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Linking Benefits to Investment Performance in US Public Pension Systems

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  • Robert Novy-Marx
  • Joshua D. Rauh
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    Abstract

    This paper calculates the effect that introducing risk-sharing during either retirement or the working life would have on public sector pension liabilities. We begin by considering the introduction of a variable annuity for the retirement phase, modeled on the Wisconsin Retirement System, in which positive benefit adjustments are granted only if asset returns surpass 5% but benefits cannot fall below their initial levels. This change would reduce unfunded accrued liabilities by around 25%, and would lower the annual contribution increases required to target full funding in 30 years by 11%. If there is no minimum benefit guarantee, the impact of introducing variable annuities is substantially larger: the unfunded liability would fall by over half and required annual contribution increases would fall by 44%. Alternative measures that have similar effects on costs include increasing employee contributions by 10.3% of pay while keeping benefits unchanged; or giving employees a collective DC plan with an employer contribution of 10% of pay for future service. We discuss these results in the context of models of lifecycle portfolio choice, which suggest that employees should generally prefer to take risk earlier in their lives rather than later.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18491.

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    Date of creation: Oct 2012
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    Publication status: published as Linking Benefits to Investment Performance in US Public Pension Systems , Robert Novy-Marx, Joshua D. Rauh. in Retirement Benefits for State and Local Employees: Designing Pension Plans for the Twenty-First Century , Clark, Rauh, and Duggan. 2014
    Handle: RePEc:nbr:nberwo:18491

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    1. Tang, Ning & Mitchell, Olivia S. & Mottola, Gary R. & Utkus, Stephen P., 2010. "The efficiency of sponsor and participant portfolio choices in 401(k) plans," Journal of Public Economics, Elsevier, Elsevier, vol. 94(11-12), pages 1073-1085, December.
    2. Ponds, E.H.M. & Riel, B. van, 2007. "Sharing Risk: The Netherlands' New Approach to Pensions," Open Access publications from Tilburg University urn:nbn:nl:ui:12-387569, Tilburg University.
    3. Ponds, Eduard H. M. & Riel, Bart Van, 2009. "Sharing risk: the Netherlands' new approach to pensions," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 8(01), pages 91-105, January.
    4. Jeffrey R. Brown & Nellie Liang & Scott Weisbenner, 2007. "Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans," NBER Working Papers 13169, National Bureau of Economic Research, Inc.
    5. Clark, Robert L. & Schieber, Sylvester J., 2004. "Adopting cash balance pension plans: implications and issues," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 3(03), pages 271-295, November.
    6. Amy B. Monahan, 2010. "Public Pension Plan Reform: The Legal Framework," Education Finance and Policy, MIT Press, vol. 5(4), pages 617-646, October.
    7. Novy-Marx, Robert & Rauh, Joshua D., 2011. "Policy options for state pension systems and their impact on plan liabilities," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 10(02), pages 173-194, April.
    8. Barr, Nicholas & Diamond, Peter, 2008. "Reforming Pensions: Principles and Policy Choices," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780195311303, October.
    9. Jeffrey R. Brown & David W. Wilcox, 2009. "Discounting State and Local Pension Liabilities," American Economic Review, American Economic Association, American Economic Association, vol. 99(2), pages 538-42, May.
    10. Luis M. Viceira, 2001. "Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income," Journal of Finance, American Finance Association, American Finance Association, vol. 56(2), pages 433-470, 04.
    11. Bulow, Jeremy I, 1982. "What Are Corporate Pension Liabilities?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(3), pages 435-52, August.
    12. Horneff, Wolfram J. & Maurer, Raimond H. & Mitchell, Olivia S. & Stamos, Michael Z., 2010. "Variable payout annuities and dynamic portfolio choice in retirement," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 9(02), pages 163-183, April.
    13. Robert Novy‐Marx & Joshua Rauh, 2011. "Public Pension Promises: How Big Are They and What Are They Worth?," Journal of Finance, American Finance Association, American Finance Association, vol. 66(4), pages 1211-1249, 08.
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