Senior economist, supervisory strategy at De Nederlandsche Bank, Dirk Broeders, has completed research which calculates an explicit formula for risk sharing by pension funds.
Broeders says typically funds use asset liability modelling to set asset allocation, but he says by using option pricing theory, the optimal level of risk sharing between a corporate plan and its sponsor can also be achieved.
“It’s typical for funds doing asset allocation to use ALM, but if you use option pricing theory you can get the same type of analysis but it gives you the extra edge to get the optimal level,” he said.
In its most simple form, risk is shared by the beneficiary and sponsor through contributions and conditional indexing, such as whether to increase payouts due to changes such as cost of living adjustments.
Broeders’ research shows that where the sponsor can cover the deficits of the plan, that is the most basic level, the optimal is the square root of the indexation level.
Entitled “Essays on the Valuation of Discretionary Liabilities and Pension Fund Investment Policy”, the research forms Broeders’ PhD from Tilburg University and adds to the academic research on pension finance.