Korea Capital Market Institute

 This study explores the features of defined benefit(DB) plans and defined contribution(DC) plans in Korea and compares the potential values of each type of retirement plan using the option pricing model and stochastic future value model. Based on the comparison, some policy recommendations are proposed in order to improve DB and DC plans.

 Unlike the traditional DB pension, DB plans in Korea provide workers a lump sum retirement benefits when they retire. The lump-sum benefits in DB plans are calculated based on the years of service and final salaries. Therefore, the longevity risk after retirement in DB plans that is borne by employers in other countries is transferred to the retirees. The remaining difference between DB plans and DC plans is who takes the investment risk during the working phase. While the participants in DB plans can take guaranteed return on investment same as the wage growth rate, participants in DC plans should bear the investment risk.

 This paper values the option imbedded in DB plans using the option pricing model. From an employee’s point of view, a DB plan consists of an underlying asset (DC plan), a long position in a put option, and a short position in a call option, that is a DB plans equal to a DC plan plus a put option minus a call option. The option value analysis of retirement plan shows that a contract under which financial institutions guarantee the minimum rate of return and take risk can be used to reduce the investment risk of pension fund. For example, financial institutions, guarantee minimum rate of return for a period of time, and take a certain percentage of extra return when actual return exceed the guaranteed minimum rate. This contract can be seen as an integrated agreement of buying one put option and selling part of a call option(waiver contract). There can be another type of contract under which financial institutions ensure the minimum rate of return or yield, and the actual rate of return up to a specific level, and then if actual returns go higher than the specific level, the differences between a certain level and actual rate are paid in fees.

 
 This paper also uses the stochastic future value model and compares the expected retirement wealth of DB plans and DC plans. The stochastic future value model implies that more active investment strategies in DC plans are needed in order to match the retirement asset in DB plans.

 Finally, this paper proposes some policy recommendations including the increase of the minimum funding ratio in DB plans, guaranteed minimum return contracts, and increase in contribution rate of DC plans.