Discussant: Yuewu Xu, TIAA-CREF
Kent Smetters noted that conversion from a Pay-As-You-Go (PAYG) DB plan to individual DC accounts can sometimes fail to significantly reduce risk-adjusted unfunded liabilities due to benefit guarantees in the DC plan. He related a conversation he had with Senator Phil Gramm (R-Texas) in which Senator Gramm stated that for political reasons a reform of the Social Security system involving the transition to DC accounts would have to come with a benefit guarantee of 120 percent of the projected pre-reform level. Kent stated that a benefit guarantee this generous would actually increase Social Security’s unfunded liabilities. The overall point is that offering guarantees as part of the conversion from DB to DC can create possible moral hazard. Furthermore, there is a high potential cost associated with certain types of guarantees. This has relevance for Florida and other state and local governments considering pension plan conversions in the K-12 sector with accompanying benefit guarantees.
Yuewu Xu demonstrated that some aspects of Kent Smetters option methodology could be replicated in a much simpler fashion by using the straightforward Black-Scholes option pricing approach.
