Pension Fund ALM - Can Pension Funds Stabilize Funding Levels and Improve Long-Term Return by Hedging Longevity Risk?

14 Pages Posted: 24 May 2019

Date Written: April 27, 2019

Abstract

In this paper we analyze the impact hedging longevity risk can have on a pension fund’s funding ratio volatility and ALM strategy. Our model captures all relevant aspects of the ALM problem and is calibrated to industry statistics; however, we’ve sacrificed model complexity to make the solution more intuitive and presentable. Our main conclusion is that hedging longevity risk creates additional risk budget to be put towards more rewarding asset allocation strategies, thereby improving the overall ALM outcome of the modelled pension fund.

We show that at representative parameters for the risk and return on the balance sheet, and a range of realistic hedge prices, executing longevity hedges elevates the Efficient Frontier across all reasonable risk budgets. Therefore, implementing a longevity hedging strategy can improve the fund’s Sharpe Ratio and ALM outlook considerably. This is especially true for funds with a low risk budget, e.g. when the funding ratio is close to 105%.

Our results are consistent with earlier work on this topic by Cocco and Gomes (2012), who demonstrate the benefits of financial assets designed to hedge shocks to the survival probabilities in a life cycle model with longevity risk. Our analysis differs since we focus on the pension fund rather than the household balance sheet, use a more extensive model for the financial market, have an explicit definition of the hedge instrument and use market information on the pricing of longevity hedges which lacks in.

Keywords: Asset Liability Management, Asset Allocation, Longevity Risk, Longevity Hedging, Pension Fund

JEL Classification: G11, G22, G23, H55

Suggested Citation

Schrager, David, Pension Fund ALM - Can Pension Funds Stabilize Funding Levels and Improve Long-Term Return by Hedging Longevity Risk? (April 27, 2019). Available at SSRN: https://ssrn.com/abstract=3378946 or http://dx.doi.org/10.2139/ssrn.3378946

David Schrager (Contact Author)

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