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

16 Pages Posted: 19 Jul 2007  

Jeffrey N. Gordon

Columbia Law School; European Corporate Governance Institute (ECGI)

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 Classification: D30, G23, G28, H55, Ill, J18, J38, K31

Suggested Citation

Gordon, Jeffrey N., The 'Prudent Retiree Rule': What to Do When Retirement Security is Impossible?. Lewis & Clark Law Review, Vol. 11, No. 481, 2007; Columbia Law and Economics Working Paper No. 314. Available at SSRN: https://ssrn.com/abstract=1000231

Jeffrey N. Gordon (Contact Author)

Columbia Law School ( email )

435 West 116th Street
Ctr. for Law and Economic Studies
New York, NY 10027
United States
212-854-2316 (Phone)
212-854-7946 (Fax)

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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