Unhedgeable Inflation Risk within Pension Schemes
60 Pages Posted: 22 May 2019
Date Written: May 2019
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.
Keywords: incomplete markets, pension contract, Unhedgeable inflation risk, Valuation, welfare loss
JEL Classification: C61, E21, G11, G23
Suggested Citation: Suggested Citation