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Controlling the cost of minimum benefit guarantees in public pension conversions

  • SMETTERS, KENT

Reformed public DC plans typically contain a minimum benefit guarantee (DC-MB). This paper explores risk management techniques to control the cost of these guarantees in DC systems with minimum benefit guarantees (DC-MB). The paper finds two approaches are particularly useful. The first approach borrows an idea from the recent catastrophic insurance literature. The guarantee is placed over a standardized portfolio, requiring agents to accept any 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 that might extend beyond the standardized portfolio which might entice 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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Article provided by Cambridge University Press in its journal Journal of Pension Economics and Finance.

Volume (Year): 1 (2002)
Issue (Month): 01 (March)
Pages: 9-33

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Handle: RePEc:cup:jpenef:v:1:y:2002:i:01:p:9-33_00
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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. 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.
  3. 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.
  4. 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.
  5. Alan J. Marcus, 1983. "Corporate Pension Policy and the Value of PBGC Insurance," NBER Working Papers 1217, National Bureau of Economic Research, Inc.
  6. 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.
  7. Martin Feldstein & Andrew Samwick, 1997. "The Economics of Prefunding Social Security and Medicare Benefits," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 115-164 National Bureau of Economic Research, Inc.
  8. 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.
  9. 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.
  10. 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.
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