Funding and investment decisions in a stochastic defined benefit pension plan with several levels of labor-income earnings

In this paper we consider the optimal management of an aggregated dynamic pension fund. There are n classes of workers whose salaries are stochastic. A portion of the salary is contributed to the funding process and the manager invests in a portfolio with m risky assets and a risk-free security. The main objective is to minimize the cost of contributions in a bounded horizon T and to maximize the utility of final surplus, measured as the relative fund level respect to the mean salary. The aim of the paper is to describe the properties of fund allocation and optimal contribution when salaries differ across contributors to the fund.Both authors gratefully acknowledge financial support from Consejería de Educación y Cultura de la Junta de Castilla y León (Spain) under project VA099/04 and Spanish Ministerio de Ciencia y Tecnología and FEDER funds under project BFM2002–00425. We are indebted to an anonymous referee for the criticisms and valuable comments.Publicad

Labor Market Uncertainty and Pension System Performance

The financial market crisis has prompted policymakers to devote substantial attention to ways in which capital market risks shape pension performance, but few analysts have asked how shocks to human capital shape retirement wellbeing. Yet human capital risks due to fluctuations in labor earnings, employment volatility, and survival, can have a profound influence on pension accumulations and payouts. This paper reviews existing studies and offers a framework to think about how human capital risk can influence pension outcomes. We conclude with thoughts on how future analysts can better assess sensitivity of pension plan outcomes to a labor income uncertainty

Prudent Investors: The Asset Allocation of Public Pension Plans

After 2000, the vast majority of defined benefit (DB) pension plans encountered a decrease in their funding ratios, largely due to a drop in asset prices. It is possible that public sector pension plans may have acted imprudently by chasing returns, once they encountered underfunding. We identify four indicators for DB plans’ imprudent investment behavior: no portfolio rebalancing, employer conflicts of interest, trustee conflicts of interest, and failure to implement best investment practices. To see if public sector pension plans rebalance their portfolios, we use data from the Federal Reserve’s Flow of Funds, dating from 1952 to 2007. To test for the remaining three hypotheses, we use data from the Census’ State and Local Government Employee Retirement Systems data base, where consistent data for state and local government plans are available from 1993 to 2005. Our results suggest that there is no evidence that public sector plans systematically engaged in imprudent investment behavior and that this did not systematically differ after 2000 from the earlier period.

Earnings-related mandatory pensions : concepts for design

The author offers a framework for economic policy on mandatory earnings-related pensions. He does not discuss the gains and losses from mandating insurance and savings, nor the use of this policy as a vehicle for income redistribution. Instead, he concentrates on areas that are less well understood: the microeconomics, the macroeconomics, and the political economy of mandatory pensions. His analysis focuses on three main areas: insurance design, privatization, and degree of funding. In each area, he provides a checklist of design issues, drawn from international experience and economic analysis. For insurance, there are two sets of choices: between flat actuarial factor or individual actuarial factor and between defined benefit or defined contribution (in the sense of financial guarantee). For privatization, the essential choices are between private or nationalized provision, and between private or national demand. For funding, the choices are between funding or not funding, and between apparent funding or pay-as-you-go financing. Some combinations can be discarded. Privatization should not be combined with flat actuarial factors, for example, because private suppliers will compete for access to rents that accrue to workers who are awarded implicit subsidies. Privatization is compatible with apparent funding, but not with pay-as-you-go financing, because in the latter there are no funds to invest in the capital market. The policy choice is ultimately between two coherent designs whose relative advantages and drawbacks the author discusses. One, is an individual actuarial factor with privatized production and demand, with risk explicitly allocated to pensions, and with partial funding. Two, is a flat actuarial factor coupled with nationalized production, pay-as-you-go financing, and statutory promises of fixed real pensions (defined benefit).Banks&Banking Reform,Environmental Economics&Policies,Health Economics&Finance,Insurance&Risk Mitigation,Pensions&Retirement Systems

Programs without alternative: Public pensions in the OECD

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Population ageing and fiscal sustainability in Finland: a stochastic analysis

This study analyses the fiscal sustainability of the Finnish public sector using stochastic projections to describe uncertain future demographic trends and asset yields. While current tax rates are unlikely to yield sufficient tax revenue to finance public expenditure with an ageing population, if developments are as expected, the problem will not be very large. However, there is a small, but not negligible, probability that taxes will need to be raised dramatically, perhaps by over 5 percentage points. Such outcomes, if realised, could destabilise the entire welfare state. The study also analyses three policy options aimed at improving sustainability. Longevity adjustment of pension benefits and introduction of an NDC pension system would reduce the expected problem and narrow the sustainability gap distribution. Under the third option, pension funds would invest more in equities and expect to get higher returns. This policy also limits the sustainability problem, but only under precondition that policymakers in the future can live with substantially larger variation in the value of the funds without adjusting tax rules or benefits.public finance; fiscal sustainability; uncertainty; stochastic simulations

How Will Defined Contribution Pension Plans Affect Retirement Income?

How has the emergence of defined contribution pension plans, such as 401(k)s, affected the financial security of future retirees? We consider this question using a detailed survey of pension formulas in the Survey of Consumer Finances. Our simulations show that average and median pension benefits are higher under defined contribution plans that for defined benefit plans. Defined benefit plans are slightly better at providing minimum benefits, but for plausible values of risk aversion, a defined contribution plan drawn randomly from those available in 1995 is still preferred to a defined benefit plan drawn randomly from those available in 1983. This result is robust to different assumptions regarding the spending of defined contribution balances between jobs, equity rates of return, and the date of retirement. In short, we suggest that defined contribution plans can strengthen the financial security of retirees.

Reforming Pensions

This article, based on two books (2008, forthcoming), sets out principles for pension design: pension systems have multiple objectives, analysis should consider the pension system as a whole, analysis should be in a second-best context, different systems share risks differently and have different effects by generation and by gender. The article considers policy implications: there is no single best pension design; earlier retirement does not reduce unemployment; unsustainable pension promises should be addressed directly; adding funding in a PAYG mandatory system may or may not be welfare improving; and implementation matters – design should not exceeds a country’s capacity to implement.pension, social security

A Lifecycle Analysis of Defined Benefit Pension Plans

This paper employs a lifecycle model from the consumption-savings literature to examine the tradeoffs between defined benefit and defined contribution pension plans. We examine the effects of varying risk aversion, varying initial income and financial wealth, and varying wage processes (that may be correlated with returns on the risky asset). Results indicate that wage-indexed claims are not an optimal vehicle for retirement policy if the decision to participate is made early in life, because individuals hold most of their wealth in their human capital and would not wish to increase their exposure to income shocks. Later in life, after most of a worker’s human capital has been converted to financial assets, defined benefit pension plans help increase diversification by reducing exposure to financial market risk. The access that defined benefit plans provide to annuities markets and possible guaranteed rates of return over the risk-free rate increase the value of defined benefit plans to workers. The model also predicts that wage-indexed claims will be more valuable when equity markets provide low expected returns or are highly variable and when annuity markets are inefficient. The model illustrates two economic functions performed by defined benefit plans. Firstly, DB plans pool individual wage risks. This allows older workers to buy a wagelinked security that increases their exposure to wage risks. Secondly, they create a group annuities market that reduces the cost of adverse selection.