Voluntary Participation in a Defined Benefit Pension Scheme: An Option Pricing Approach

47 Pages Posted: 24 Dec 2015

Date Written: November 23, 2015

Abstract

This paper evaluates an American pension option, whereby participants have the option to convert their defined benefit (DB) pension entitlements of a collective scheme to an individual defined contribution (DC) plan, using contingent claim analysis. This way, we can evaluate the participation decisions under a voluntary collective pension scheme. We approximate the value of this option with risky investment returns by applying Least Squares Monte Carlo simulations as proposed by Longstaff and Schwartz (2001). When more decision dates are included, generations are more willing to participate in the collective pension scheme. If the funding rate falls below a critical value, some young generations will exercise the option. As a result, other generations might be willing to leave as well, which results in a collapse of the collective pension scheme. In the absence of mandatory participation, it is only a matter of time before such a break down occurs.

Keywords: Pension funds, participation decisions, valuing American options, Least Squares Monte Carlo simulations, stability

JEL Classification: C61, G23, J32

Suggested Citation

Chen, Damiaan, Voluntary Participation in a Defined Benefit Pension Scheme: An Option Pricing Approach (November 23, 2015). Netspar Discussion Paper No. 11/2015-042, Available at SSRN: https://ssrn.com/abstract=2707296 or http://dx.doi.org/10.2139/ssrn.2707296

Damiaan Chen (Contact Author)

University of Amsterdam ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

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