Guaranteeing Defined Contribution Pensions: The Option to Buy-Back a Defined Benefit Promise

Abstract

After a long commitment to defined benefit (DB) pension plans for US public sect or employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk which was previously borne by state DB plans has now devolved to employees covered by the new DC plans. In light of this trend, some states have proposed a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to bu y back their DB benefit for a price. This paper develops a theoretical framewor k to analyze the option design and illustrate how employee characteristics influ ence the option's cost. We illustrate the potential magnitude of a buy-back opt ion value enacted recently by the State of Florida for its public employees. If employees were to exercise the buy-back option optimally, the market value of t his option could represent up to 100 percent of the DC contributions over the wo rklife.