(May 27, 2014) — Introducing alternative pension policies could help unsustainable US public pension plans reach higher funded ratios in the long-term, according to research from Dutch experts.
Typical US state defined benefit (DB) pension plans could gain from changes in portfolio composition, increasing participant contributions, and reducing indexation that is used to match an employee’s salary to the inflation rate, the researchers said.
“We apply the so-called method of value-based asset-liability management (ALM) to address reform-induced value redistribution among the different stakeholders of the fund—the various cohorts of plan participants and tax payers,” said Zina Leknuite of Tilburg University, Roel Beetsma of the University of Amsterdam, and Eduard Ponds of pension manager APG. “Essentially the method involves rewriting a pension plan in terms of embedded options held by the fund’s stakeholders.”
The authors simulated a typical public DB plan over a period of 75 years and observed its policies and funding ratios in both standard ALM and value-based ALM.
Its “classic” ALM results found that boosting contributions, speeding up the amortization payments, or significantly reducing indexation to consumer-price inflation led to a long-term improvement of the funding ratio.
In particular, the authors emphasized the need for a conditional indexation rule, such as one linked to performance rather than cost-of-living adjustments that has become popular among Dutch pension funds.
“This way of using indexation has a tendency of improving the financial position of the fund, but at the same time compressing the spread in the distribution of possible funding ratios and, thereby, also compressing the spread in the distribution of contribution rates, as its amortization component is linked to the funding ratio,” the authors said.
The value-based ALM observation of the simulated fund showed that the current pension yields considerable net benefit to all aspects of fund participants, which then puts heavy financial burden on taxpayers. The researchers found that during the 75-year period, plan participants received almost $28 trillion in benefits while taxpayers contributed about $17 trillion.
In such a scenario, the authors tried multiple policy reforms and found several alternative strategies that improved funding ratios and alleviated burdens from taxpayers.
First, doubling participants’ contributions did not affect net benefits from the pension contract while taxpayers saved almost $4.5 trillion. Halving the indexation to the consumer price index inflation rate alleviated almost $3 trillion to $4 trillion while reducing participants’ pension value by 20%. Research found little change in pension value from changes in the investment portfolio but helped shift values between taxpayers and the fund’s outstanding value.
“The substantial net benefit of the promises to fund participants at the cost of taxpayers could be an argument for fund boards and participants to initiate steps towards improving their funding by raising contributions or by cutting back on benefit levels,” the authors said. “The looming financial burden on taxpayers and the prospective deterioration of public services may chase away individuals of working age from specific states.”
Read the full paper here.
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