Guaranteeing Defined Contribution Pensions: The Option to Buy-Back a Defined Benefit Promise

Abstract

After a long commitment to defined benefit (DB) pension plans for U.S. public sector employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk that was previously borne by state DB plans has now devolved to employees covered by the new DC plans. In light of this trend, some states have introduced a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to buy back their DB benefit for a price. This article develops a theoretical framework to analyze the option design and illustrate how employee characteristics influence the option's cost. We illustrate the potential impact of a buy-back option in a pension reform enacted recently by the State of Florida for its public employees. If employees were to exercise the buy-back option optimally, the market value of this option could represent up to 100 percent of the DC contributions over their work life.

Florida's Pension Election: From DB to DC and Back

“…Although our model is deterministic in nature, we believe that it provides a number of intuitive insights that are quite robust. Our results can be contrasted with Lachance, Mitchell, and Smetters (2003). We estimate that the increase in retirement wealth that arises from having the 2nd election is equivalent to at most 30 percent in future value, and only when utilized optimally.…”

Pension Portfolio Choice and Peer Envy

“…Although DC plans allow employees more flexibility in maintaining their pension wealth, they also cause employees to bear market risk. In fact, previous work shows that having an opportunity to switch back to a DB plan from a DC plan is sometimes optimal for employees as the risk associated with DC plans can have real impacts on retirement wealth (Lachance, Mitchell, and Smetters, 2003;Milevsky and Promislow, 2004). As such, it is important to understand how employees make financial decisions with regard to their pensions and the effect of their behavior on their allocations.…”

Social Security Benefit Uncertainty under Individual Accounts

“…The introduction of a simple individual account would increase the overall variability of outcomes as measured by benefit 8. See also Lachance et al (2003) for an application of this approach to the valuation of defined contribution versus defined benefit income streams. replacement rates far more than as measured by benefit levels.…”