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Public sector pension systems have also begun
to change. Even in the public sector in the US
there is a gradual movement toward defined
contribution plans as states and localities
have been unreliable in their funding of
defined benefit plans and the resultant major
pension gaps have put pressure on state and
city budgets. Alternatives such as defined
contribution plans are perceived to apply
less budgetary pressure and lower long-term
liabilities on the state.
Defined contribution plans put the individual
in charge of his or her own savings, but these
plans mean that the individual needs to put
aside money, determine asset allocation and
take on the risk of insufficient savings and
subsequent payout. This places much greater
risk on the shoulders of each individual than
a system with group pooling and higher
certainty under a funded defined benefit plan.
The focus of this review is the following
question: How can or should defined
contribution systems best provide for the
payout stage of the savings accumulated
before retirement? In particular, one of the
most challenging issues surrounding a defined
contribution approach is what happens when
an individual reaches retirement age. What are
the appropriate choices in fashioning the pay-
out stage from defined contribution plans?
The core problem
The core problem involves the uncertainty
about how long an individual will live. In the
United States, for example, a 65-year old
female has an average life expectancy of
age 85. But she has more than a 30 percent
probability of living past 90, and a 5 percent
probability of living past 95.
So how should she withdraw her funds from
her retirement account? If her withdrawals are
based on living to the average life expectancy,
she faces a significant risk of running out
of money because she lives longer than the
average. Yet if she plays it very conservatively
and assumes she will live to say 100, her
withdrawals may be too low to sustain her
standard of living.
The best way of addressing this uncertainty
is to pool the risks from individual life
expectancies through a life annuity. A life
annuity involves exchanging the accumulated
balance for a regular payment as long as
the annuitant is alive. Some annuities also
provide survivor benefits, so that if one spouse
passes away, the other can continue to collect
a payment. The annuity, in effect, provides
longevity insurance: the annuitant need not
worry about outliving her assets.
The best way of addressing this
uncertainty is to pool the risks
from individual life expectancies
through a life annuity. A life
annuity involves exchanging
the accumulated balance for a
regular payment as long as the
annuitant is alive.