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Controlling the Cost of Minimum Benefit Guarantees in Public Pension Conversions

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  • Kent Smetters

Abstract

Unfunded defined-benefit (DB) public pension plans throughout the world are being converted to funded defined-contribution (DC) plans that typically contain a minimum benefit guarantee (DC-MB). Risk management techniques must be used to control the cost of these guarantees. The most common technique is to 'over-fund' the benefit: the contribution rate is set high enough so that the expected benefit is much larger than the guaranteed minimum benefit. This paper shows that while over-funding is very effective in controlling guarantee costs in traditional DB plans, it is highly ineffective for DC-MB plans. This result holds even at very large contribution rates and when risky investments are restricted to a very diversified index like the S&P500. Calculations show that the true risk-adjusted value of unfunded guarantees in a realistic DC-MB plan equals 40 to 90 percent (or more) of the value of the unfunded liability in the DB benefit being replaced, depending on design. This result is true even when the contribution rate in the DC-MB plan is chosen to produce an expected benefit five times larger than the DB benefit. This paper considers two approaches to controlling guarantee costs. The first approach borrows from the recent catastrophic insurance literature. A 'standardized' portfolio is guaranteed, requiring agents to accept 'basis risk' if they chose a non-standard portfolio. However, for large conversions from DB to DC-MB plans, in which there is little or no DB benefit remaining the government must still worry about any 'implicit guarantee' extending beyond the standardized portfolio, thereby enticing agents to accept a lot of basis risk (a 'Samaritan's Dilemma'). The second method, therefore, uses a more brute force approach: private portfolio returns in the good states of the world are taxed while returns in the bad states are subsidized. Both options are very effective at controlling guarantee costs, and they can be used separately or together. Calculations demonstrate that all of the unfunded liabilities associated with modern pay-as-you-go public pension programs can be eliminated under both approaches even at a modest contribution rate.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8732.

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Date of creation: Jan 2002
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Publication status: published as Smetters, Kent, 2002. "Controlling the cost of minimum benefit guarantees in public pension conversions," Journal of Pension Economics and Finance, Cambridge University Press, vol. 1(01), pages 9-33, March.
Handle: RePEc:nbr:nberwo:8732

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  1. Feldstein, Martin (ed.), 1998. "Privatizing Social Security," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226241012.
  2. Martin Feldstein & Andrew Samwick, 1997. "The Economics of Prefunding Social Security and Medicare Benefits," NBER Working Papers 6055, National Bureau of Economic Research, Inc.
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  7. Martin Feldstein & Andrew Samwick, 2000. "Allocating Payroll Tax Revenue to Personal Retirement Accounts to Maintain Social Security Benefits and the Payroll Tax Rate," NBER Working Papers 7767, National Bureau of Economic Research, Inc.
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    • Feldstein, Martin & Liebman, Jeffrey B., 2002. "Social security," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 4, chapter 32, pages 2245-2324 Elsevier.
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Cited by:
  1. Hoevenaars, Roy P.M.M. & Ponds, Eduard H.M., 2008. "Valuation of intergenerational transfers in funded collective pension schemes," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 578-593, April.
  2. Sergi Jiménez-Mart�n & Alfonso R. Sánchez Mart�n, 2007. "An evaluation of the life cycle effects of minimum pensions on retirement behavior," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(5), pages 923-950.
  3. Olivia S. Mitchell & Alexander Muermann, 2003. "The Demand for Guarantees in Social Security Personal Retirement Accounts," Working Papers wp060, University of Michigan, Michigan Retirement Research Center.
  4. Sule Sahin & Adem Yavuz Elveren, 2009. "A Cost Analysis of a Minimum Pension Guarantee for the Individual Pension System in Turkey," Working Paper Series, Department of Economics, University of Utah 2009_13, University of Utah, Department of Economics.
  5. Marie-Eve Lachance & Olivia S. Mitchell, 2002. "Understanding Individual Account Guarantees," NBER Working Papers 9195, National Bureau of Economic Research, Inc.
  6. Marie-Eve Lachance & Olivia S. Mitchell, 2003. "Guaranteeing Individual Accounts," American Economic Review, American Economic Association, vol. 93(2), pages 257-260, May.
  7. Richard Johnson, 2003. "Portfolio choice in tax-deferred and Roth-type savings accounts," Research Working Paper RWP 03-08, Federal Reserve Bank of Kansas City.
  8. Muermann, Alexander & Mitchell, Olivia S. & Volkman, Jacqueline M., 2006. "Regret, portfolio choice, and guarantees in defined contribution schemes," Insurance: Mathematics and Economics, Elsevier, vol. 39(2), pages 219-229, October.

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