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Defined Contribution Pension Plans: Who Has Seen the Risk?

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  • Peter A. Forsyth

    (David R. Cheriton School of Computer Science, University of Waterloo, Waterloo, ON N2L 3G1, Canada
    This work was supported by the Natural Sciences and Engineering Research Council of Canada.)

  • Kenneth R. Vetzal

    (School of Accounting and Finance, University of Waterloo, Waterloo, ON N2L 3G1, Canada)

Abstract

The trend towards eliminating defined benefit (DB) pension plans in favour of defined contribution (DC) plans implies that increasing numbers of pension plan participants will bear the risk that final realized portfolio values may be insufficient to fund desired retirement cash flows. We compare the outcomes of various asset allocation strategies for a typical DC plan investor. The strategies considered include constant proportion, linear glide path, and optimal dynamic (multi-period) time consistent quadratic shortfall approaches. The last of these is based on a double exponential jump diffusion model. We determine the parameters of the model using monthly US data over a 90-year sample period. We carry out tests in a synthetic market which is based on the same jump diffusion model and also using bootstrap resampling of historical data. The probability that portfolio values at retirement will be insufficient to provide adequate retirement incomes is relatively high, unless DC investors adopt optimal allocation strategies and raise typical contribution rates. This suggests there is a looming crisis in DC plans, which requires educating DC plan holders in terms of realistic expectations, required contributions, and optimal asset allocation strategies.

Suggested Citation

  • Peter A. Forsyth & Kenneth R. Vetzal, 2019. "Defined Contribution Pension Plans: Who Has Seen the Risk?," JRFM, MDPI, vol. 12(2), pages 1-27, April.
    • Handle: RePEc:gam:jjrfmx:v:12:y:2019:i:2:p:70-:d:225342
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    References listed on IDEAS

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    Cited by:

    1. Lars Stentoft, 2020. "Computational Finance," JRFM, MDPI, vol. 13(7), pages 1-4, July.

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