Pension plan solvency and extreme market movements: a regime switching approach

Niloufar Abouraschi, Iain Clacher, Mark C. Freeman, David Hillier, Malcolm Kemp, Qi Zhang

Research output: Contribution to journalArticle

2 Citations (Scopus)
58 Downloads (Pure)

Abstract

We develop and test a new approach to assess defined benefit pension plan solvency risk in the presence of extreme market movements. Our method captures both the ‘fat-tailed’ nature of asset returns and their correlation with discount rate changes. We show that the standard assumption of constant discount rates leads to dramatic underestimation of future projections of pension plan solvency risk. Failing to incorporate leptokurtosis into asset returns also leads to downward biased estimates of risk, but this is less pronounced than the time-varying discount rate e§ect. Further modifying the model to capture the correlation between asset returns and the discount rate provides additional improvements in the projection of future pension plan solvency. This reduces the perceived future risk of underfunding because of the negative correlation between interest rate changes and asset returns. These results have important implications for those with responsibility for balancing risk against expected return when seeking to improve the current poor funding positions of defined benefit pension schemes.
Original languageEnglish
Pages (from-to)1292-1319
Number of pages28
JournalEuropean Journal of Finance
Volume22
Issue number13
Early online date23 Sep 2014
DOIs
Publication statusPublished - 31 Jan 2016

Keywords

  • pension fund solvency
  • leptokurtosis
  • risk estimation
  • value at risk

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