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Guaranteeing Defined Contribution Pensions: The Option to Buy Back a Defined Benefit Promise


  • Marie-Eve Lachance
  • Olivia S. Mitchell
  • Kent Smetters


After a long commitment to defined benefit (DB) pension plans for U.S. public sector employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk that was previously borne by state DB plans has now devolved to employees covered by the new DC plans. In light of this trend, some states have introduced a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to buy back their DB benefit for a price. This article develops a theoretical framework to analyze the option design and illustrate how employee characteristics influence the option's cost. We illustrate the potential impact of a buy-back option in a pension reform enacted recently by the State of Florida for its public employees. If employees were to exercise the buy-back option optimally, the market value of this option could represent up to 100 percent of the DC contributions over their work life. Copyright 2003 The Journal of Risk and Insurance.

Suggested Citation

  • Marie-Eve Lachance & Olivia S. Mitchell & Kent Smetters, 2003. "Guaranteeing Defined Contribution Pensions: The Option to Buy Back a Defined Benefit Promise," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 70(1), pages 1-16.
  • Handle: RePEc:bla:jrinsu:v:70:y:2003:i:1:p:1-16

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    References listed on IDEAS

    1. John Geanakoplos & Olivia S. Mitchell & Stephen P. Zeldes, "undated". "Social Security Money's Worth," Pension Research Council Working Papers 97-20, Wharton School Pension Research Council, University of Pennsylvania.
    2. Olivia S. Mitchell, 1999. "New Evidence on the Money's Worth of Individual Annuities," American Economic Review, American Economic Association, vol. 89(5), pages 1299-1318, December.
    3. Olivia Mitchell & Flávio Ataliba F. D. Barreto, 1997. "After Chile, What? Second-Round Social Security Reforms in Latin America," Revista de Analisis Economico – Economic Analysis Review, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines, vol. 12(2), pages 3-36, June.
    4. Olivia S. Mitchell, "undated". "Developments in Pensions," Pension Research Council Working Papers 98-4, Wharton School Pension Research Council, University of Pennsylvania.
    5. Bodie, Zvi, 1990. "Pensions as Retirement Income Insurance," Journal of Economic Literature, American Economic Association, vol. 28(1), pages 28-49, March.
    6. 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.
    7. James F. Moore & Olivia S. Mitchell, "undated". "Projected Retirement Wealth and Saving Adequacy," Pension Research Council Working Papers 98-1, Wharton School Pension Research Council, University of Pennsylvania.
    8. Martin Feldstein, 2009. "Reducing the Risk of Investment-Based Social Security Reform," NBER Chapters,in: Social Security Policy in a Changing Environment, pages 201-218 National Bureau of Economic Research, Inc.
    9. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    10. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-384, March.
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    Cited by:

    1. Olivia S. Mitchell & David McCarthy, 2002. "Annuities for an Ageing World," CeRP Working Papers 21, Center for Research on Pensions and Welfare Policies, Turin (Italy).
    2. 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.
    3. Amy Rehder Harris & John Sabelhaus & Michael Simpson, 2005. "Social Security Benefit Uncertainty under Individual Accounts," Contemporary Economic Policy, Western Economic Association International, vol. 23(1), pages 1-16, January.
    4. Pierre Devolder & Sébastien de Valeriola, 2017. "Minimum Protection in DC Funding Pension Plans and Margrabe Options," Risks, MDPI, Open Access Journal, vol. 5(1), pages 1-14, January.
    5. Iqbal Owadally & Steven Haberman & Denise Gómez Hernández, 2013. "A Savings Plan With Targeted Contributions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(4), pages 975-1000, December.
    6. Brown, Jeffrey R. & Weisbenner, Scott J., 2014. "Why do individuals choose defined contribution plans? Evidence from participants in a large public plan," Journal of Public Economics, Elsevier, vol. 116(C), pages 35-46.
    7. Ngee-Choon Chia & Albert K C Tsui, 2005. "Reverse Mortgages as Retirement Financing Instrument: An Option for “Asset-rich and Cash-poor” Singaporeans," SCAPE Policy Research Working Paper Series 0503, National University of Singapore, Department of Economics, SCAPE.
    8. Olivia S Mitchell & John Piggott & Michael Sherris & Shaun Yow, 2006. "Financial Innovation for an Ageing World," RBA Annual Conference Volume,in: Christopher Kent & Anna Park & Daniel Rees (ed.), Demography and Financial Markets Reserve Bank of Australia.
    9. Clark, Robert L. & Hanson, Emma & Mitchell, Olivia S., 2016. "Lessons for public pensions from Utah's move to pension choice," Journal of Pension Economics and Finance, Cambridge University Press, vol. 15(03), pages 285-310, July.
    10. 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.
    11. Chia, Ngee-Choon & Tsui, Albert K.C., 2005. "Medical savings accounts in Singapore: how much is adequate?," Journal of Health Economics, Elsevier, vol. 24(5), pages 855-875, September.
    12. Gopi Shah Goda & Colleen Flaherty Manchester, 2013. "Incorporating Employee Heterogeneity into Default Rules for Retirement Plan Selection," Journal of Human Resources, University of Wisconsin Press, vol. 48(1), pages 198-235.
    13. 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.
    14. Dirk Broeders, 2010. "Valuation of Contingent Pension Liabilities and Guarantees Under Sponsor Default Risk," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 77(4), pages 911-934.
    15. Diana H. A. Tsai, 2005. "Knowledge Spillovers and High-technology Clustering: Evidence from Taiwan's Hsinchu Science-Based Industrial Park," Contemporary Economic Policy, Western Economic Association International, vol. 23(1), pages 116-128, January.
    16. repec:fau:fauart:v:67:y:2017:i:4:p:342-369 is not listed on IDEAS
    17. Martin Boyer & Franca Glenzer, 2016. "Pensions, annuities, and long-term care insurance: On the impact of risk screening," Cahiers de recherche 1603, Chaire de recherche Industrielle Alliance sur les enjeux économiques des changements démographiques.
    18. Ngee-Choon Chia & Albert K C Tsui, 2005. "Reverse Mortgages as Retirement Financing Instrument : An Option for “Asset-rich and Cash-poor†Singaporeans," Finance Working Papers 22566, East Asian Bureau of Economic Research.
    19. Jacqueline Volkman Wise, 2013. "Pension Portfolio Choice and Peer Envy," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(2), pages 461-489, June.

    More about this item

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • H - Public Economics


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