Pension Risk Management in the Enterprise Risk Management Framework

Abstract

AbstractThis article presents an enterprise risk management (ERM) model for a firm that is composed of a portfolio of capital investment projects and a defined benefit (DB) plan for its workforce. The firm faces the project, operational, and hazard risks from its investment projects as well as the financial and longevity risks from its DB plan. The firm maximizes its capital market value net of pension contributions subject to constraints that control project, operational, hazard, financial, and longevity risks as well as an overall risk. The analysis illustrates the importance of integrating pension risk into the firm's ERM program by comparing firm value with and without managing pension risk with other risks in an ERM program. An ERM program considering pension effect integrates the risks of the operation and pension divisions and, thus, achieves diversification benefits between and within these two divisions. We also show how pension hedging strategies can impact the firm's net value under the ERM framework. While the existing literature suggests that a longevity swap is less expensive than a pension buy‐out because the latter is more capital intensive, this analysis shows that the buy‐out is more effective in increasing firm value.