GCFP Awards $20k to Contest Winners

MIT’s Golub Center for Finance and Policy announces the winner of its contest to engineer a better retirement plan for public sector employees 

The team was honored at the GCFP annual conference in September in Cambridge, MA

The Golub Center for Finance and Policy (GCFP) at the Massachusetts Institute of Technology (MIT) today announced that a multi-disciplinary team from South Africa won its contest to design an optimal “collective defined contribution” retirement plan for public sector employees.

The contest, which launched last year, asked entrants to devise an investment and risk-sharing strategy that would generate the highest achievable level of stable retirement income for workers, while alleviating some of the challenges facing public pension schemes. The first-place winners work in the product solutions division at Old Mutual, the Cape Town-based life assurance group. The second-place team was a collaboration of graduate students from MIT and Yale.

“At a time when public pensions are under severe financial pressure and their sustainability remains in question, it’s clear that decisionmakers in the U.S. and around the world need to explore new ways to deliver a decent retirement to their employees at a more affordable cost,” says Deborah Lucas, the Director of the GCFP and the Sloan Distinguished Professor of Finance at the school.

“We are excited to have received a number of creative and innovative ideas that can be operationalized in the real world, including the thoughtful analysis from the winning team from Old Mutual. The important next step will be to explore with plan administrators how the model might be applied within their own systems.”

In recent decades, the U.S. has seen a sharp drop in the number and size of defined benefit (DB) pensions in the private sector. In the public sector, however, DB pensions are still widespread: the vast majority of states and cities sponsor these kinds of plans for their employees. Despite their prevalence, though, funding is a problem. According to estimates, unfunded liabilities for state and city pension plans—the shortfall between the present value of plan assets and future benefits owed—exceeds $5 trillion.

The leading alternative to DB pensions, defined contribution (DC) plans, include the popular 401(k). DC plans never have an underfunding problem because future benefits are limited to what can be supported by contributions and investment returns.

But public sector unions are resistant to DC plans. They contend that employees with limited financial knowledge could make poor investment choices, which would leave them at risk for insufficient retirement income. Moreover, they say, the costs of administering and investing in a DC plan, with individual accounts for each participant, are much higher than those of a DB plan.

The Golub Center contest, which included a prize pool of $20,000, asked entrants to explore the best way to structure a third type of retirement plan: a collective defined contribution plan (CDCP). These plans provide protections from shortfalls in retirement income while allowing participants to reap the benefits of professional asset management.

“Our contest was about coming up with smart new designs that combined the best of both worlds for public pension plans: a CDCP without the funding deficits of DB plans, but with lower operating costs and better risk management than DC plans,” says Bob Pozen, a Senior Lecturer at the Sloan School who also sponsored the contest.

“These kinds of hybrid solutions, which are already popular in Singapore and the Netherlands, result in a more diversified portfolio and typically generate higher returns. They are the future for public sector pensions.”

Under a CDCP, individual employees have a personal account balance comprised of their contributions, employer matches, and the portion of collective investment returns that are allocated to their account. While benefit distributions are linked to those balances, the assets are held in a collective fund: a key feature of a CDCP is that all employer and employee contributions are invested and managed in one collective pool. Benefits depend on investment performance, and risk sharing across multiple generations of retirees and workers increases the predictability of benefit payments and reduces volatility.

Contest entrants needed to design an investment strategy, payout, and risk-sharing policy for CDCP managers to follow that would provide retirees with the highest achievable scheduled benefit subject to limits on the probability and severity of benefit shortfalls.

According to the judges, the winning team’s proposal featured “a clever combination of financial engineering and intergenerational risk sharing.” Their model, which allows portfolio managers to take on more risk in stock and bond selection based on the size of an intergenerational reserve fund, produces a higher average benefit for retirees than a static investment strategy.

“We are passionate about the pension fund industry and we are thrilled to have won this competition,” says Kieyam Gamieldien, one of the winning team members. “Old Mutual is committed to being at the forefront of new developments aimed at addressing the short-comings of current systems around the world, and we look forward to future opportunities to shape the local and international industry and contribute to the important work that the Golub Center is doing in this area.” 

Gamieldien’s team members included: Niraj Rijhumal, Tinashe Chatora, Coenraad Coetzer, Fred van der Vyver, and Marvin Nair.  The second-place team was comprised of: Michael Patchen, who earned his MBA from the MIT Sloan School this year and is now an investment research associate at William Blair, and Shantanu Mundhada, a PhD candidate in applied physics at Yale.

The GCFP honored three representatives from the winning team at its annual conference on September 10-11 in Cambridge, MA. The conference, which convenes academic and non-academic researchers, as well as policy-makers and practitioners with expertise on retirement finance, featured academic paper presentations and expert panel discussions.