Valuation of intergenerational transfers in funded collective pension schemes

This paper applies contingent claim analysis to value pension contracts for real-life collective pension plans with intergenerational risk sharing and offering DB-like benefits. We rewrite the balance sheet of such a pension fund as an aggregate of embedded generational options. This implies that a pension fund is a zero-sum game in value terms, so any policy change inevitably leads to value transfers between generations. We explore intergenerational value transfers that may arise from a plan redesign or from changes in funding policy and risk sharing rules. We develop a stochastic framework which accounts for time-varying investment opportunities and computes the embedded generational options. Changes in the values of the generational options enable us to evaluate the impact of policy modifications in the pension contract with respect to intergenerational transfers and redistribution. We find that a switch to a less risky asset mix is beneficial to elderly members at the expense of younger members who lose value. A reallocation of risk bearing from a plan with flexible contributions and fixed benefits to a plan with fixed contributions and flexible benefits leads to value redistribution from older plan members to younger ones.

Asset Liability Management

Market valuation of assets is a topic that has been discussed for quite some time now, but the valuation of pension contracts including all embedded options is a major challenge for pension fund policy makers. On top of that, pension fund beneficiaries are increasingly demanding more transparency with regard to the exact nature of their pension arrangement, or their pension deal. This article sheds some light on the management of the current and future financial health of a defined-benefit public pension fund. Most funds conduct a so-called Asset Liability Management (ALM) study that investigates the impact of decisions with regard to investment, contribution, and indexation policy on the various stakeholders of the fund (employees, employers, and retired and future generations)

Strategic asset allocation with liabilities: Beyond stocks and bonds

This paper studies the strategic asset allocation for an investor with risky liabilities which are subject to inflation and real interest rate risk and who invests in stocks, government bonds, corporate bonds, T-bills, listed real estate, commodities and hedge funds. Using a vector autoregression for returns, liabilities and macro-economic state variables the paper explores the intertemporal covariance structure of assets and liabilities. We find horizon effects in time diversification, risk diversification, inflation hedge and real interest rate qualities. The covariance structure gives insights into which asset classes have a term structure of risk that is different from that of stocks and bonds. The alternative assets classes add value for long-term investors. Differences in strategic portfolios for asset-only and asset-liability investors are due to differences in the global minimum variance and liability hedge portfolio. We find that the benefits of long-term investing are larger when there are liabilities

Regret aversion and annuity risk in defined contribution pension plans

The high value of the implicit option to choose a retirement date at which interest rates are particularly high and life annuities relatively cheap, leads to the possibility to introduce regret aversion in the retirement investment decision of defined contribution plan participants. As a remedy for regret aversion in retirement investment decisions, this paper develops and prices a lookback option on a life annuity contract. We determine a closed-form option value under the restriction that the option holder invests risklessly during the time to maturity of the option and without the guarantee that the exact amount of retirement wealth is converted into a life annuity at retirement. Thereafter the investment restriction is relaxed and the guarantee of exact conversion is imposed and the option is priced via Monte Carlo simulations in an economic environment with a stochastic discount factor. Option price sensitivities are determined via the pricing of alternative options. We find that the price of a lookback option, with a maturity of three years, amounts to 8%-9% of the wealth at the option issuance date. The option price is highly sensitive to the exercise price of the option, i.e. pricing alternative options (e.g. Asian) substantially lowers the price. Time to maturity and interest rate volatility are other important option price drivers. Asset allocation decisions and initial interest rates hardly affect the option price.