Pension plan solvency and extreme market movements: A regime switching approach

Abouraschi, N.; Clacher, I.; Freeman, M.; Hillier, D.; Kemp, M.; Zhang, Q.

doi:10.1080/1351847x.2014.946528

Pension plan solvency and extreme market movements: A regime switching approach

Abouraschi, N.; Clacher, I.; Freeman, M.; Hillier, D.; Kemp, M.; Zhang, Q.

Authors

N. Abouraschi

I. Clacher

M. Freeman

D. Hillier

M. Kemp

Q. Zhang

Abstract

We develop and test a new approach to assess defined benefit (DB) pension plan solvency risk in the presence of extreme market movements. Our method captures both the ‘fat-tailed’ nature of asset returns and their correlation with discount rate changes. We show that the standard assumption of constant discount rates leads to dramatic underestimation of future projections of pension plan solvency risk. Failing to incorporate leptokurtosis into asset returns also leads to downward biased estimates of risk, but this is less pronounced than the time-varying discount rate effect. Further modifying the model to capture the correlation between asset returns and the discount rate provides additional improvements in the projection of future pension plan solvency. This reduces the perceived future risk of underfunding because of the negative correlation between interest rate changes and asset returns. These results have important implications for those with responsibility for balancing risk against expected return when seeking to improve the current poor funding positions of DB pension schemes.

Citation

Abouraschi, N., Clacher, I., Freeman, M., Hillier, D., Kemp, M., & Zhang, Q. (2016). Pension plan solvency and extreme market movements: A regime switching approach. European Journal of Finance, 22(13), 1292-1319. https://doi.org/10.1080/1351847x.2014.946528

Journal Article Type	Article
Acceptance Date	Jul 9, 2014
Online Publication Date	Sep 23, 2014
Publication Date	Oct 20, 2016
Deposit Date	Mar 24, 2016
Publicly Available Date	Apr 5, 2016
Journal	European Journal of Finance
Print ISSN	1351-847X
Electronic ISSN	1466-4364
Publisher	Taylor and Francis Group
Peer Reviewed	Peer Reviewed
Volume	22
Issue	13
Pages	1292-1319
DOI	https://doi.org/10.1080/1351847x.2014.946528
Public URL	https://durham-repository.worktribe.com/output/1408371

Files

Published Journal Article (Advance online version) (1.1 Mb)
PDF

Publisher Licence URL
http://creativecommons.org/licenses/by/4.0/

Copyright Statement
Advance online version © 2014 The Author(s). Published by Taylor & Francis.
This is an Open Access article distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/
licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. The moral rights of the named author(s) have been asserted.