Adjusting Risk and Return of Personal Retirement Accounts
August 28, 2001
Private financial markets could provide a minimum guarantee for Personal Retirement Account (PRA) annuities as part of an investment-based reform of Social Security, according to a study by economists Martin Feldstein and Elena Ranguelova. Under such a system, individuals could enjoy the higher returns offered by investing in stocks and bonds while managing the market risk.
Individuals could, in effect, purchase a "put option" guaranteeing a minimum level of retirement annuity from their PRA. They would pay for it by selling a "call option" on returns above a specified level. Such a combination of put and call options is called a "collar." Some variable annuities, for instance, use collars to guarantee a minimum payment financed by forgoing some portion of potential returns above that level, or above some higher level.
Collars could be used to limit the extent of uncertainty of the PRA returns or completely eliminate the risk of future annuities falling below the level of benefits Social Security promises under current law (the benchmark).
Among a number of scenarios the researchers considered:
- A combination of the current payroll tax and an additional PRA contribution rate equal to 2.5 percent of covered earnings would guarantee the benchmark Social Security benefit.
- Raising the PRA contribution to 3 percent means that future benefits would fall in the collar range of 100 percent to 145 percent of the benchmark.
- Reducing the guarantee level to 90 percent of projected future benefits would increase the upside potential to 150 percent of the benchmark with a 2.5 percent PRA contribution, and to 195 percent of currently projected benefits with a 3.0 percent contribution.
Thus, use of financial derivatives could allow individuals to decide the level of risk they are prepared to accept in return for the possibility of higher retirement annuities.
Source: Andrew Balls, ""Reducing the Risk of Investment-Based Social Security," NBER Digest, January 2001; based on Martin Feldstein and Elena Ranguelova, "Accumulated Pension Collars: A Market Approach to Reducing the Risk of Investment-Based Social Security Reform," NBER Working Paper No. 7861, August 2000, National Bureau of Economic Research.
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