Linking Benefits to Investment Performance in US Pension Systems


Some countries, such as Norway, have incorporated a pension model called “risk-sharing”—a model where COLAs (and sometimes even benefit amounts) are contingent on investment performance. In other words, plan participants bear much more investment risk than participants in traditional DB plans.

What if that policy were extended to every public pension system in the United States? What effect would it have on liabilities?

Robert Novy-Marx and Joshua D. Rauh published a paper on the topic in the Journal of Public Economics last month.

From the paper:

Replacing COLAs across the US with PLAAs [performance-linked annuity adjustments] with a 5% hurdle and a guarantee that benefits would not fall below their initial level at retirement reduces the present value of legacy liabilities by $575 billion (or 12%) and the unfunded legacy liability by around 25%. Without minimum benefit guarantees, the legacy liability falls by $1.2 trillion (or 26%) and the unfunded legacy liability falls by 53%.

These reforms would also lower the annual required revenue increases to fund state plans within 30 years. These required increases stand at $1147 per household per year under current plan rules. They fall to $770 per household per year with PLAAs if benefits are not guaranteed to remain above a minimum level, but to only $1016 per year if benefits are guar-anteed not to fall below the initial level at retirement.

Of course, those numbers would come at a price for retirees: they’d bear extra risk during retirement under this policy. From the paper:

The PLAA arrangement leaves participants bearing risk only during retirement, not during the time they are working. Standard intuition from the lifecycle portfolio literature suggests that given a choice, individuals prefer to bear risk during the earlier years of their lives instead of the later years.


In a utility framework, we find that depending on the parameters, PLAAs with the hurdle rates and floors that we study in this paper can have either gains or losses relative to a COLA in terms of expected utility. Of course, the PLAAs we compare to COLAs here are generally substantially cheaper to provide, particularly with 5% hurdle rates and above. Even where expected utility is reduced, there are points of the distribution where the utility outcomes from the PLAAs surpass those of the COLAs, due to the benefits of equity exposure to CRRA utility agents with relatively modest degrees of risk aversion.

The rest of the paper can be read here.

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