Model risk in a CDC pension scheme

Model risk in a collective defined contribution (CDC) pension scheme is analysed. It is seen that the scheme manager’s view of the future affects the balance of payments between generations in the scheme. This is also an important risk because the scheme manager chooses the model but the members bear the consequences of the model risk.
The surprising result is that it is the entropy of the probabilistic model chosen by the manager to predict the future, which affects the payments. The higher the entropy, the greater the difference in the payments between the generations in the scheme.
The conclusion is that the manager of a CDC scheme should optimise the member’s outcomes by minimising the model risk. This may be a more effective tool to optimise outcomes than controlling the investment risk, since the raison d’etre of CDC pension schemes is to take investment risk.