JUAN YERMO, Organization for Economic Co-Operation and Development (OECD)
Email: juan.yermo@oecd.org

Good governance is increasingly recognized as an important aspect of an efficient private pension system, enhancing investment performance and benefit security. Yet, despite regulatory and industry initiatives, governance weaknesses persist across OECD and non-OECD countries. This paper highlights the main governance challenges faced by policymakers (particularly with trust-based pension systems), and draws on recent policy initiatives to propose possible solutions to strengthen governance arrangements. The paper suggests that some of the more serious cases of governance failures could be solved through a more balanced representation of stakeholders in the governing body, higher levels of expertise (which may be achieved via training or the use of independent trustees) and the implementation of codes of conduct addressing conflicts of interest. The absence of governance arrangements for defined contribution style pension plans also needs to be addressed, potentially via management committees, increased fiduciary responsibility for relevant parties or via a strengthened role for pension supervisory authorities. Consolidation of the pension industry in some countries may also be required to achieve economies of scale and reduce costs, which in turn would allow pension funds to dedicate more resources to strengthening their internal governance.

KEVIN KREITZMAN, ERS Group
Email: kkreitzman@ersgroup.com

Leveraged Employee Stock Ownership Plan ("ESOP") transactions originated in the 1950s, yet there are still unresolved valuation issues that arise from a complex set of operating expenses, financing structures and contingent claims that are unique to leveraged ESOPs. Although complex, these transactions provide no exceptions to general financial economic principles and can be evaluated using existing standards and methodologies. Existing valuation practices have supported transactions executed at stock prices that are expected to decline, sometimes dramatically, immediately after the transaction is closed. Such a situation, in which the current stock price exceeds an expected future price, is illogical and contrary to financial economic valuation models and theories. When this occurs, either the pre-transaction price or the expected post-transaction price (or both) are wrong.

TAO HAO, Watson Wyatt Worldwide
Email: tao.hao@watsonwyatt.com

In this paper, various option pricing models are used to provide analytical solutions to valuing defined pension liabilities (or securitised parts of pension liabilities) in incomplete markets. Unlike when markets are complete, there is not a single arbitrage-free price for liabilities but instead a range of prices consistent with the absence of arbitrage. We analyse and compare the application of incomplete market variants of the following models to pension liabilities: i) the standard Black-Scholes (1973) option model ii) the Margrabe (1978) exchange options model; iii) the Stulz (1982) rainbow option model to price pension schemes liabilities. No matter which approach is used, we find the range of liability prices to be broad, implying it is difficult to put a precise market value on pension liabilities. However, we also find that the implication for strategic asset allocation is relatively minimal; strategic asset allocations, at least in the models we looked at, appear to be relatively robust to incomplete markets. This conclusion is more about risk exposure than the financial instruments used to achieve a given level of risk exposure, as the desired financial instruments may depend considerably on the degree of market completeness.

ROBERT NOVY-MARX, University of Chicago - Graduate School of Business
Email: rnm@ChicagoGSB.edu
JOSHUA D. RAUH, University of Chicago - Graduate School of Business, National Bureau of Economic Research (NBER)
Email: jrauh@gsb.uchicago.edu

The value of pension promises already made by US state governments will grow to approximately $7.9 trillion in 15 years. We study investment strategies of state pension plans and estimate the distribution of future funding outcomes. We conservatively predict a 50% chance of aggregate underfunding greater than $750 billion and a 25% chance of at least $1.75 trillion (in 2005 dollars). Adjusting for risk, the true intergenerational transfer is substantially larger. Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded.

OLIVIA S. MITCHELL, University of Pennsylvania - Insurance & Risk Management Department, National Bureau of Economic Research (NBER)
Email: mitchelo@wharton.upenn.edu
JOHN PIGGOTT, University of New South Wales - School of Economics
Email: J.Piggott@unsw.edu.au
CAGRI S. KUMRU, Australian School of Business at UNSW
Email: cs.kumru@unsw.edu.au

Large publicly-held pools of assets are playing an increasingly prominent role in the global investment arena. We compare three distinct forms of such public funds, namely foreign exchange reserve funds, sovereign wealth funds, and public pension funds, to highlight their differences and similarities. We review previous studies on ways to better secure prudent and economically sound public fund management practices in these funds, as well as how to evaluate their governance and investment policies and how to better protect the assets from political interference. Drawing from the pension and corporate finance literature, we also link their management to governance practices and country-specific characteristics, and contrast those with empirical findings on linkages with corporate governance.

KENNETH J. MCDONNELL, Employee Benefit Research Institute (EBRI)
Email: MCDONNELL@EBRI.ORG

This paper examines some of the causes of the differences in total compensation costs between state and local government employers and private-sector employers. As of September of 2007, overall total compensation costs were 51.4 percent higher among state and local government employers ($39.50 per hour worked) than among private-sector employers ($26.09 per hour worked) (calculated from Figure 1). Total compensation costs consist of two major categories: wages and salaries and employee benefits. For both of these categories, state and local government employers' costs were higher than those of private-sector employers: 42.6 percent higher for wages and salaries and 72.8 percent higher for employee benefits (calculated from Figure 1). The differences in compensation costs between public-sector and private-sector employers are driven by the differing mix of job functions, work force composition, and concentrations of workers. The composition of the benefit package is another major factor in explaining the difference in compensation costs. Benefit participation rates are higher for state and local government employees and the costs of providing these benefits are higher.

The PDF for the above title, published in the June 2008 issue of EBRI Notes, also contains the fulltext of another June 2008 EBRI Notes article abstracted on SSRN: "The Number of Individual Account Retirement Plans Owned by American Families."

ANDRAS BODOR, World Bank
Email: abodor@worldbank.org
DAVID A. ROBALINO, World Bank
Email: drobalino@worldbank.org
MUKUL RUTKOWSKI, World Bank
Email: Mrutkowski@worldbank.org

Mandatory pension systems can have a negative impact on individual savings and labor supply decisions. In particular, defined benefit pension schemes that are not actuarially fair, can create incentives for early retirement, and therefore, reduce labor supply and the stock of human capital. After a review of frequently applied approaches to assess the incentives generated by a pension system, the paper develops an indicator to predict the age-specific retirement probabilities induced by a particular pension system given heterogeneous individual preferences. The paper then describes how this indicator could be used to project the size of the labor force by gender, age and skill level, and correspondingly, the dynamics of human capital accumulation. Finally, the paper develops a set of life-cycle income measures to assess how the pension system affects decisions regarding the supply of labor in the public and private sectors. The methods are illustrated in the case of Morocco.