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Valuation of Contingent Pension Liabilities and Guarantees Under Sponsor Default Risk

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  • Dirk Broeders

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.

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  • Dirk Broeders, 2010. "Valuation of Contingent Pension Liabilities and Guarantees Under Sponsor Default Risk," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 77(4), pages 911-934, December.
    • Handle: RePEc:bla:jrinsu:v:77:y:2010:i:4:p:911-934
    DOI: 10.1111/j.1539-6975.2010.01357.x
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    Cited by:

    1. Dirk Broeders & Kristy Jansen, 2021. "Pension Funds and Drivers of Heterogeneous Investment Strategies," Working Papers 712, DNB.
    2. Jacob A. Bikker & Dirk W.G.A. Broeders & Dirk Jan de Dreu, 2010. "Stock Market Performance and Pension Fund Investment Policy: Rebalancing, Free Float, or Market Timing?," International Journal of Central Banking, International Journal of Central Banking, vol. 6(2), pages 53-79, June.
    3. Dirk Broeders & An Chen, 2013. "Pension Benefit Security: A Comparison of Solvency Requirements, a Pension Guarantee Fund, and Sponsor Support," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(2), pages 239-272, June.
    4. Joachim Inkmann & David Blake & Zhen Shi, 2017. "Managing Financially Distressed Pension Plans In The Interest Of Beneficiaries," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 84(2), pages 539-565, June.
    5. Dirk Broeders & An Chen & David Rijsbergen, 2013. "Valuation of liabilities in hybrid pension plans," Applied Financial Economics, Taylor & Francis Journals, vol. 23(15), pages 1215-1229, August.
    6. Nick Draper & Casper Ewijk & Marcel Lever & Roel Mehlkopf, 2014. "Stochastic Generational Accounting Applied to Reforms of Dutch Occupational Pensions," De Economist, Springer, vol. 162(3), pages 287-307, September.
    7. Broeders, Dirk W. G. A. & Jansen, Kristy A. E. & Werker, Bas J. M., 2021. "Pension fund's illiquid assets allocation under liquidity and capital requirements," Journal of Pension Economics and Finance, Cambridge University Press, vol. 20(1), pages 102-124, January.
    8. Dirk Broeders & Eduard H.M. Ponds, 2012. "Dutch Pension System Reform. A Step Closer to the Ideal System Design," ifo DICE Report, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 10(03), pages 65-76, November.
    9. Dirk Broeders & Kristy Jansen & Bas Werker, 2017. "Pension fund's illiquid assets allocation under liquidity and capital constraints," DNB Working Papers 555, Netherlands Central Bank, Research Department.
    10. Dirk Broeders & Eduard H.M. Ponds, 2012. "Dutch Pension System Reform. A Step Closer to the Ideal System Design," ifo DICE Report, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 10(3), pages 65-76, November.
    11. Dirk Broeders & Paul Hilbers & David Rijsbergen & Ningli Shen, 2014. "What Drives Pension Indexation in Turbulent Times? An Empirical Examination of Dutch Pension Funds," De Economist, Springer, vol. 162(1), pages 41-70, March.
    12. J. de Dreu & J.A. Bikker, 2009. "Pension fund sophistication and investment policy," Working Papers 09-13, Utrecht School of Economics.
    13. Dirk Broeders & An Chen & David Rijsbergen, 2013. "Valuation of liabilities in hybrid pension plans," Applied Financial Economics, Taylor & Francis Journals, vol. 23(15), pages 1215-1229, August.
    14. repec:ces:ifodic:v:10:y:2012:i:3:p:19069676 is not listed on IDEAS
    15. An, Heng & Huang, Zhaodan & Zhang, Ting, 2013. "What determines corporate pension fund risk-taking strategy?," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 597-613.
    16. de Dreu, Jan & Bikker, Jacob A., 2012. "Investor sophistication and risk taking," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 2145-2156.
    17. Chen, Zhiqiang & Pelsser, Antoon & Ponds, Eduard, 2014. "Evaluating the UK and Dutch defined-benefit pension policies using the holistic balance sheet framework," Insurance: Mathematics and Economics, Elsevier, vol. 58(C), pages 89-102.
    18. Bégin, Jean-François, 2020. "Levelling the playing field: A VIX-linked structure for funded pension schemes," Insurance: Mathematics and Economics, Elsevier, vol. 94(C), pages 58-78.
    19. Broeders, D. & Ponds, E.H.M., 2012. "Dutch pension system reform – A step closer to the ideal system?," Other publications TiSEM 9d057b0e-edd6-48a5-b67d-c, Tilburg University, School of Economics and Management.
    20. Jansen, Kristy, 2021. "Essays on institutional investors, portfolio choice, and asset prices," Other publications TiSEM fd998408-d282-4e0f-b542-4, Tilburg University, School of Economics and Management.

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