Controlling the cost of minimum benefit guarantees in public pension conversions

Abstract

Reformed public DC plans typically contain a minimum benefit guarantee (DC-MB). This paper explores risk management techniques to control the cost of these guarantees in DC systems with minimum benefit guarantees (DC-MB). The paper finds two approaches are particularly useful. The first approach borrows an idea from the recent catastrophic insurance literature. The guarantee is placed over a ‘standardized’ portfolio, requiring agents to accept any ‘basis risk’ if they chose a non-standard portfolio. However, for large conversions from DB to DC-MB plans, in which there is little or no DB benefit remaining, the government must still worry about any ‘implicit guarantee’ that might extend beyond the standardized portfolio which might entice agents to accept a lot of basis risk (a ‘Samaritan's Dilemma’). The second method, therefore, uses a more brute force approach: private portfolio returns in the good states of the world are taxed while returns in the bad states are subsidized. Both options are very effective at controlling guarantee costs, and they can be used separately or together. Calculations demonstrate that all of the unfunded liabilities associated with modern pay-as-you-go public pension programs can be eliminated under both approaches even at a modest contribution rate.