Portfolio Choice, Minimum Return Guarantees, and Competition in DC Pension Systems

Abstract

Regulation in countries that have adopted defined contribution (DC) pension systems based on savings accounts typically includes minimum return guarantees (MRG) provisions to limit the risk of financial downturns. This paper studies the consequences of this regulation over asset allocation within a standard model of dynamic portfolio selection, where managers act strategically while making their investment decisions as in (Basak and Makarov, 2008, Strategic Asset Allocation with Relative Performance Concerns. Working Paper. London Business School).

We study a standard dynamic portfolio choice problem in a setting that includes two new ingredients: strategic interaction among portfolio managers and the presence of a MRG. The (pure strategy Nash) equilibrium portfolios are provided in closed-form in the Black and Scholes setting. They are shown to be weighted averages of investment rules that are themselves optimal in scenarios that may become optimal once the uncertainty has resolved.

Our results also suggest that MRG rules that rely on index-based benchmark portfolios (as opposed to peer-group ones) may help to mitigate some of the problems that arise when portfolio managers are too prone to relative performance concerns (i.e., the selection of myopic portfolios).

Keywords: DC pension system, performance constraints, portfolio selection, strategic interactions

JEL Classification: D81, G11, G18, H55