Accumulated Pension Collars: A Market Approach to Reducing the Risk of Investment-Based Social Security Reform

The paper shows how a new type of financial derivative—an accumulated pension collar—can be used to guarantee that an investment-based Social Security program provides at least the level of real retirement income projected under current Social Security rules. In effect, future retirees purchase a series of put options which guarantee that retirement benefits do not fall below a benchmark. They pay for this insurance by giving up the part of the variable retirement income which exceeds a certain level, effectively selling a series of call options. We price the accumulated pension collar via Monte Carlo simulations using the risk neutral valuation technique.
Assuming that two thirds of the benchmark is provided by the traditional pay-as-you-go program, we find that by saving additional 2.5 percent of earnings retirees can obtain the benchmark. Raising the savings rate to 3 percent of earnings increases substantially the income that individuals can keep, raising it to 145 percent of the currently projected level of benefits.