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

Abouraschi, Niloufar and Clacher, Iain and Freeman, Mark C. and Hillier, David and Kemp, Malcolm and Zhang, Qi (2016) Pension plan solvency and extreme market movements : a regime switching approach. European Journal of Finance, 22 (13). pp. 1292-1319. ISSN 1351-847X (https://doi.org/10.1080/1351847X.2014.946528)

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Abstract

We develop and test a new approach to assess defined benefit 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 e§ect. 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 defined benefit pension schemes.

ORCID iDs

Abouraschi, Niloufar, Clacher, Iain, Freeman, Mark C., Hillier, David ORCID logoORCID: https://orcid.org/0000-0002-1591-4038, Kemp, Malcolm and Zhang, Qi;
  • Item type:Article
    ID code:49149
    Dates:
    Date
    Event
    31 January 2016
    Published
    23 September 2014
    Published Online
    9 July 2014
    Accepted
    Notes:Published as part of the special Issue of papers presented at the Fifth International Conference on Mathematical and Statistical Methods for Actuarial Sciences and Finance. This is an Accepted Manuscript of an article published in European Journal of Finance on 23/09/2014, available online: http://www.tandfonline.com/10.1080/1351847X.2014.946528
    Subjects:Social Sciences > Commerce > Accounting
    Social Sciences > Finance
    Department:Strathclyde Business School > Accounting and Finance
    Depositing user: Pure Administrator
    Date deposited:09 Sep 2014 13:37
    Last modified:11 Nov 2024 10:46
    URI:https://strathprints.strath.ac.uk/id/eprint/49149
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