Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities versus Phased Withdrawal Plans

How might retirees consider deploying the retirement assets accumulated in a defined contribution pension plan? One possibility would be to purchase an immediate annuity. Another approach, called the “phased withdrawal” strategy in the literature, would have the retiree invest his funds and then withdraw some portion of the account annually. Using this second tactic, the withdrawal rate might be determined according to a fixed benefit level payable until the retiree dies or the funds run out, or it could be set using a variable formula, where the retiree withdraws funds according to a rule linked to life expectancy. Using a range of data consistent with the German experience, we evaluate several alternative designs for phased withdrawal strategies, allowing for endogenous asset allocation patterns, and also allowing the worker to make decisions both about when to retire and when to switch to an annuity. We show that one particular phased withdrawal rule is appealing since it offers relatively low expected shortfall risk, good expected payouts for the retiree during his life, and some bequest potential for the heirs. We also find that unisex mortality tables if used for annuity pricing can make women’s expected shortfalls higher, expected benefits higher, and bequests lower under a phased withdrawal program. Finally, we show that delayed annuitization can be appealing since it provides higher expected benefits with lower expected shortfalls, at the cost of somewhat lower anticipated bequests.

Portfolio regulation of life insurance companies and pension funds

This paper examines the rationale, nature and financial consequences of two alternative approaches to portfolio regulations for the long-term institutional investor sectors life insurance and pension funds. These approaches are, respectively, prudent person rules and quantitative portfolio restrictions. The argument draws on the financial-economics of investment, the differing characteristics of institutions’ liabilities, and the overall case for regulation of financial institutions. Among the conclusions are: · regulation of life insurance and pensions need not be identical; · prudent person rules are superior to quantitative restrictions for pension funds except in certain specific circumstances (which may arise notably in emerging market economies), and; · although in general restrictions may be less damaging for life insurance than for pension funds, prudent person rules may nevertheless be desirable in certain cases also for this sector, particularly in competitive life sectors in advanced countries, and for pension contracts offered by life insurance companies. These results have implications inter alia for an appropriate strategy of liberalisation. 1 The author is Professor of Economics and Finance, Brunel University, Uxbridge, Middlesex UB3 4PH, United Kingdom (e-mail ‘[email protected]’, website: ‘www.geocities.com/e_philip_davis’). He is also a Visiting Fellow at the National Institute of Economic and Social Research, an Associate Member of the Financial Markets Group at LSE, Associate Fellow of the Royal Institute of International Affairs and Research Fellow of the Pensions Institute at Birkbeck College, London. Work on this topic was commissioned by the OECD. Earlier versions of this paper were presented at the XI ASSAL Conference on Insurance Regulation and Supervision in Latin America, Oaxaca, Mexico, 4-8 September 2000, and at the OECD Insurance Committee on 30 November 2000. The author thanks participants at the conference and A Laboul for helpful comments. Views expressed are those of the author and not necessarily those of the institutions to which he is affiliated, nor those of the OECD. This paper draws on Davis and Steil (2000)

Stakeholders in pension finance

This dissertation examines three stakeholders in pension finance: the individual, the policymaker, and the pension provider (e.g., an insurer or a pension fund). In a setting beset by unforeseen financial market circumstances and demographic changes that disfavor financial security in retirement, a re-evaluation of these stakeholders' role is necessary. We explore the regulation and design of retirement plans by incorporating features that characterize the future retirement landscape, such as the increasing burden of risk borne by the individual, and the potential involvement of market investors in the provision of retirement contracts. The implications of our findings encompass guidance for individuals in managing longevity risk, evaluation of the appeal of longevity risk exposure to investors, insights on contract design for the pension provider, and proposals to the policymaker on regulatory measures that foster a sustainable retirement environment

Four Essays in Equity-Linked Life and Pension Insurance : Financial Analysis of Surrender Guarantees, Pension Guarantee Funds and Pension Retirement Plans

