Pension Risk Management with Funding and Buyout Options

Insurance: Mathematics and Economics, Forthcoming

Fox School of Business Research Paper No. 17-012

47 Pages Posted: 21 Feb 2017 Last revised: 24 Apr 2017

See all articles by Samuel H. Cox

Samuel H. Cox

University of Manitoba - Asper School of Business

Yijia Lin

University of Nebraska at Lincoln - Department of Finance

Tianxiang Shi

Temple University - Risk Management & Insurance & Actuarial Science

Date Written: March 14, 2017

Abstract

There has been a surge of interest in recent years from defined benefit pension plan sponsors in de-risking their plans with strategies such as “longevity hedges” and “pension buyouts” (Lin et al., 2015). While buyouts are attractive in terms of value creation, they are capital intensive and expensive, particularly for firms with underfunded plans. The existing literature mainly focuses on the costs and benefits of pension buyouts. Little attention has been paid to how to capture the benefits of de-risking within a plan’s financial means, especially when buyout deficits are significant. To fill this gap, we propose two options, namely a pension funding option and pension buyout option, that provide financing for both underfunded and well funded plans to cover the buyout risk premium and the pension funding deficit, if a certain threshold is reached. To increase market liquidity, we create a transparent pension funding index, calculated from observed capital market indices and publicly available mortality tables as well as pension mandatory contributions, to determine option payoffs. A simulation based pricing framework is then introduced to determine the prices of the proposed pension options. Our numerical examples show that these options are effective and economically affordable. Moreover, our sensitivity analyses demonstrate the reliability of our pricing models.

Keywords: Defined Benefit Pension Plan, Risk Management, Pricing, Funding Options, Buyout Options

JEL Classification: J32, G32

Suggested Citation

Cox, Samuel H. and Lin, Yijia and Shi, Tianxiang, Pension Risk Management with Funding and Buyout Options (March 14, 2017). Insurance: Mathematics and Economics, Forthcoming; Fox School of Business Research Paper No. 17-012. Available at SSRN: https://ssrn.com/abstract=2919884 or http://dx.doi.org/10.2139/ssrn.2919884

Samuel H. Cox

University of Manitoba - Asper School of Business ( email )

181 Freedman Crescent
Winnipeg, Manitoba R3T 5V4
Canada

Yijia Lin (Contact Author)

University of Nebraska at Lincoln - Department of Finance ( email )

Lincoln, NE 68588-0490
United States

Tianxiang Shi

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk
Philadelphia, PA 19122
United States

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