Linking Benefits to Investment Performance in US Public Pension Systems

Speaker(s): 
Joshua Rauh (Northwestern University)
Date: 
Thursday, December 13, 2012 - 2:00pm
Location: 
Spandauer Strasse 1, Room 23

This paper calculates the effect that introducing risk-sharing during either retirement or the working life would have on public sector pension liabilities, which currently are imposing unfunded debts of over $4 trillion on US state and local governments. We begin by considering the introduction of a variable annuity for the retirement phase in which positive benefit adjustments are granted only if asset returns surpass 5% but benefits cannot fall below their initial levels. This change would reduce unfunded accrued liabilities by around 25%, and would lower the annual contribution increases required to target full funding in 30 years by 11%. If there is no minimum benefit guarantee, the impact of introducing variable annuities is substantially larger: the unfunded liability would fall by over half and required annual contribution increases would fall by 44%. Alternative measures that have similar effects on costs include increasing employee contributions by 10.3% of pay while keeping benefits unchanged; or giving employees a collective defined contribution plan with an employer contribution of 10% of pay for future service. We discuss these results in the context of models of lifecycle portfolio choice, which suggest that employees should generally prefer to take risk earlier in their lives rather than later.