Pricing Risk in Corporate Pension Plans: Understanding the Real Pension Deal

Abstract

New accounting rules and increased scarcity of risk capital have led to growing pressure on corporations to shift pension plan risk from employers to participants. This implies a shift from defined benefit plans to a variety of collective and individual defined contributions plans. Most of these shifts have been ad-hoc and not based on clear and objective criteria. This article shows how negotiations could be clarified by using modern option pricing and financing techniques. Both the value of the guarantees regarding accrued pension rights, as well as future rights to be accrued, can be objectively determined. For example, the authors show that a shift from a typical defined benefit plan to a collective defined contribution plan should cost the employer a lump sum payment of twelve percent of the accrued pension obligations and an increase in the contribution rate of four percent of pay.