Evaluating the Design of Private Pension Plans
The growth of private pensions and their expanding role in retirement income systems calls for a better understanding and management of the risks that they are exposed to. Investment risk features most prominently amongst them, as evidenced by the average decline of 20 percent in OECD private pension assets between January and October 2008.
From the perspective of the plan member, private pensions are a form of long-term savings, where contributions today are invested in order to pay for benefits tomorrow. Plan members generally prefer guaranteed benefits, as in a defined benefit (DB) plan, but trade-offs such as the cost of volatility in contributions, need to be taken into account. Increasingly, however, employers are turning to (collective) defined contribution (DC) plans where contribution rates are fixed but retirement income risks are borne entirely by employees.
The principal purpose of this paper is to analyse the trade-off between the (un)certainty in contributions on the one hand and benefits on the other that is embedded in different pension arrangements. The paper employs the funding ratio (ratio of assets to liabilities) and the replacement rate (ratio of benefits to salaries) as key criteria for evaluating the risk sharing characteristics of a private pension plan or scheme from the perspective of the plan member. The focus is on risk sharing within the various schemes, irrespective of whether it is the employer, employees, or a combination of both that pays contributions.