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Minimum Funding Ratios for Defined-Benefit Pension Funds

  • Arjen Siegmann

We compute minimum funding ratios for Defined Benefit (DB) plans based on the expected utility that can be achieved in a Defined Contribution (DC) pension scheme. Using Monte Carlo simulation, expected utility is computed for three different specifications of utility: power utility, mean-shortfall and mean-downside deviation. Depending on risk aversion and the level of sophistication assumed for the DC-scheme, minimum acceptable funding ratios are between 0.87 and 1.20. If the DC-scheme is constrained to a fixed-contribution setup, minimum funding ratios are between 0.87 and 0.98. Furthermore, the attractiveness of the DB plan increases with the expected equity premium and the fraction invested in stocks. We conclude that the expected value of intergenerational solidarity, implicit in the DB pension fund, can be large. Given a pension fund with a funding ratio of 1.30, a participant in a DC plan has to pay a 2.7 to 6.1%-point higher contribution to achieve equal expected utility.

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File URL: http://www.dnb.nl/binaries/WP%20180-2008%20-%20Minimum%20Funding%20Ratios%20for%20Defined-Benefit%20Pension%20Funds_tcm46-188336.pdf
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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 180.

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Date of creation: Sep 2008
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Handle: RePEc:dnb:dnbwpp:180
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Web page: http://www.dnb.nl/en/

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  1. Zvi Bodie & Alan J. Marcus & Robert C. Merton, 1988. "Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-offs?," NBER Chapters, in: Pensions in the U.S. Economy, pages 139-162 National Bureau of Economic Research, Inc.
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