Pension liability valuation and asset allocation in the presence of funding risk

Defined benefit pension liabilities are usually computed by discounting future pension promises with yields of 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 future funding ratios. We show that an optimal asset allocation which accounts for this dependency varies in a nonlinear way with the initial funding ratio of the pension plan.