Understanding Individual Account Guarantees

Abstract

Demographic aging renders workers vulnerable to the inherent uncertainty of unfunded social security systems. This realization has set off a global wave of social security reforms, and numerous countries have now set up Individual Accounts (IA) plans in response. Strengths of IAs are that participants gain ownership in their accounts, and they also may diversify their pension investments; additionally, they produce a capitalized, funded system that enhances old-age economic security. While IAs reduce the risk participants face due to unfunded social security systems, participants holding capital market investments in IAs are exposed to fluctuations in the value of their pension assets. Concern over market volatility has prompted some to emphasize the need for "guarantees" of pension accumulations. This paper offers a way to think about guarantees in the context of a social security reform that includes Individual Accounts. When a pension guarantee has economic value to participants, it will have economic costs. We illustrate how these costs can be important and vary significantly with time horizon, investment mix, and guarantee design. Our findings indicate that plan designers and budget analysts would do well to recognize such costs and identify how they can be financed.

Valuation of Government Policies and Projects

“…Proposals to include such accounts as part of social security, and the expectation that in the event of unexpectedly poor performance the government would offset a portion of losses, has motivated a number of studies on the cost of such guarantees (e.g., Pennacchi 1999, Lachance & Mitchell 2002, CBO 2006, and Biggs et. al.…”

Public Pension Reform: A Primer

“…Implicit pricing occurs when no such purchase takes place and the coverage is simply reflected in the return structure that the individual faces on his pension assets, or in a higher tax burden elsewhere to finance an independent social safety net. Lachance and Mitchell (2003) use an option valuation technique to infer the cost of an explicit guarantee provided by a pension fund itself and show that the costs are very substantial when portfolios are heavily invested in stocks rather than bonds. Their intuition is simple: stocks have a higher volatility and, thus, a higher chance of activating the guarantee than bonds.…”

“…A corollary of the result is that increasing the share of bonds reduces the cost of the guarantee. In terms of the pension policy of a plan sponsor offering such a guarantee, the findings of Lachance and Mitchell (2003) imply that they might have an incentive to opt for more conservative fund strategies and more insurance to diminish the likelihood of having to top fund assets in the future, thus significantly reducing the range of assets returns potentially accessible to the individual pensioners.…”

The Role of Economic Policy in Social Security Reform: Perspectives from the President's Commission

“…The Commission elected not to propose PRA guarantees, instead calling for more research on the likely structure of such investment options. For relevant research on pension guarantees see Bodie (2001); Bodie and Merton (1993);Feldstein and Ranguelova (2000); Lachance and, among others..…”