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Conditional Indexation in Defined Benefit Pension Plans

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  • Jacob A. Bikker
  • Peter J.G. Vlaar

Abstract

In 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 Info

Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 086.

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Date of creation: Feb 2006
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Handle: RePEc:dnb:dnbwpp:086

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Related research

Keywords: Average wage defined benefit pension; Monte Carlo simulations; Regulation. J.E.L. Code: C15; C59; G23; J18;

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References

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  1. Lawrence H. Summers, 1982. "Observations on the Indexation of Old Age Pensions," NBER Working Papers 1023, National Bureau of Economic Research, Inc.
  2. E. Philip Davis, 2004. "Is there a Pensions Crisis in the U.K.?," The Geneva Papers on Risk and Insurance, The International Association for the Study of Insurance Economics, vol. 29(3), pages 343-370, 07.
  3. Blake, David, 2000. "Does It Matter What Type of Pension Scheme You Have?," Economic Journal, Royal Economic Society, vol. 110(461), pages F46-81, February.
  4. Ponds, Eduard H. M., 2003. "Pension funds and value-based generational accounting," Journal of Pension Economics and Finance, Cambridge University Press, vol. 2(03), pages 295-325, November.
  5. Peter Vlaar, 2005. "Defined Benefit Pension Plans and Regulation," DNB Working Papers 063, Netherlands Central Bank, Research Department.
  6. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  7. M.C.J. van Rooij & A.H. Siegmann & P.J.G. Vlaar, 2004. "Palmnet: A pension asset and liability model for the Netherlands," WO Research Memoranda (discontinued) 760, Netherlands Central Bank, Research Department.
  8. Zvi Bodie & John B. Shoven, 1983. "Financial Aspects of the United States Pension System," NBER Books, National Bureau of Economic Research, Inc, number bodi83-1, July.
  9. Christian E. Weller, 2004. "The future of public pensions in the OECD," Cambridge Journal of Economics, Oxford University Press, vol. 28(4), pages 489-504, July.
  10. Ponds, E.H.M., 2003. "Pension funds and value-based generational accounting," Open Access publications from Tilburg University urn:nbn:nl:ui:12-347898, Tilburg University.
  11. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, vol. 3(3), pages 183-193, June.
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Citations

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Cited by:
  1. J. Gorter & J.A. Bikker, 2011. "Investment risk taking by institutional investors," Working Papers 11-11, Utrecht School of Economics.
  2. J.A. Bikker & Dirk W. G. A Broeders & David A. Hollanders & Eduard H. M. Ponds, 2009. "Pension funds’ asset allocation and participant age: a test of the life-cycle model," Working Papers 09-25, Utrecht School of Economics.
  3. Maarten Rooij & Arjen Siegmann & Peter Vlaar, 2008. "Market Valuation, Pension Fund Policy and Contribution Volatility," De Economist, Springer, vol. 156(1), pages 73-93, March.
  4. Dirk Broeders & An Chen & Birgit Koos, 2009. "An institutional evaluation of pension funds and life insurance companies," DNB Working Papers 227, Netherlands Central Bank, Research Department.
  5. Jacob Bikker & Jan de Dreu, 2006. "Pension fund efficiency: the impact of scale, governance and plan design," DNB Working Papers 109, Netherlands Central Bank, Research Department.

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