US – New research into personal pensions to be published by the Pension Research Council shows that there is a defined economic cost to pension guarantees, which the researchers say can be likened to a financial asset and priced accordingly.
“When a pension guarantee has economic value to participants, it will have economic costs,” say Wharton School researchers Marie-Eve Lachance and Olivia Mitchell in a Pension Research Council working paper to be published next year.
“Plan designers and budget analysts should recognise such costs and identify how they can be financed,” they say. A pension guarantee needs to be accounted for properly “since real economic resources are required to finance them”.
“Unfortunately there is much confusion regarding the economic value of such costs due in part to the fact that some seek to compute guarantees with risk adjustments, while others discount these payments to the time of the valuation.”
Their proposal is to define guarantee costs “such that the values generated indicate true economic resource costs”.
They have come up with a way to define such costs, likening the pension guarantee to a financial asset that can be valued. “If the pension guarantee commitment were made to capital market investors, the value of the guarantee could be determined by using option pricing techniques,” they say.
This approach would enable a “market value” for the guarantee to be arrived at. “Since the nature of the counterparty should not influence the economic value of the liability, the approach used with capital market investors should also be valid with social security participants.”
They suggest the guarantee conforms to a “put option” – which is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.
They add that pension guarantee costs depend on three factors: 1) relation between guarantee formula and benefit structure 2) portfolio volatility 3) interaction between these elements and the investor’s investment horizon.
Proposals to include guarantees should not only specify costs, but also how they could be financed, the researchers say. Financing issues include: 1) who bears guarantee cost 2) who manages the guarantee 3) price structure.
It is important to realise the existence of guarantee costs, whether or not it is clear who shoulders the cost, they say. “Failing to report economic costs and benefits of guarantees cannot avoid the reality that economic resources are still at risk under the guarantee, and value as being transferred to participants.”
They envisage off-the-peg guarantees being offered by financial services firms. “One might image financial services firms offering contracts that are standardised in terms of earnings, portfolio mix, retirement age, and so forth.”
Dr. Mitchell is the executive director of the Pension Research Council, which is part of the Wharton School at the University of Pennsylvania.