Stochastic Modelling and Comparison of Two Pension Plans

In this project, we simulate the operation of a stylized jointly sponsored pension plan (JSPP) and a stylized defined contribution (DC) plan with identical contribution patterns using a vector autoregressive model for key economic variables. The performance of the two plans is evaluated by comparing the distribution of pension ratios for a specific cohort of new entrants. We find that the DC plan outperforms the JSPP in terms of expected pension ratio, and experiences only a moderate degree of downside risk. This downside risk is not enough to outweigh the upside potential even for a relatively risk-averse member, as reflected in the expected discounted utility of benefits under the two plans. Under more sophisticated rate stabilization techniques, the probability that the DC plan outperforms the JSPP increases. When the bond yield and stock return processes begin from values far above their long-term means (not far below, as is the case today), the DC plan is projected to outperform the JSPP even more frequently, because the higher required contributions accrue to the advantage of the individual member only, instead of also financing benefits for others.