The defined pension fund quandary – securing the future in unsecure times
As the world of pension provisions shifts from unfunded social security to privately-funded schemes, future retirees are faced with a variety of pension plans.
Deciding when and how much to pay in is important whatever the choice they make. However, until now research has failed to account for the potential effect of the unstable economic climate on the performance of pension funds, liquidity risks, potential delays, and the possible irregularity with which payments may be made. A new model has been devised that will help people minimise the cost of contributing to their pension fund and keep the value of the fund as close to the original forecast as possible.
Private pension funds currently break down into two main categories, which differ in terms of potential risk and benefit – defined contribution schemes or defined benefit plans. In the former case, financial risk is covered by affiliates and the potential returns depend upon the performance of the assets invested, which usually comprise a combination of stocks and bonds. This is the more commonly-taken option as it provides a greater level of insurance. In the latter case, the company sponsoring the pension plan covers any potential risks and performance is independent of the returns generated by assets. In this case, it is especially important for the company carrying the weight of the fund to time contributions correctly.
The defined benefit plan litmus test
The two private options have one main point in common – the time in advance at which payments are made. In short, the longer-standing contributions are, the higher the potential gain. However, it is the defined benefit plan that has generated the most research interest, not to mention from the companies who support their employees’ pension plan in the first place.
The harsh reality is that fluctuations in the markets are bound to have an effect on such plans, thereby making it especially important that contributions are paid in at carefully judged times to ensure that the mathematical reserve set up at the beginning is sufficient to cover any possible liabilities. It is here where research up until now has failed to address these two key variables – the timing of contributions and market volatility.
Impulsive but controlled investment
Analysis thus far of the defined benefit plan has been based upon the assumption that payments are made on a continuous basis and/or at regular intervals. In a context of total economic stability devoid of change, this would make perfect sense, which cannot be said to be the case today. In addition, no account has been made for the transaction costs inherent in such plans.
The reality (especially in today’s economic climate) is that fluctuating economic cycles make it particularly important that the sponsoring company picks and chooses the right moment. In addition, it has to make contributions in order to offset increased charges relating to the retirement of employees and limit deviations of fund assets from the initial mathematical reserve. Therefore, the timing and amounts paid in depend on the performance of the combination of bonds and stocks, the respective proportion of which is laid out in the management mandate that formalises the link between the sponsor company and the pension fund. It is therefore paramount that timing and all associated variables be weighed up before investments are made.
A model in anticipation of change
A recently-devised mathematical model incorporates several key factors into the equation, namely: the existence of fluctuating economic cycles, transaction costs, illiquidity risk (where the decision to buy or sell affects the market price of stocks), potential time delays between the contribution call and the effective purchase of assets, and the probability of impulse.
The key of this proposed model is in the best possible interest of both the sponsoring company and the future retiree who will at some point draw his or her private pension – to minimise the cost of contributions to fund, keep the market value of the pension plan as close to the original forecast as possible, and benefit from the most profitable plan possible upon retirement. Market frictions are a reality, as are the costs involved in setting up and supplanting a pension plan, so the need is as great as ever to propose to sponsoring companies a model that will support them in optimising the timing and size of the contributions it will pay into a defined benefit pension plan.
This article draws inspiration from the paper Impulse control of pension fund contributions in a regime switching economy, written by Donatien Hainaut and published in The European Journal of Operational Research 239, 2014.
Donatien Hainaut is an Associate Professor of Finance and Accounting at ESC Rennes School of Business, France. His research interests include Quantitative Finance, Risk Management, Pricing of Financial and Insurance Derivatives, and Asset Liability Management