Designing and Pricing Guarantee Options in Defined Contribution Pension Plans
30 Pages Posted: 12 Feb 2015 Last revised: 11 Dec 2015
Date Written: September 28, 2015
The shift from defined benefit (DB) to defined contribution (DC) is pervasive among pension funds, due to demographic changes and macroeconomic pressures. In DB all risks are borne by the provider, while in plain vanilla DC all risks are borne by the beneficiary. For DC to provide income security some kind of guarantee is required. A minimum guarantee clause can be modeled as a put option written on some underlying reference portfolio of assets and we develop a discrete model that optimally selects the reference portfolio to minimise the cost of a guarantee. While the relation DB-DC is typically viewed as a binary one, the model can be used to price a wide range of guarantees creating a continuum between DB and DC. Integrating guarantee pricing with asset allocation decision is useful to both pension fund managers and regulators. The former are given a yardstick to assess if a given asset portfolio is fit-for-purpose; the latter can assess differences of specific reference funds with respect to the optimal one, signalling possible cases of moral hazard. We develop the model and report numerical results to illustrate its uses.
Keywords: Pensions, minimum guarantee, defined benefits, defined contributions, embedded options, risk sharing, portfolio selection, stochastic programming
JEL Classification: G23, C61, G11, G22, G28
Suggested Citation: Suggested Citation