Change Is Needed to Ward off Bleak Old Age
Byline: Harry Kat
One cannot open a newspaper these days without reading something about the collapse of defined-benefit private pension schemes. Because of increased taxes on pension funds, plunging stock markets, low interest rates and longer life expectancy, most pension schemes are in big trouble. In response, many companies are winding up their final salary schemes.The public is outraged and some call for government intervention. For the more-than-casual observer, however, there is nothing wholly unexpected about this. Technically speaking, a company pension is similar to an option contract. The employee pays a premium and, in return, the employer provides him or her with an uncertain future pay-off, depending on the employee's final salary and, when indexed, inflation as well.
Entering into such a contract presents the employer with a serious hedging problem, which is similar to that of an investment bank selling OTC options. The employer, therefore, has to design an investment strategy, trading mainly stocks and bonds, so that he or she has enough money to pay the employee when retirement comes.
Again, this is similar to how an investment bank hedges its option books. There is one important difference, though. Unlike the options sold by the investment bank, the payoff of the pension contract is determined by variables that cannot be traded directly in the markets. The investment bank will be able to hedge itself relatively accurately most of the time but, because last earned salary and inflation are largely non-tradable, this is unlikely to be the case for the pension fund.
Trading stocks and bonds to hedge a payoff depending on largely uncorrelated variables such as last earned salary and inflation is asking for trouble. No decent investment bank will take a risk like this on its own book. It will only enter into such a contract when it can do the deal back-to-back and hedge itself by doing the opposite trade with someone else at the same time.
Having established that large hedging errors are almost unavoidable in defined-benefit pension schemes, the next question is to determine who eventually carries the hedging risk: the employer or the employee? At first sight, it looks like the risk lies with the employer. After all, it is the employer who sets up the scheme. All employees do is pay. Unfortunately, this is not how things are. Most pension schemes allow employers one or more ways out of the contract when the hedging strategy goes wrong. …