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Back to the funding ratio! Addressing the duration puzzle and retirement income risk of defined contribution pension plans

Author

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  • Mantilla-Garcia, Daniel
  • Martellini, Lionel
  • Garcia-Huitrón, Manuel E.
  • Martinez-Carrasco, Miguel A.

Abstract

Effective risk management in pension funds requires the use of appropriate long-term risk and performance indicators. However, Defined Contribution (DC) pension plans currently rely on short-term metrics that don't align with the retirement income goals of beneficiaries. Against this backdrop, we introduce a funding ratio measure for DC plans defined as the plan assets divided by accrued benefits derived from any given (defined) stream of contributions. The funding ratio's denominator is the present value of the total retirement income achievable if all contributions had been invested in fully amortizing fixed-income portfolios called retirement bonds. We also use the retirement bonds to introduce a class of target-income strategies that can effectively reduce income risk as retirement approaches, but also secure minimum funding ratio levels. These simple asset allocation rules strongly dominate the standard target-date fund strategies routinely used by DC plans, in terms of retirement outcomes for beneficiaries.

Suggested Citation

  • Mantilla-Garcia, Daniel & Martellini, Lionel & Garcia-Huitrón, Manuel E. & Martinez-Carrasco, Miguel A., 2024. "Back to the funding ratio! Addressing the duration puzzle and retirement income risk of defined contribution pension plans," Journal of Banking & Finance, Elsevier, vol. 159(C).
    • Handle: RePEc:eee:jbfina:v:159:y:2024:i:c:s0378426623002479
    DOI: 10.1016/j.jbankfin.2023.107061
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