The 'Prudent Retiree Rule': What to Do When Retirement Security is Impossible?

Abstract:     
Policy debates about the appropriate risk levels for individual retirement plans and social retirement plans (like social security) often pay insufficient attention to the inescapable trade-off between payment risk (the risk of insufficient funding for anticipated benefits) and short fall risk (the risk of insufficient benefits for a satisfactory retirement). Thus a prudent retiree rule would permit a prudent level of contingent funding of retirement payouts. Contingent funding - basing benefit expectations on funding sources that may not materialize - increases payment risk, yet pension systems without some contingent funding will produce inferior benefits in most states of the world, increasing shortfall risk. Contingent funding can take different forms: underfunding (in an actuarial sense) of defined benefit promises, which means reliance on the firm's continued profitability; a tilt toward equity investments in a defined contribution plan, including an appropriate level of employer own stock, and reliance on pay-as-you-go (PAYGO) funding of social security benefits in which each generation funds its predecessor's benefits. The case for the prudent retiree rule is strengthened through a better appreciation of the underlying risks to retirement security: demographic risk (too many retirees relative to workers); economic risk (insufficient economic growth) and distributional risk (non-effort-based individual economic outcomes). Policies that address these risks can significantly reduce the risks associated with contingent funding.

JEL Classifications: D30, G23, G28, H55, Ill, J18, J38, K31

Accepted Paper Series