Pension Guarantees, Capital Adequacy and International Risk Sharing

The economic function of pensions is to provide income security to people in their old age. Around the world pensions are provided through a mix of social security, occupational pension plans, and investment products of financial intermediaries, but ultimately they are backed by governments either through explicit or implicit guarantees. Pension systems are too big and too important to fail. When retirement income is provided through individual investment accounts, as in the case of 401k plans in the U.S., it is essential that they carry a guarantee of a minimum level of income, wealth, or rate of return provided by the asset management firm. A guarantee transfers primary responsibility for bearing downside risk from consumers to producers, who typically have far greater knowledge and skill in handling it. There are at least three reasons for having guarantees: 1. It greatly reduces the moral hazard problem in the provision of such products, and therefore results in lower marketing and distribution costs for society. 2. It makes it far more transparent to consumers what they are buying, and therefore reduces the need for costly financial “education” which has not proved effective in the past. 3. Many consumers mistakenly think there is almost no risk in the long-run performance of the stock market. Making consumers aware that there is such risk, and that it can only be avoided at a cost, increases consumer and societal welfare. This paper explores the principles for managing pension guarantees efficiently using option pricing theory as the basic analytical framework. It considers how financial innovation and the increasing globalization of financial markets can be employed to guarantee pensions more efficiently than in the past