How to mimic DB-like benefits in a DC product
A classic defined benefit scheme delivers a real annuity at retirement, which is considered to be the optimal pension provision for individuals. The unsustainability of these schemes combined with new regulation is driving a worldwide shift towards defined contribution solutions, which do not deliver a guarantee and thus a suboptimal pension.
People seek to maximize their well-being, not at a single point in time, but over time. (Barr and Diamond, 2008). Following Yaari (1965), Milevsky (2004) states that ‘in a life cycle model without bequest motives, retirees should convert their liquid assets into life annuities that provide longevity insurance and protection against outliving one’s money.’ This should maximize lifetime utility following the life cycle hypothesis originally developed by Ando and Modigliani (1963)1. A nominal annuity does not achieve the optimal level of welfare because the purchasing power of the benefits might decrease over time due to inflation. Brown and Nijman (2011) conclude that individual welfare is received from consuming real goods, and that consumption smoothing over the life cycle is meant in real terms. A real annuity at retirement day is then the optimal solution.
This thesis shows through a simulation study that using financial derivatives there is a way to combine the best of the two worlds into an individual pension product that has clearly defined ownership while delivering a DB like pension.