Managing Sponsor Risk in Pension Plans: Dynamic Strategies vs. Pension Assurance

Abstract

Defined-benefit (DB) pension funds, often underfunded, rely on the legal obligation of their sponsor to secure pension rights for individuals.Because that guarantee is risky, ways must be found to secure the pension promises. This paper is the first to identify the optimal pension fund portfolio, taking into account the riskiness of the sponsor's guarantee.These schemes may be undermined by agency conflicts. This paper identifies the optimal pension fund portfolio, taking into account the riskiness of the sponsor's guarantee and risk-shifting incentives at pension funds.Lastly, this paper shows that offering pension funds a limited, riskless external insurance against sponsor risk to replace the potentially unlimited but risky sponsor guarantee reduces the risk-shifting incentives at pension funds and fully mitigates sponsor risk. The optimally designed Pension Indemnity Assurance (PIA) gives incentives that are opposite those of public protection schemes such as the PBGC or PPF.An appendix detailing the implementation of such 'First-Best' generalised portfolio insurance strategies is available at the following URL: http://ssrn.com/abstract=2509057