Defined Contribution Pension Plans: Who Has Seen the Risk?

Abstract

The trend towards eliminating defined benefit (DB) pension plans in favour of defined contribution (DC) plans implies that increasing numbers of pension plan participants will bear the risk that final realized portfolio values may be insufficient to fund desired retirement cash flows. We compare the outcomes of various asset allocation strategies for a typical DC plan investor. The strategies considered include constant proportion, linear glide path, and optimal dynamic (multi-period) time consistent quadratic shortfall approaches. The last of these is based on a double exponential jump diffusion model. We determine the parameters of the model using monthly US data over a 90-year sample period. We carry out tests in a synthetic market which is based on the same jump diffusion model and also using bootstrap resampling of historical data. The probability that portfolio values at retirement will be insufficient to provide adequate retirement incomes is relatively high, unless DC investors adopt optimal allocation strategies and raise typical contribution rates. This suggests there is a looming crisis in DC plans, which requires educating DC plan holders in terms of realistic expectations, required contributions, and optimal asset allocation strategies.

A Proposal of a Pension Plan Design Based on Collective Pension Funds

“…The value of the rates of return jt is assumed stochastic simulated under the bootstrap sampling method (Forsyth & Vetzal, 2019) with 1,000 simulations and assuming a vector of historical returns of the Mexican IPC index for equities and long-term government bonds over a period from 2004 to 2021. Also, according to CONSAR (2022), a discount rate of 2.5% is assumed for the calculation of the value of the lifetime annuities.…”

Computational Finance

“…The increased use of Defined Contribution (DC) plans implies that more pension plan participants will bear the risk that final realized portfolio values may be insufficient to fund desired retirement cash flows. Forsyth and Vetzal (2019) compare the outcomes of various asset allocation strategies for a typical DC plan investor in a synthetic market and also using bootstrap resampling of historical data. They propose a strategy based on optimal dynamic (multi-period) time consistent quadratic shortfall and demonstrate that the probability that portfolio values at retirement will be insufficient to provide adequate retirement incomes is relatively high, unless DC investors adopt optimal allocation strategies and raise typical contribution rates.…”

“…The published papers consider asset pricing in general with applications to bond pricing, see Dunne (2019), commodity modelling, see Cheng et al (2019), and derivatives pricing, see Létourneau and Stentoft (2019), Reesor and Marshall (2020) and Stentoft (2019); uses calibration techniques, see Van Dijk et al (2018); and considers issues related to hedging, see Dunne (2019). The published papers develop new multivariate models, see Cheng et al (2019), considers option pricing in this challenging setting, see Reesor and Marshall (2020), and addresses issues related to risk management, see Cheng et al (2019), Forsyth andVetzal (2019), andVan Dijk et al (2018). The volume contains several papers that use simulation, see Dunne (2019), Létourneau and Stentoft (2019), Mukerji et al (2019), andStentoft (2019), and papers that provide new ways to model volatility, see Cheng et al (2019), and for estimating this, see Petrov et al (2019).…”