A Guaranteed-Return Contract For Pension Funds’ Investments In The Capital Market

Current arrangements for pensions in Israel suffer from numerous problems and shortcomings. This paper deals with one of the more serious among them, the channeling of pension funds into nontradable earmarked bonds at guaranteed and subsidized rates of interest. This arrangement enables the pension funds to bypass the capital market, with all the negative effects that this situation causes. Incorporating the pension funds into the capital market in Israel is very important for the development and improvement of the primary and secondary capital markets. The problem is that pension funds’ managers and members are apprehensive about investing in tradable capital markets, particularly in equity, due to their volatility. High volatility means that the value can drop sharply, and may cause the funds difficulties in meeting their commitments to their members. It will therefore be hard to integrate the funds into the capital market without developing instruments that will deal with the concerns of the pension funds arising from this uncertainty. Such market-oriented instruments, provided by the private sector, do exist in other countries, but the authors are of the opinion that without at least temporary involvement of the government to encourage the development of the market, it will prove difficult to create such instruments in Israel and to convince the pension funds to invest in the capital market. This paper will show that the problem can be solved by changing the use made of the current budgetary support allocated for pensions. Converting the current arrangement into a direct subsidy of the funds or their members, as has been proposed, will not solve the problem of uncertainty. This paper focuses on the problem of the funds’ uncertainty which arises from the capital market’s volatility. The proposal herein consists of two main components: the first is creating pension funds for new members which will not be entitled to purchase earmarked bonds at guaranteed interest; the second is a limited-quantity tender of a composite contract which will enable funds to hedge the risk inherent in investing in shares (the purchase of put options by the funds) against their waiving part of the market return (by writing call options). The body dealing with the tender could be a public corporation (such as Inbal Insurance Co.) whose equity capital would be increased by transferring sums of money which would otherwise be directed to pension subsidies. The authors expect that in the not-too-distant future the private sector will join these activities, as occurred in the development in the foreign-exchange options market when the Bank of Israel started its activity in that area. A simulation for the years 1969–99 reveals that the return received by those pension funds which invested in the stock market in combination with the proposed contract exceeded that currently being earned on earmarked bonds, and even the insurer’s account accrued a positive balance in that period by applying the contract. In other words, the situation of the pension funds and their members would have been better than it is currently. Nevertheless, there could be periods when share prices fall constantly, causing erosion of the capital equity of the public corporation selling the proposed contract, and it is suggested that to minimize the probability of such an event, the extent of the contracts offered should alter in accordance with the degree of risk relative to the company’s equity.