The Victory of Hope Over Angst? Funding, Asset Allocation, and Risk-Taking in German Public Sector Pension Reform

38 Pages Posted: 11 Apr 2007

See all articles by Raimond Maurer

Raimond Maurer

Goethe University Frankfurt - Finance Department

Olivia S. Mitchell

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

Ralph Rogalla

St. John's University - Tobin College of Business - School of Risk Management, Insurance, and Actuarial Science; Goethe University Frankfurt - Department of Finance

Date Written: April 2007

Abstract

Public employee pension systems have traditionally been of the pay-as-you-go defined benefit (DB) variety, where retiree payments are financed by taxes (contributions) levied on the working generation. The same holds for Germany, where civil servants are promised a (mostly) unfunded, noncontributory, tax-sponsored DB pension, representing substantial liabilities currently not recognized as explicit obligations to the public sector. This paper analyzes the risks and rewards of moving to a (partially) prefunded pension system for most civil servants in the German federal state of Hesse. First, we conduct an actuarial valuation of pension promises to retired and active civil servants, which we conservatively put at € 44 billion in present value, or about 150 percent of explicit state debt. Second, we project 50 years into the future and estimate the payroll-related contribution rate sufficient to fund the civil servant pension obligation. Next, using a Monte Carlo framework and a stochastic present value approach, and a Conditional Value at Risk measure, we identify an asset allocation for plan assets that minimizes worst-case pension costs. Prefunding the pension with a tax worth about 20 percent of payroll, and investing the assets 30 percent in equities and 70 percent in bonds, substantially reduces expected and minimizes worst-case pension costs. Finally, we illustrate contribution rates and asset allocation when the plan sponsor is limited to a particular risk budget. In one interesting case, current taxpayers are asked to pay additional regular contributions of only 15 percent while the portfolio is held 43 percent in equities. This mix allows future generations to benefit from possible contribution holidays and withdrawals, while providing an acceptable level of risk of supplementary contributions resulting from underfunding.

Suggested Citation

Maurer, Raimond and Mitchell, Olivia S. and Rogalla, Ralph, The Victory of Hope Over Angst? Funding, Asset Allocation, and Risk-Taking in German Public Sector Pension Reform (April 2007). Pension Research Council Paper No. WP2007-8. Available at SSRN: https://ssrn.com/abstract=979302 or http://dx.doi.org/10.2139/ssrn.979302

Raimond Maurer (Contact Author)

Goethe University Frankfurt - Finance Department ( email )

Grüneburgplatz 1
House of Finance
Frankfurt, 60323
Germany

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

Ralph Rogalla

St. John's University - Tobin College of Business - School of Risk Management, Insurance, and Actuarial Science ( email )

101 Astor Place
New York, NY 10003
United States

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

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