund size and asset requirements, as well as a new channel of risk arising from fluctuations in fund returns. We use our calibrated model to study the implications of a shift to an economy with defined contribution plans. The new steady state is characterized by a higher risk-free rate and a lower capital premium. Consumption volatility increases for retirees but decreases for workers.
Asset pricing and risk sharing implications of alternative pension plan systems originally published in Alpha Architect. Please read the Alpha Architect FINDINGS at your convenience.
