Academic journal article Journal of Risk and Insurance

Valuation of Contingent Pension Liabilities and Guarantees under Sponsor Default Risk

Academic journal article Journal of Risk and Insurance

Valuation of Contingent Pension Liabilities and Guarantees under Sponsor Default Risk

Article excerpt

ABSTRACT

This article analyzes the relationship between a pension fund with contingently indexed defined benefit liabilities and its sponsor, using contingent claims analysis. As pension funds generally choose to run a mismatch risk, future surpluses and deficits will occur. Surpluses are divided between beneficiaries and sponsor through contingent indexation of the benefits and refunding. Covering a deficit at the pension fund level is a function of the sponsor's financial ability to do so. This article suggests that this system creates an asymmetric allocation of the residual risk between sponsor and beneficiaries. The optimal investment policy for the pension fund in this context can be found by reverse engineering option valuation formulas. The main conclusion is that sponsor default risk negatively impacts the optimum risk profile and thereby the market value of contingent pension liabilities.

INTRODUCTION

In its principles for the regulation of occupational pension schemes the OECD states that pension funds must be legally separated from the sponsor. This detachment is also prescribed by the Employee Retirement Income Security Act in the United States and by Directive 2003/41/EC of the European Parliament on the activities and supervision of institutions for occupational retirement provision. Pension funds thus serve as special purpose vehicles to ensure that the accrued pension rights of the beneficiaries are not subjected to the sponsor's default risk. In reality, however, there is no clean economic break between the sponsor and its pension fund. Particularly in the case of funded defined benefit schemes, subsequent situations of overfunding and underfunding may lead to additional cash flows between the two entities. Risk management at the pension fund level largely accounts for this. Pension funds in general do not, or are unable to, invest in the portfolio that exactly replicates nature of their defined benefit liabilities. Generally there is a lack of suitable guaranteed real return investment opportunities. Under this restriction, guaranteeing inflation or wage indexed pensions might become infeasible at reasonable costs. Therefore, in many defined benefit pension schemes, part of the pension promise is contingent on the performance of the pension fund assets. In return for taking mismatch risk, pension fund trustees accept the possibility of encountering strong or weak financial conditions. This not only affects the pension fund and its beneficiaries, but also the sponsor. There is considerable evidence (see, e.g., Feldstein and Seligman, 1981; Bulow, Morck, and Summers, 1987; Carroll and Niehaus, 1998; Coronado and Sharpe, 2003) that the funding level of the defined benefit pension plan is reflected in the market value of the sponsor. In addition to this value transparency argument, Lin, Merton, and Bodie (2006) find that the market risk of the sponsor's equity reflects the risk level of the pension plan. The economic rationale for this is that in case of a (large probability of a) funding deficit, the sponsor may have the legal or moral obligation to increase contributions to the pension fund. On the other hand, surpluses in the pension fund tend to be, at least partially, claimed by the sponsor. Contribution holidays are a common phenomenon in prosperous times. These additional funding or refunding decisions can be considered as implicit options on the pension fund's assets. Through these contingent claims, there is a distinct financial connection between the pension fund and its sponsor.

These contingent claims in pension schemes have been described by Sharpe (1976), Treynor (1977), Bulow (1982) and more recently by Blake (1998), Kocken (2006), and Bikker and Vlaar (2007). Contingent claims analysis can be used to show that in a complete market, a pension fund is a zero-sum game in valuation terms among the relevant stakeholders: retirees, employees, and corporate shareholders. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.