Conditional Indexation in Defined Benefit Pension Plans
AbstractIn the Netherlands, the typical pension contract nowadays comprises an average earnings defined benefit pension in which only nominal benefits are guaranteed, but with the intention to provide wage indexation. In the new supervisory regime, the guaranteed pension rights, based on market valuation, are subject to risk-based solvency requirements. Provisioning is not required for conditional pension rights, though contributions have to be consistent with the indexation ambition, as communicated with the participants. This paper analyses to what extent indexation is indeed likely, given different indexation and contribution policies. Thereby, it explains how intergenerational risk sharing in defined benefit pension plans can provide a reasonable insurance of pension benefits against wage or price inflation. Moreover, it illustrates the tenability of defined benefit pension plans under ageing, the new fair-value accounting regimes, and possible volatility on financial markets. The analysis is based on a stochastic Pension Asset and Liability Model for the Netherlands (PALMNET). According to the PALMNET simulations, voluntary provisioning for indexation is to be recommended. Without reserving, indexation cuts may be severe and the solvency requirements incidentally lead to extreme premiums. Fully guaranteed indexation is virtually unaffordable under the new supervisory regime, because the real discount rate is generally both very low and volatile.
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Bibliographic InfoPaper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 086.
Date of creation: Feb 2006
Date of revision:
Average wage defined benefit pension; Monte Carlo simulations; Regulation. J.E.L. Code: C15; C59; G23; J18;
Find related papers by JEL classification:
- C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
- E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
- G3 - Financial Economics - - Corporate Finance and Governance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-02-19 (All new papers)
- NEP-EEC-2006-02-19 (European Economics)
- NEP-FIN-2006-02-19 (Finance)
- NEP-IAS-2006-02-19 (Insurance Economics)
- NEP-MAC-2006-02-19 (Macroeconomics)
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