Managing Contribution and Capital Market Risk in a Funded Public Defined Benefit Plan: Impact of CVaR Cost Constraints
34 Pages Posted: 26 Aug 2008 Last revised: 26 Nov 2011
Date Written: August 25, 2008
We analyze the risks and rewards of moving from an unfunded defined benefit pension sys-tem to a funded plan for civil servants in Germany, allowing for alternative strategic contribu-tion and investment patterns using a Monte Carlo framework. For this purpose, we integrate traditional pension plan manager objectives (i.e. contribution rate volatility) and a Conditional Value at Risk restriction on overall plan costs. First, we estimate contributions as a percent of salary that would fully fund future benefit promises for active employees. Second, we identify a contribution and investment strategy that will minimize contribution rate volatility while at the same time restrict worst-case plan costs to the deterministic plan liability; this turns out to be a contribution rate of 13.4% of the payroll, combined with an asset mix of 41% in equities, 59% in bonds. Third, we analyze the time path of expected and worst-case contribution rates under the optimal strategy to explore chances of contribution rate cuts for current and future generations. We show that moving toward a funded pension system for German civil servants can be beneficial to both taxpayers and civil servants.
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