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Unhedgeable inflation risk within pension schemes

Author

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  • Chen, D.H.J.
  • Beetsma, R.M.W.J.
  • van Wijnbergen, S.J.G.

Abstract

Pension schemes generally aim to protect the purchasing power of their participants, but cannot completely do this when due to market incompleteness inflation risk cannot be fully hedged. Without a market price for inflation risk the value of a pension contract depends on the investor’s risk appetite and inflation risk exposure. We develop a valuation framework to deal with two sources of unhedgeable inflation risk: the absence of instruments to hedge general consumer price inflation risk and differences in group-specific consumption bundles from the economy-wide bundle. We find that the absence of financial instruments to hedge inflation risks may reduce lifetime welfare by up to 6% of certainty-equivalent consumption for commonly assumed degrees of risk aversion. Regulators face a dilemma as young (workers) and old participants (retirees) have different capacities to absorb losses from unhedgeable inflation risks and as a consequence have a different risk appetite.

Suggested Citation

  • Chen, D.H.J. & Beetsma, R.M.W.J. & van Wijnbergen, S.J.G., 2020. "Unhedgeable inflation risk within pension schemes," Insurance: Mathematics and Economics, Elsevier, vol. 90(C), pages 7-24.
    • Handle: RePEc:eee:insuma:v:90:y:2020:i:c:p:7-24
    DOI: 10.1016/j.insmatheco.2019.10.009
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    Cited by:

    1. Xiaoyi Zhang, 2022. "Optimal DC Pension Management Under Inflation Risk With Jump Diffusion Price Index and Cost of Living Process," Methodology and Computing in Applied Probability, Springer, vol. 24(2), pages 1253-1270, June.
    2. Chen, Damiaan H.J. & Beetsma, Roel M.W.J. & van Wijnbergen, Sweder J.G., 2023. "Intergenerational sharing of unhedgeable inflation risk," Insurance: Mathematics and Economics, Elsevier, vol. 113(C), pages 140-160.

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    More about this item

    Keywords

    Unhedgeable inflation risk; Welfare loss; Incomplete markets; Pension contract; Valuation;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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