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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.

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Article provided by The American Risk and Insurance Association in its journal Journal of Risk & Insurance.

Volume (Year): 70 (2003)
Issue (Month): 1 ()
Pages: 1-16

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Handle: RePEc:bla:jrinsu:v:70:y:2003:i:1:p:1-16
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  1. Olivia S. Mitchell, . "Developments in Pensions," Pension Research Council Working Papers 98-4, Wharton School Pension Research Council, University of Pennsylvania.
  2. Bodie, Zvi, 1990. "Pensions as Retirement Income Insurance," Journal of Economic Literature, American Economic Association, vol. 28(1), pages 28-49, March.
  3. 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.
  4. Olivia S. Mitchell & James M. Poterba & Mark J. Warshawsky, . "New Evidence on the Money's Worth of Individual Annuities," Pension Research Council Working Papers 97-9, Wharton School Pension Research Council, University of Pennsylvania.
  5. Olivia S. Mitchell & Flavio Ataliba Barreto, . "After Chile, What? Second-Round Social Security Reforms in Latin America," Pension Research Council Working Papers 97-4, Wharton School Pension Research Council, University of Pennsylvania.
  6. Geanakoplos, J. & Mitchell, O.S. & Zeldes, S.P., 1998. "Social Security Money's Worth," Papers 98-05, Columbia - Graduate School of Business.
  7. 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 363-84, March.
  8. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
  9. James F. Moore & Olivia S. Mitchell, . "Projected Retirement Wealth and Saving Adequacy," Pension Research Council Working Papers 98-1, Wharton School Pension Research Council, University of Pennsylvania.
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