Defined Contribution Pension Plans: Who Has Seen the Risk?

30 Pages Posted: 14 Mar 2019

See all articles by Peter Forsyth

Peter Forsyth

University of Waterloo - David R. Cheriton School of Computer Science

Kenneth R. Vetzal

University of Waterloo

Date Written: February 21, 2019

Abstract

The trend towards eliminating defined benefit (DB) pension plans in favor of defined contribution (DC) plans implies that increasing numbers of pension plan participants will bear the risk that final realized portfolio values may be insufficient to fund desired retirement cash flows. We compare the outcomes of various asset allocation strategies for a typical DC plan investor. The strategies considered include constant proportion, linear glide path, and optimal dynamic (multi-period) time consistent quadratic shortfall approaches. The last of these is based on a double exponential jump diffusion model. We determine the parameters of the model using monthly US data over a 90 year sample period. We carry out tests in a synthetic market which is based on the same jump diffusion model and also using bootstrap resampling of historical data. The probability that portfolio values at retirement will be insufficient to provide adequate retirement incomes is relatively high, unless DC investors adopt optimal allocation strategies and raise typical contribution rates. This suggests there is a looming crisis in DC plans, which requires educating DC plan holders in terms of realistic expectations, required contributions, and optimal asset allocation strategies.

Keywords: defined contribution plan, probability of shortfall, quadratic shortfall, dynamic asset allocation, resampled backtests

JEL Classification: G11, C61

Suggested Citation

Forsyth, Peter and Vetzal, Kenneth R., Defined Contribution Pension Plans: Who Has Seen the Risk? (February 21, 2019). Available at SSRN: https://ssrn.com/abstract=3340048 or http://dx.doi.org/10.2139/ssrn.3340048

Peter Forsyth (Contact Author)

University of Waterloo - David R. Cheriton School of Computer Science ( email )

200 University Avenue West
Waterloo, ON
Canada

Kenneth R. Vetzal

University of Waterloo ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada
519-885-1211 (Phone)
519-888-7562 (Fax)

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