The Term Structure of Funding Spreads

Abstract

Defined benefit pension liabilities are usually computed by discounting promised future pension payments using the yields on either risk-free or AA-rated bonds. We argue that a pension plan in financial distress should use discount rates that reflect the inherent funding risk. We propose a new valuation approach that utilizes the term structure of funding-risk-adjusted discount rates. These discount rates depend on the current asset allocation of the pension plan which affects expected future funding ratios. We show that an optimal asset allocation which accounts for this dependency varies in a highly nonlinear way with the initial funding ratio of the pension plan. In particular, the optimal allocation to stocks is higher than conventionally determined when the level of underfunding is severe, but lower when the level of underfunding is only moderate.