Guarantees in pension plans
Many pension plans and life insurance contracts contain guarantees. These typically take the form of guaranteed returns on the investments or a guaranteed benefit. In the Netherlands, most pension plans have a nominal floor, i.e. a guaranteed nominal benefit, with indexation conditional on the financial situation of the fund. This nominal floor can be cut only in exceptional circumstances. The supervisory framework uses the guarantees to establish the value of the fund’s liabilities. Typically, the guarantees are in nominal terms but some pension plans have real (price or wage indexed) guarantees. Also in the private, voluntary market guarantees are common, especially in life insurance products. On the other hand, we see very few DC systems with guarantees or option-like investments that guarantee a minimum return or have investment in options or portfolio-insurance type strategies.
Practitioners indicate that guarantees are important in the communication with pension plan members. There may be several reasons for this. First, it is not easy to understand an ‘open ended’ contract where the pension depends on investment returns. Communicating pension rights appears easier (however, this argument relies to some extent on money illusion). Second, guarantees reduce the incompleteness of the pension contract. Typical pension plans are far from a complete financial contract and leave a lot of discretion to the board of the pension plan. Guaranteed minimum benefits put a lot of discipline on the discretionary decisions, especially in bad states of the world. Thus, guarantees may alleviate governance problems and make the plan members trust the contract more.
In this project, we’d like to understand the economic reasons for providing guarantees and investigate what the optimal form and the optimal amount of guarantees is for a pension plan. These are by no means trivial questions. Standard life-cycle models of optimal saving, investment and consumption typically do not generate demand for guarantees. On the other hand, behavioral finance work suggests that investors are loss-averse and prefer guarantees. Structuring guarantees in a way that satisfies the preferences of a heterogeneous pension plan clientele is complex. A final question we plan to address is how to implement financial strategies that deliver guaranteed returns and how to price these in incomplete markets.