Shaping Returns in DC Pension Accounts: The Question of Rate of Return Guarantees

Abstract

While many economists have priced rate of return guarantees inside retirement accounts, in an incomplete market the value of a guarantee to individual investors may be different from its cost. Using a calibrated lifecycle model, we jointly estimate both lifetime asset allocation and asset location for individuals with DC retirement accounts who cannot trade dynamically, who face significant unhedgeable income risk and who receive means tested benefits and pay taxes. We use the model to estimate the demand for a 5 year guaranteed investment product which allows individuals to construct a wide variety of 5 year investment portfolio rate of return guarantees inside their DC retirement accounts. We find that the ability of investors to choose their asset allocation between equities and bonds largely eliminates any demand for 5 year portfolio return guarantees at fair prices for investors with standard preferences. Guarantees are most valuable for individuals who are pessimistic about future equity returns but who have low risk aversion and so choose not invest in bonds. We suggest that portfolio restrictions on asset allocation inside retirement accounts may consequently be a more cost effective way of managing risk exposure than explicit rate of return guarantees for most people in DC retirement systems.