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

16 Pages Posted: 21 Mar 2003

See all articles by Marie-Eve Lachance

Marie-Eve Lachance

affiliation not provided to SSRN

Olivia S. Mitchell

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)

Kent A. Smetters

University of Pennsylvania - Business & Public Policy Department; National Bureau of Economic Research (NBER)

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Abstract

After a long commitment to defined benefit (DB) pension plans for U.S. public sector employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk that 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 introduced a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to buy back their DB benefit for a price. This article develops a theoretical framework to analyze the option design and illustrate how employee characteristics influence the option's cost. We illustrate the potential impact of a buy-back option in a pension reform 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 this option could represent up to 100 percent of the DC contributions over their work life.

Suggested Citation

Lachance, Marie-Eve and Mitchell, Olivia S. and Smetters, Kent, Guaranteeing Defined Contribution Pensions: The Option to Buy Back a Defined Benefit Promise. Journal of Risk & Insurance, Vol. 70, pp. 1-16, March 2003. Available at SSRN: https://ssrn.com/abstract=388535

Marie-Eve Lachance (Contact Author)

affiliation not provided to SSRN

Olivia S. Mitchell

University of Pennsylvania - The Wharton School ( email )

Philadelphia, PA 19104-6365
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kent Smetters

University of Pennsylvania - Business & Public Policy Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6372
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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