We develop a model of the Pension Protection Fund (PPF), a defined benefit pension guarantee system for the UK, based on an analogy between pension liabilities and corporate debt obligations. We show that the PPF is likely to face many years of low claims interspersed irregularly with periods of very large claims. There is a significant chance that these claims will be so large that the PPF will default on its liabilities, leaving the government with no option but to bail it out. The cause of this problem is the double impact of a fall in equity prices on the PPF: it makes sponsor firms more likely to default and it makes defaulted plans more likely to be underfunded. We use our model to derive a fair premium for PPF insurance under different circumstances, to estimate the extent of cross-subsidies in the PPF between strong and weak sponsors, and to show that risk-rated premiums are unlikely to have a substantial effect on either the size or the lumpiness of claims. We argue that for the PPF to operate effectively, it should be introduced in tandem with strong minimum funding requirements and a lower level of benefit guarantee than at present.
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Article provided by Institute for Fiscal Studies in its journal Fiscal Studies.
Volume (Year): 26 (2005) Issue (Month): 2 (June) Pages: 139-167 Download reference. The following formats are available: HTML
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Find related papers by JEL classification: G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies