Unhedgeable Inflation Risk within Pension Schemes

60 Pages Posted: 22 May 2019

See all articles by Roel M. W. J. Beetsma

Roel M. W. J. Beetsma

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM); European Commission; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); Tinbergen Institute - Tinbergen Institute Amsterdam (TIA); Netspar

Damiaan Chen

University of Amsterdam

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: May 2019

Abstract

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

Beetsma, Roel M. W. J. and Chen, Damiaan and van Wijnbergen, Sweder, Unhedgeable Inflation Risk within Pension Schemes (May 2019). CEPR Discussion Paper No. DP13742. Available at SSRN: https://ssrn.com/abstract=3391089

Roel M. W. J. Beetsma (Contact Author)

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM) ( email )

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Damiaan Chen

University of Amsterdam ( email )

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Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

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+31-35-624 91 82 (Fax)

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Centre for Economic Policy Research (CEPR)

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