In this dissertation we study three very important types of insurance, equity-linked life insurance with surrender guarantees, pension insurance and the insurance provided by (pension) insurance guarantee funds. In chapter 2 we study the market consistent valuation of equity linked life insurance contracts, particularly the valuation of a surrender option. In our model the policyholder can surrender exogenously and endogenously. More importantly, we model the realistic perspective that the surrender option value depends on the state of the economy. The state of the economy can represent financial market regimes, macroeconomic regimes or business cycles. The consideration of economic states is an important contribution since equity-linked life insurance contracts are long-dated and in the long run there can occur several structural changes in the economic conditions which considerably affect both the value of the underlying financial portfolio and most importantly the surrender behavior of the policyholder. Chapter 3 and chapter 4 are concerned with the (re)insurance of pension guarantee funds (PGF). These government imposed pension schemes provide (re)insurance to defined benefit (DB) plan holders in terms of paying pension benefits if the corresponding sponsoring company and the pension fund are insolvent. We study and model solution concepts for pension guarantee funds to better protect policyholders by reducing the risk exposure of their financial guarantee. We model two solution concepts. In chapter 3 we provide a formal model to compute a risk-based premium paid to the PGF under distress termination, the conventional type of termination, where a pension fund is closed due to the insolvency of the sponsoring company. We incorporate several realistic perspectives and compare our theoretical pricing formula for a sample of the largest US DB plan sponsors. In chapter 4 we study the other type of termination, involuntary termination. Under involuntary termination the PGF terminates a substantially underfunded DB plan. In that case the crucial question is when the PGF should optimally intervene. We determine an optimal timing of intervention in terms of a critical funding ratio of the insured DB pension fund. The basic idea of our model is that the PGF acts in the interest of the beneficiaries and maximizes their expected utility. In addition the PGF protects its financial guarantee by controlling two solvency requirements, the shortfall probability and the expected shortfall of the DB plan. In chapter 4 the DB plan is modeled more specifically and compared to the other main pension retirement plan, the defined contribution plan (DC plan). The analysis is conducted in an expected utility framework under different preferences by taking an essential tradeoff into account. Specifically, the policyholder faces salary risk in both retirement plans, he faces investment risk only in the DC plan and portability risk, the risk of losing benefits when changing the employer is mostly present in the DB plan. As a means of comparison we take the critical job switching intensity or more intuitively the average number of job moves after which the DC plan is preferred in expected utility terms

Optimal funding and investment strategies in defined contribution pension plans under Epstein-Zin utility

A defined contribution pension plan allows consumption to be redistributed from the plan member’s working life to retirement in a manner that is consistent with the member’s personal preferences. The plan’s optimal funding and investment strategies therefore depend on the desired pattern of consumption over the lifetime of the member. We investigate these strategies under the assumption that the member has an Epstein-Zin utility function, which allows a separation between risk aversion and the elasticity of intertemporal substitution, and we also take into account the member’s human capital. We show that a stochastic lifestyling approach, with an initial high weight in equity-type investments and a gradual switch into bond-type investments as the retirement date approaches is an optimal investment strategy. In addition, the optimal contribution rate each year is not constant over the life of the plan but reflects trade-offs between the desire for current consumption, bequest and retirement savings motives at different stages in the life cycle, changes in human capital over the life cycle, and attitude to risk

Intergenerational Risk-Sharing and Risk-Taking of a Pension Fund

By using their financial reserves efficiently, pension funds can smooth shocks on asset returns, and can thus facilitate intergenerational risk-sharing. In addition to the primary benefit of improved time diversification, this form of risk allocation affords the additional benefit of allowing these funds to take better advantage of the equity premium, which also favors the consumers. In this paper, our aim is twofold. First, we characterize the socially efficient policy rules of a collective pension plan in terms of portfolio management, capital payments to retirees, and dividend payments to shareholders. We examine both the first-best rules and the second-best rules, where, in the latter case, the fund is constrained by a solvency ratio and by a guaranteed minimum return to workers’ contributions. Second, we measure the social surplus of the system compared to a situation in which each generation would save and invest in isolation for its own retirement. One of the main results of the paper is that better intergenerational risk-sharing does not reduce the risk born by each generation. Rather, it increases the expected return to the workers’ contributions

Determination of Optimal Investment Strategies for A Defined Contribution (Dc) Pension Fund with Multiple Contributors, Proportional Administrative Costs and Taxation

This study centres on determining the optimal investment strategies for defined contribution (DC) pension fund with multiple contributors, administration cost and taxation on the invested fund. We assume that a certain proportion of the member’s contributions as administrative cost which is remitted to the pension fund manager also following the Nigerian Pension Reform Act of 2004 the invested fund is subjected to tax. We obtained an optimized equation using Hamilton Jacobi equation, then solve the equation using Legendre transformation method to obtained explicit solutions of the optimal investment strategy for CARA utility function. We observed that the tax has a direct effect on the investment strategies