Contest Details

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The success of a collective retirement plan will depend on finding an optimal plan design and figuring out appropriate investment strategies given various market scenarios. To help evaluate those choices, we have developed a basic financial model of how such a collective retirement plan might work during the asset accumulation phase. (An overview of the model is available here.) It is designed to be a tool for you to use in developing a proposal for the best ways to achieve the objectives of a collective investment plan. You can vary some of the assumptions and may also choose to modify the source code (written in R). Your assumptions and the version of the code that you use must be included with your submission.

To ensure reasonable and consistent assumptions across competing proposals, we’ve fixed certain model parameters. Those include the expected returns and joint risk of the available asset classes; demographic assumptions like the distribution of ages at which workers are hired, the probability by age with which they separate prior to retirement, and the age of retirement; and economic assumptions such as real wage growth and average inflation.

Objective

Your objective is to craft an investment strategy and risk-sharing policy that would provide retirees with the highest achievable scheduled benefit for retirees. Your answer should be submitted for each of two risk-tolerance scenarios.

A. Lower-Risk Scenario. The chance of the realized benefit falling short of the scheduled benefit is less than 10%, and the chance of the realized benefit falling short of 80% of the scheduled benefit is less than 2%.

B. Higher-Risk Scenario. The chance of the realized benefit falling short of the scheduled benefit is less than 20%, and the chance of the realized benefit falling short of 50% of the scheduled benefit is less than 2%.

Questions

Quantitative Component
  1. Asset allocation. A critical choice affecting the amount and riskiness of resources available to retirees is asset allocation during the accumulation phase. What do you think is an optimal split in the investment pool between stocks, bonds, and alternative assets? What guidance would you offer about whether the shares invested in different asset classes should be held constant over time or whether they should vary with plan or market conditions? Would participant preferences be reflected in the asset allocation choice, and if so, how?
     
  2. Risk sharing across cohorts. Risk sharing can be accomplished across cohorts by capping the annual returns credited to a worker’s individual account and sweeping any excess into a common buffer pool that is used to create a floor rate of return for retirees when funds are available. What would you set as the return ceiling? What would you set as the return floor? Make sure to take into account the interaction of your asset allocation rule with the floor and ceiling rates. Under your proposed strategy, how often is the buffer pool inadequate to ensure floor benefits to retirees and how large are the average shortfalls?

70% of the prize money will be awarded based on the best answer to the questions above. In the event of multiple winning entries the prize money will be split evenly across the winners. Entries can be submitted by individuals or by teams.

Qualitative Component

The remaining 30% of the prize money will reward the contestants (first place and runner-up) who not only find an attractive investment strategy and risk-sharing policy, but who also lay out the most compelling vision for the overall structure of a CDCP. Qualitative entries should address some or all of the following questions in no more than 2,000 words.

  1. Contribution rates. For the purpose of making contest submissions comparable, you are asked to assume that workers and employers each contribute a fixed 10% of annual wages to the plan. However, we are also interested in your views on pension adequacy. In your view and based on your analysis, would those percentages provide adequate retirement resources? Are those contribution levels higher or lower than what you would recommend? Would you modify the rules to adjust contribution rates in response to investment performance (e.g., increase them after an extended period of below-expected returns)? Assume that workers in these plans do not participate in Social Security.

  2. Managing the buffer pool. The buffer pool can become very large relative to the size of obligations that it is protecting due to prolonged periods of higher-than-expected asset returns or conservative risk-sharing rules that cap individual accumulations at a relatively low level. What would you consider to be an excess accumulation? What would you do with the excess funds? Possibilities include but are not limited to increased cost of living adjustments for retirees, contribution holidays, and adjustment of ceilings and floors.   

  3. Separating workers. Many employees will leave the system prior to full vesting due to career and/or location changes, death, or disability. The more generous is the rule for what separated workers can take with them, the less is available to reward employees that stay in the system until they are fully vested. What in your view is a fair rule for how much separating workers take with them? How would your proposed rule impact retirees? Note that to make contest entries comparable, the model assumes that separating workers with less than 32 years of service have a claim to their own contributions plus returns from the investment portfolio as well as their employer’s contributions with interest at the risk-free rate, but you can experiment with different assumptions by changing the code.

  4. Accommodating different risk tolerances. (Optional; you can submit an entry without addressing this.) Some people may have a preference for a high degree of certainty about retirement income, while others may be willing to bear more investment risk for the possibility of higher average income. To meet that demand, suggest a system that would accommodate those differences by offering employees a menu with two options of ceiling/floor pairs, and the two different investment strategies that would best support the targeted risk/return profiles.  

  5. Other issues, other approaches. (Optional; you can submit an entry without addressing this.) To focus on some of the most important aspects of plan design and to avoid additional complexity, we have not addressed several important issues. Those include: inflation protection, whether and to what extent retirees are required to annuitize, and how the plan manages investments on behalf of retired workers. Furthermore, there are other approaches for sharing investment risk that could be adopted. For instance, payouts could depend on total plan asset holdings and demographic projections rather than the tracking of notional individual balances as in the model here. You are encouraged to offer your thoughts on any of these issues and how an optimal plan design should deal with them.

