Sustainability of funded pension schemes: A financial position perspective using options

Abstract

This study offers in-depth knowledge of the socio-economic characteristics of funded pension projects. It is based on the financial position of pension market actors during the transition of the pension system to a more funded capitalized scheme, mainly through the option benefit model. This is possible due to the fact that the economy is not viewed as a single earning cohort. The study analytically demonstrates a socio-economic anomaly in the funded pension system, which is in favor of high-earning cohorts at the expense of low-earning cohorts. This anomaly is realized due to lack of insurance and exposure to financial and systemic risks. Furthermore, the anomaly might lead to the pension re-reform back to an unfunded scheme, mainly due to political pressure. A minimum pension guarantee was found to be a rebalance mechanism to this anomaly, which increases the probability of a sustainable pension scheme. Specifically, it is argued that implementing a guarantee with an intra-generational, risk-sharing mechanism is the most effective way to reduce the impact of this abnormality. Moreover, the paper shows the convergence process toward implementing a minimum pension guarantee in many countries that have capitalized their pension systems during the last three decades, in particular in Latin America and Central and Eastern Europe.

Keywords

• defined contribution
• pay-as-you-go
• put option
• social security