Risk Transfer in Public Pension Plans

Actuaries and sponsors of public sector defined benefit pension plans agree that each generation of taxpayers should bear its fair share of the long term plan cost. Actuarial methods and assumptions are designed to equate expected costs across generations. This paper uses arbitrage principles to show that equating expected costs unfairly lowers risk-adjusted costs for early generations and raises them for later generations. The use of expected rather than risk-adjusted returns on risky assets leads to sub-optimal asset allocations, granting of valuable options (skim funds), and costly financing strategies such as Pension Obligation Bonds.