Notes:

A. Entry rules and evaluation. A short written description of your proposed investment strategy and risk-sharing policy, and the version of the code that you used to come up with them, must be included with your email submission.

We will run simulations using your proposed strategies to confirm that they meet the constraints in (A) and (B) above, using the required assumptions on returns, etc. The constraints will be checked in years 35, 70, and 100 to assure that the strategy is sustainable over time. The first check is in year 35 to ensure that the system, which starts with a mix of workers of various ages, has reached a steady state.

B. Investment strategy. A critical choice affecting the amount and riskiness of resources available to retirees is asset allocation during the accumulation phase. The goal is to determine the optimal split between stocks, bonds, and alternative assets. You can specify constant asset shares (e.g., 60% stocks, 10% alternatives, and 30% bonds), or a dynamic rule that varies those shares annually as a function of variables such as the size of the Reserve Fund, past returns, the age distribution of the work force, etc.

Trading involves transaction costs. Dynamic strategies will be evaluated with a 5 basis point cost applied to trades in stocks and bonds, and a 15 basis point cost applied to alternative assets. For example, if the current asset portfolio is 60% stocks, 10% alternatives, and 30% bonds, and if it is rebalanced to 50% stocks, 5% alternatives, and 45% bonds the next year, a charge will be assessed against the Reserve Fund equal to the total portfolio value multiplied by the factor .0005(.6-.5)+.0015(.1-.05)+.0005(.45-.3).

C. Risk-sharing policy. Risk sharing is assumed to be accomplished across cohorts by capping the annual returns credited to a worker’s notional individual account and using a Reserve Fund to top up the payments to fully vested retirees to the level of scheduled benefits.

Funds held by the Plan in the Reserve Fund arise from annual returns in excess of the chosen ceiling return, from surpluses from separating workers, and from investment returns on the Fund. Reserve Fund assets are assumed to be invested conservatively, earning the risk-free rate.

The Reserve Fund helps to ensure that fully vested retirees receive no less than the scheduled benefit with a high likelihood. Specifying a risk-sharing policy involves answering two questions: What is the return ceiling above which returns are transferred into the Reserve Fund? What is the scheduled benefit? You will need to take into account the interaction of your asset allocation rule with the scheduled benefit and return ceiling, and choose a combination that is optimal for the lower-risk and higher-risk scenarios, respectively.

We are asking about two different risk scenarios to illustrate a range of achievable risk/return outcomes and to demonstrate the possibility of giving participants some choice over their risk/return profile while preserving the benefits of collective asset management and risk-sharing.

D. Computational model. To evaluate proposed investment strategies and risk-sharing policies, we have developed a basic model of how such a collective retirement plan operates during the asset accumulation phase. Reading the code, which is in R, is the best way to fully understand the model logic. An overview of the model is also available. You can use the model to help develop your answers to the questions on investment strategies and risk-sharing policies. You will need to modify the source code if you want to incorporate dynamic investment strategies. If you modify the code, your entry must include the modifications so that the results can be reproduced.

E. Fixed parameters. To ensure reasonable and consistent assumptions across competing entries, we’ve fixed certain model parameters. Those include the expected returns and joint risk of the available asset classes; demographic assumptions including the distribution of ages at which workers are hired, the probability by age with which they separate prior to retirement, and the age of retirement; economic assumptions such as real wage growth and average inflation; and rules for vesting and the payouts to workers that separate prior to vesting. You can change these in the code to explore the effects of alternative assumptions, but we will use the fixed values to evaluate the quantitative contest entries.


Additional Definitions:

Ceiling return. The rate of return on plan assets above which investment earnings are transferred from notional individual employee accounts into the Reserve Fund.

Fully vested retirees. These are employees leaving the firm with at least 32 years on the job that are entitled to full benefits.

Replacement rate. The replacement rate is defined as the annuity amount that can be supported by assets at retirement or separation divided by the average wage over the last 5 years of employment. It is often used as an indicator of pension adequacy. The model assumes that the annual annuity payment that can be supported is 4% of accumulated assets.

Scheduled benefit. This is the payout to fully vested retirees that is based on a floor rate of return notionally credited to their accounts annually. Fully vested retirees will receive at least the scheduled benefit unless the sum of their true individual account value and the plan’s Reserve Fund are insufficient to support the scheduled benefits. When available funds are insufficient retirees receive the sum of their true individual account value and any funds in the Reserve Fund.

Reserve Fund ceiling. To avoid excessive build-up of reserve assets and to keep the system stable over time, total accumulations in the Reserve Fund are capped and any excess accumulations are distributed back to individual worker accounts in proportion to the existing account balance. The Reserve Fund ceiling is set by each contestant by choosing some multiple of one year’s total payouts at the scheduled benefit rate.

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