Guaranteeing Defined Contribution Pensions: The Option to Buy Back a Defined Benefit Promise

Abstract

After a long commitment to defined benefit (DB) pension plans for U.S. public sector employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk that was previously borne by state DB plans has now devolved to employees covered by the new DC plans. In light of this trend, some states have introduced a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to buy back their DB benefit for a price. This article develops a theoretical framework to analyze the option design and illustrate how employee characteristics influence the option's cost. We illustrate the potential impact of a buy-back option in a pension reform enacted recently by the State of Florida for its public employees. If employees were to exercise the buy-back option optimally, the market value of this option could represent up to 100 percent of the DC contributions over their work life. Copyright 2003 The Journal of Risk and Insurance.

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