Understanding Individual Account Guarantees

Demographic aging renders workers vulnerable to the inherent uncertainty of unfunded social security systems. This realization has set off a global wave of social security reforms, and more than 20 countries have set up Individual Accounts (IA) plans in response. Strengths of IAs are that participants gain ownership in their accounts, and they also may diversify their pension investments; additionally they produce a capitalized, funded system that enhances old-age economic security. While IAs reduce the risk participants face due to unfunded social security system, holding capital market investments in IAs could expose participants to fluctuations in the value of their pension assets. Concern over market volatility has prompted some to emphasize the need for “guarantees” of pension accumulations. This paper offers a way to think about guarantees in the context of a reform that includes Individual Accounts. We illustrate that guarantee costs can be important and they can vary significantly with time horizon, investment mix, and guarantee design. The findings indicate that plan designers and budget analysts would do well to recognize such costs and identify how they can be financed. Authors’ Acknowledgements The authors are grateful for comments provided by Zvi Bodie, Neil Doherty, Alex Muermann, and Kent Smetters. They also benefited from research support provided by the Michigan Retirement Research Center, the Shannon Schieber Memorial Fund, and the Society of Actuaries (Lachance); the Pension Research Council (Mitchell); and the Department of Insurance and Risk Management at the Wharton School of the University of Pennsylvania (both authors). Opinions remain solely those of the authors. Lachance and Mitchell, 2002.