Nonetheless, there may be concern among policymakers that IA participants will face capital market risk, particularly if they concentrate their accounts in stock market investments in the pursuit of higher returns. One approach to this problem is to restrict the extent of equities allowed in workers' accounts; another is to offer guarantees.
This chapter has explored several guarantee designs and assessed their likely costs. It shows that offering guarantees on defined contribution pension accounts could be costly, even when participants are restricted to holding no more than half their portfolio in stock and the rest in bonds. For instance, in this framework our model suggests that a 10-year Treasury bond return guarantee would still require increasing annual contributions by 65 bps, or 16 percent of contributions, for the long-term saver. This would likely be perceived as a substantial cost increase over and above the basic contribution by most plan participants. If these costs were not self-financed, substantial subsidies would be required. Subsidies of this sort must be measured, recognized, and their financing implications spelled out in detail for a full accounting of the economic costs and benefits of guarantees.
These cost estimates might seem high to people accustomed to the argument that stock returns are expected to outperform bond returns over time. We argue, however, that because of the paucity of independent observations in historical data on long holding periods, past returns are noisy predictors of future returns. In addition, guarantee costs are driven by stock and bond volatility rather than their expected returns.
This Appendix details the modeling assumptions used to derive cost estimates for the illustrative examples discussed in the text. We summarize guarantee costs for four workers who participate in the IA program for, respectively, T=10, 20, 30, and 40 years. It is assumed that the IA starts in 2004 and economic variables are projected accordingly. Sections A and B of this Appendix describe the economic and demographic assumptions. The stochastic processes followed by the bills, bonds, and stocks are modeled separately in Section C. Section D details the elements necessary to compute the IA values as well as the social security annuity. Section E derives the cost of each guarantee formula while Section F shows how to generate numerical values for the guarantee costs using a Monte Carlo simulation.
All projections are expressed in nominal values, with the inflation and real processes modeled separately. Assumptions for inflation growth, real wage growth, and real interest rates are taken from the OASDI Annual
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Book title: The Pension Challenge: Risk Transfers and Retirement Income Security. Contributors: Olivia S. Mitchell - Editor, Kent Smetters - Editor. Publisher: Oxford University Press. Place of publication: Oxford, England. Publication year: 2003. Page number: 177.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.