Measuring the cost of regulatory funding ratio constraints for defined benefit pension plans

  • Yuan Yue Yuan Yue

As a risk management tool, pension regulators require pension funds to maintain their short term and nominal funding ratios higher than a certain level with a high probability, while pension funds typically have long term and real ambitions. This thesis aims at measuring the effects of such regulatory constraints on pension funds’ investment decisions. We address the problem in a complete market where equity risk, stochastic interest rate and stochastic inflation are present.
We find that regulatory constraints significantly limit pension funds’ portfolio choice. When the funding ratio constraints are binding, pension funds are forced to hold more nominal assets
and less equity than without constraints, thus leading to utility losses. The utility losses are more significant when constraints are short term as opposed to long term and when investors are less risk
averse. When stochastic interest rate and stochastic inflation is present, the constrained investors suffer from much less utility losses compared to the myopic portfolio case because of the demand
to hedge the liabilities. Another important finding of our paper is that when the current funding ratio is close to the regulatory “floor”, investors with different risk aversion hold similar portfolios since they are obliged to meet the constraints and have to put their own risk appetite aside in such situations.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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