How Derivatives Can Help Solve the Pension Fund Crisis
27 Pages Posted: 4 Aug 2003
Date Written: June 25, 2003
In this paper we use a scenario-based ALM model to study the effects on the risk-return profile of defined benefit pension funds from including options in the pension fund portfolio. Our results show that properly constructed option strategies can add substantial value to pension fund management. The results are robust with respect to variations in horizon, equity risk premium and volatility assumptions. The optimal strategy, however, should be determined in an asset-liability context and not ad hoc, as the intuitively most appealing strategies are not necessarily the most effective. In addition, we find that different types of funds may require significantly different option strategies. What works well for one fund may be less effective or even counter-productive for another. Overall, incorporating options appears an efficient way of improving long-term pension fund health and therefore the sustainability of defined benefit pension schemes.
Keywords: Pension fund, derivatives, options, asset-liability management, scenarios
JEL Classification: G23
Suggested Citation: Suggested Citation