Abstract
We establish 16 good practice principles in modelling defined contribution pension plans. These principles cover the following issues: model specification and calibration; modelling quantifiable uncertainty; modelling member choices; modelling member characteristics, such as occupation and gender; modelling plan charges; modelling longevity risk; modelling the post-retirement period; integrating the pre and post-retirement periods; modelling additional sources of income, such as the state pension and equity release; modelling extraneous factors, such as unemployment risk, activity rates, taxes and entitlements; scenario analysis and stress testing; periodic updating of the model and changing assumptions; and overall fitness for purpose.
Highlights
If a defined contribution (DC) pension plan is well designed, it will be a single, integrated financial product that delivers at reasonable cost to the plan member a pension that provides a high degree of retirement income security
How much do I need to contribute to my DC pension to get an expected replacement ratio of, say, 67% if I wish to retire at, say, age 65?
Panel (b) shows what happens if the equity weighting in the asset allocation strategy is increased from 25% to 50%: the expected replacement ratio rises from 43.1% to 47.6%, but the 90% prediction interval becomes more dispersed, i.e., the retirement replacement ratio becomes riskier
Summary
If a defined contribution (DC) pension plan is well designed, it will be a single, integrated financial product that delivers at reasonable cost to the plan member a pension that provides a high degree of retirement income security. We are concerned about modelling: we make a set of assumptions about economic scenarios, member decisions and so forth, and, based on those assumptions, the model projects the prospective outputs. Those projections can be used to guide both plan design and member choices, but our focus is on modelling or, more with the principles of good modelling. We begin with some general comments about model specification and calibration
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