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

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posted on 2015-02-12, 11:10 authored by Niloufar Abourashchi, Iain Clacher, Mark Freeman, David Hillier, Malcolm Kemp, Qi Zhang
We develop and test a new approach to assess defined benefit (DB) 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 effect. 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 DB pension schemes.

Funding

The authors gratefully acknowledge financial support from the Rotman International Centre for Pension Management (ICPM) at the University of Toronto and from the Actuarial Profession in the UK.

History

School

  • Business and Economics

Department

  • Business

Published in

European Journal of Finance

Citation

ABOURASHCHI, N. ... et al., 2014. Pension plan solvency and extreme market movements: a regime switching approach. European Journal of Finance, 2014 http://dx.doi.org/10.1080/1351847X.2014.946528

Publisher

© The Author(s). Published by Taylor & Francis/Routledge

Version

  • VoR (Version of Record)

Publisher statement

This work is made available according to the conditions of the Creative Commons Attribution 3.0 Unported (CC BY 3.0) licence. Full details of this licence are available at: http://creativecommons.org/licenses/by/3.0/

Publication date

2014

Notes

This is an Open Access article distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/ licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

ISSN

1351-847X

eISSN

1466-4364

Language

  • en

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