On Risk Charges and Shadow Account Options in Pension Funds

Abstract

This paper studies the economic implications of regulatory systems which allow equityholders of pension companies to not only charge a specific premium to compensate them for their higher risk (compared to policyholders), but also to accumulate these risk charges in a so-called shadow account in years when they are not immediately payable due to e.g. poor investment results. When surpluses are subsequently re-established, clearance of the shadow account balance takes priority over bonus/participation transfers to policyholders.

We see such a regulatory accounting rule as a valuable option to equityholders and our paper develops a model in which the influence of risk charges and shadow account options on stakeholders' value can be quantified and studied. Our numerical results show that the value of shadow account options can be significant and thus come at the risk of expropriating policyholder wealth. However, all can be remedied with proper attention given to the specific contract design.

Keywords: Pension contracts, options, guarantees, valuation, risk management

JEL Classification: G12, G13, G23