Nominal GDP swaps 'could be key to DC guarantee'
EUROPE - Officials at the Bank of Italy have been working on a proposal to create a public swap-based return guarantee for members of defined contribution funds.
Guiseppe Grande and Ignazio Viosco, from the Bank of Italy’s economic research department, delivered a paper to a DC risk-sharing conference in the UK last week arguing governments could improve confidence among retiring DC pension plan members.
In order to do so, the government would have to finance swaps related to nominal GDP growth which delivered at least the members’ contributions or the nominal growth rate GDP, depending on their preference, according to the economists.
More specifically, the proposal for a public guarantee is based on a government offering to place a swap contract on those years where nominal GDP growth does not outperform stock markets.
According to analysis of US stock market and GDP data presented by Grande, there were 20 years in the last 70 years where nominal GDP did not outperform stock markets.
He noted that DC plan members nearing retirement are severely exposed to investment risks and in situations like experienced in 2008 members either have to continue to work longer - a risky strategy given that financial crises weaken labour markets and market recoveries can be variable - or buy a substantially more expensive market-based guarantee.
Instead, he suggests the government could provide a swap based on nominal GDP which is then financed by the authorities through the issuance of 15-year bonds, at a cost of approximately 1% of GDP to the government.
When studying 10-year nominal growth rates, Grande found it would take six years to recover the cost of the net outlay for a swap taken in 1974, and this would recover not only the swap but the bond interest dispensed.
Of course, any guarantee would come at a price to the DC member, depending on the investment strategy they opted for.
Examples presented suggest a DC member with 100% equities would be equivalent to 1.2%-1.4% over a 10-year period, based on a 12% contribution rate, or 0.5%-0.6% over that same period for a 5% contribution rate.
The cost over 40 years for a balanced portfolio would be 0.71% of the GDP growth rate, although this increases to 1.33% if they adopt a lifecycle strategy and decreases to 0.2% for a 100% 10-year government bonds strategy.
The concept is built on academic theory only at this stage and was created from US data as this was most readily available, stressed Grande at the conference hosted by Exeter University, so further testing would need to be conducted.
However, delegates attending the conference raised concerns about whether governments would be willing to adopt such a strategy when domestic debt levels are already so high thanks to the recent financial crisis.
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