Understanding and Allocating Investment Risks in a Hybrid Pension Plan
This paper analyzes pension plan costs and investment strategies in the context of alternative hybrid pension plans which are optimal either from the perspective of the plan sponsor or the beneficiaries.The focus is in particular on how the introduction of minimum and maximum limits for pension benefits as well as minimum guarantees and caps on the return of the members’ individual investment accounts affect investment decisions and plan costs. Within a comparative static analysis framework, it is shown that for low to medium risk portfolios, minimum benefit guarantees tend to be more expensive than minimum return guarantees while for the latter costs increase exponentially with investment risk. The study also finds that portfolio choices of the sponsor and the beneficiaries show substantial differences depending on the exact plan design and the beneficiaries’ risk aversion. Combining minimum return guarantees and caps on investment returns emerged as a possible means to reduce such differences, to share investment risks and returns more equally between sponsor and beneficiaries, and to keep pension plan costs under control.