Valuation and risk management of inflation sensitive pension rights

The introduction of the new international accounting standard requires that assets and liabilities are valued at market value. Since pension liabilities are generally to some extent indexed according to inflation, this provides new challenges for both valuation and risk management. This paper discusses models that can be used to determine the fair value of inflation-sensitive pension rights. In addition, we show how these models can be used in risk management applications and we emphasize the discrepancy between currently popular methodologies, like duration analysis. We show that in case of pension schemes where indexation is conditional on the state of the pension fund, the value of the liabilities is determined by an interplay between economic variables, like interest ratesand inflation, and the asset mix. A thorough understanding of such dependencies is crucial in order to come to a proper assessment of the risks to which the liabilities are exposed.