The Value of Guarantees on Pension Fund Returns

Abstract

Social Security reform has been a serious concern to many countries. In Latin America, a number of reforms have been implemented by partially or fully privatizing pension obligations. Proposals to reform the United States Social Security system have also included privatization feature.(1) Most often, these privatization reforms have encouraged or required that individuals switch from a government-run defined benefit pension plan to a privately run defined contribution system. A potential obstacle exists, however, in gaining political approval for this type of reform. By converting to a defined contribution system, individuals may be exposed to risks not previously faced in a government-sponsored defined benefit plan. Participants in a defined contribution system risk experiencing lower than anticipated investment returns, possibly leaving them with inadequate wealth during their retirement years.(2) To make reforms involving a conversion to a defined contribution system more attractive to the public, governments have typically provided guarantees that reduce individuals' exposure to investment risks. As a result, guarantees of defined contribution pensions have recently become more common, especially in Latin America, which has been at the forefront of pension privatizations.(3) These guarantees differ from the more traditional government guarantees of defined benefit, private pension funds, such as those provided by the United States' Pension Benefit Guaranty Corporation. Defined contribution guarantees have been of two main types. One type insures the periodic rates of return earned by the pension funds in which individuals can invest. Typically, this takes the form of a guarantee that each defined contribution pension fund earns an annual rate of return greater than a pre-specified minimum. The second type of guarantee directly insures each individual's, rather than each pension fund's, return on pension savings. This type of guarantee ensures that participants in a defined contribution system receive a minimum pension payment throughout their retirement years, even if their pension savings are exhausted because of withdrawals during their retirement. Because governments usually retain an insurance obligation following a pension privatization, estimating the value of government guarantees is important for gauging the implicit subsidy associated with a particular pension reform. By accounting for the cost of guarantees in government budget statistics, an improved, market value-based measure of fiscal spending can be obtained. In addition, these cost estimates could make feasible a system of risk-based insurance premiums that would reduce or eliminate the net subsidy from providing guarantees. Previous research on valuing pension guarantees has focused on defined benefit guarantees, with little analysis devoted to guarantees on defined contribution pension plans.(4) But with the growing popularity of defined contribution pensions and their critical role in many recent pension reforms, research analyzing defined contribution guarantees is clearly needed. This article derives a number of new results for valuing these guarantees using analysis. It illustrates that the martingale pricing technique for calculating contingent claims values can be a unifying framework for valuing many kinds of guarantees. This technique may yield explicit formulas for guarantee values, or it can allow for numeric valuation by Monte Carlo simulation. Defined contribution pension guarantees bear some similarities to guarantees made by insurance companies on the minimum maturity cash value of equity-linked life insurance policies. Research on such insurance policy guarantees includes Brennan and Schwartz (1976), Boyle and Schwartz (1977), and Banicello and Ortu (1993). However, guarantees on a pension fund's periodic rates of return differ, because they are a series of sequential guarantees, not a single guarantee based on a maturity value. …