Controlling the Cost of Minimum Benefit Guarantees in Public Pension Conversions
AbstractUnfunded 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8732.
Date of creation: Jan 2002
Date of revision:
Note: AG PE
Contact details of provider:
Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Web page: http://www.nber.org
More information through EDIRC
Other versions of this item:
- 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.
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2002-02-10 (All new papers)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Martin Feldstein & Elena Ranguelova & Andrew Samwick, 1999.
"The Transition to Investment-Based Social Security when Portfolio Returns and Capital Profitability are Uncertain,"
NBER Working Papers
7016, National Bureau of Economic Research, Inc.
- Martin Feldstein & Elena Ranguelova & Andrew Samwick, 2001. "The Transition to Investment-Based Social Security When Portfolio Returns and Capital Profitability Are Uncertain," NBER Chapters, in: Risk Aspects of Investment-Based Social Security Reform, pages 41-90 National Bureau of Economic Research, Inc.
- Alan J. Marcus, 1983.
"Corporate Pension Policy and the Value of PBGC Insurance,"
NBER Working Papers
1217, National Bureau of Economic Research, Inc.
- Alan Marcus, 1987. "Corporate Pension Policy and the Value of PBGC Insurance," NBER Chapters, in: Issues in Pension Economics, pages 49-80 National Bureau of Economic Research, Inc.
- 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.
- Pesando, James E, 1982. " Investment Risk, Bankruptcy Risk, and Pension Reform in Canada," Journal of Finance, American Finance Association, vol. 37(3), pages 741-49, June.
- Marcus, Alan J, 1985. " Spinoff-Terminations and the Value of Pension Insurance," Journal of Finance, American Finance Association, vol. 40(3), pages 911-24, July.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Martin Feldstein & Jeffrey B. Liebman, 2001.
NBER Working Papers
8451, National Bureau of Economic Research, Inc.
- Martin Feldstein & Andrew Samwick, 1997.
"The Economics of Prefunding Social Security and Medicare Benefits,"
in: NBER Macroeconomics Annual 1997, Volume 12, pages 115-164
National Bureau of Economic Research, Inc.
- Martin Feldstein & Andrew Samwick, 1997. "The Economics of Prefunding Social Security and Medicare Benefits," NBER Working Papers 6055, National Bureau of Economic Research, Inc.
- Feldstein, Martin (ed.), 1998. "Privatizing Social Security," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226241012, June.
- John Y. Campbell & Martin Feldstein, 2001. "Risk Aspects of Investment-Based Social Security Reform," NBER Books, National Bureau of Economic Research, Inc, number camp01-1, December.
- Marie-Eve Lachance & Olivia S. Mitchell, 2003. "Guaranteeing Individual Accounts," American Economic Review, American Economic Association, vol. 93(2), pages 257-260, May.
- Gupta Ramesh, . "Pension Reforms in India: Myth, Reality and Policy Choices," IIMA Working Papers WP2002-09-03, Indian Institute of Management Ahmedabad, Research and Publication Department.
- Marie-Eve Lachance & Olivia S. Mitchell, 2003.
"Understanding Individual Account Guarantees,"
wp035, University of Michigan, Michigan Retirement Research Center.
- 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.
- 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.
- Sergi Jiménez-Martín & Alfonso R. Sánchez, 2003.
"An evaluation of the life-cycle effects of minimum pensions on retirement behavior,"
Economics Working Papers
715, Department of Economics and Business, Universitat Pompeu Fabra, revised Jun 2006.
- 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.
- Sergi Jiménez-Martín & Alfonso R. Sánchez Martín, 2003. "An evaluation of the life-cycle effects of minimum pensions on retirement behavior," Working Papers 108, Barcelona Graduate School of Economics.
- 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.
- 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.
- 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.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().
If references are entirely missing, you can add them using this form.