Understanding and Allocating Investment Risks in a Hybrid Pension Plan

Abstract

Abstract This chapter analyzes pension plan costs and investment strategies in the context of alternative hybrid pension plans, which are optimal either from the perspective of the plan sponsor or the beneficiaries. It evaluates the impact of minimum and maximum limits for pension benefits as well as minimum guarantees and caps on members’ investment returns. For low/medium risk portfolios, minimum benefit guarantees tend to be more expensive than minimum return guarantees, but for the latter, costs increase exponentially with investment risk. It is also shown that the sponsor’s portfolio choice differs from that of the participants, depending on plan design and risk aversion. One way to resolve these differences is to combine minimum return guarantees and caps on investment returns, which shares investment risks and returns more equally between sponsor and beneficiaries, and keeps pension plan costs under control.