Guarantees - Counting the Cost of Guaranteeing Defined Contribution Pensions

Abstract

Different types of pension involve different kinds of uncertainty. For example, public sector pension schemes involve a 'policy risk', that the scheme might be reformed in the future so that benefits turn out differently than expected. Private pension schemes are less subject to this policy risk, because governments are unlikely to confiscate private property. But defined-contribution pensions do involve capital-market risk during the accumulation phase, when contributions and investment returns build up in the fund. The risk is that the pension fund's performance is insufficient to give an individual member an adequate retirement income. This note reviews the different types of guarantees, suggesting guarantees of the returns from funded pensions can gain support for reform; but poorly designed guarantees can undermine it, and create large liabilities. The cost of guarantees should be made as transparent as possible, while option-pricing models can be used to illustrate the cost of guarantees, to inform the decision to offer guarantees, the type of guarantee, and how large it should be. Transparent financing of guarantees is best served by forcing funds to put aside their own assets; this also provides better incentives for fund managers.