Paying for Minimum Interest Rate Guarantees: Who Should Compensate Who?

Defined contribution pension schemes and life insurance contracts often have a minimum interest rate guarantee as an integrated part of the contract. This guarantee is an embedded put option issued by the institution to the individual, who is forced to hold the option in the portfolio. However, taking the inability to short this saving and other institutional restrictions into account the individual may actually face a restriction on the feasible set of portfolio choices, hence be better off without such guarantees. We measure the effect of the minimum interest guarantee constraint through the wealth equivalent and show that guarantees may induce a significant utility loss for relatively risk tolerant investors. We also consider the case with heterogenous investors sharing a common portfolio. Investors with different risk attitudes will experience a loss of utility by being forced to share a common portfolio. However, the relatively risk averse investors are partly compensated by the minimum interest rate guarantee, whereas the relatively risk tolerant investors are suffering a further utility loss.