A Derivative Valuation of the Florida Pension Election: From DB to DC and Back

Abstract

During the year 2002, The State of Florida's 600,000 public employees were given the unprecedented ability to convert their traditional Defined Benefit (DB) pension plan, into a self-managed Defined Contribution (DC) plan, where the individual controls asset allocation and investment decisions. To mitigate some of the personal risk associated with investment self-determination, the State of Florida granted each and every employee electing the DC plan, the right but not the obligation, to switch back into the DB plan at any point prior to retirement. The strike price of this option is the accumulated benefit obligation (ABO) in the DB plan. Motivated by these reforms, our paper presents some analytic results relating to the optimal time, and financial value, of this unique pension option. We start with a simple deterministic model to provide intuition, and conclude with a full-fledged stochastic model that derives a formal option value. Our paper goes beyond some of the recent academic literature by providing simple analytic guidance on the optimal time to 'elect', as well as our differing estimates of the value of this guarantee. In contrast to some competing papers in the insurance literature, we conclude that value of the so-called option is at most worth 30% of the DC contribution rate; and only when exercised at the 'optimal time'. Furthermore, for most Florida State employees above the age of 45, the option has little economic value, since the DB plan dominates the DC plan from day one. Of course, it remains to be seen what percent of Florida's 600,000 state employees will 'elect' to behave rationally with their newfound pension autonomy.