Curious contracts: Pension fund redesign for the future

by Theo P Kocken

ISBN 90-72194-78-0

241 pages hardback

Available free of charge from

Tutein Nolthenius,’s-Hertogenbosch

n December 11, 2006, Theo Kocken of Cardano Risk Management in Rotterdam, The Netherlands defended his PhD thesis ‘Curious Contracts’. His thesis contains a number of interesting, innovative elements, which imply an entirely new way of looking at pensions and the future of pensions provision.

Kocken views a corporate pension fund as a package of embedded options and analyses the implications for pension redesign and hedging. The three most important options identified are: (1) the indexation option, ie the obligation of the beneficiaries to waive (wage or price inflation) indexation when the fund’s funding ratio drops below a certain level, (2) the employer guarantee option, ie the obligation of the parent company to restore the fund’s funding ratio to a certain level, and (3) the default option, ie the credit exposure of the beneficiaries to a simultaneous default of the parent company and a funding deficit in the pension fund.

The latter option is certainly not hypothetical. In the US, the Pension Benefit Guarantee Corporation is looking at an expected loss for US beneficiaries due to defaults of companies with funding deficits of no less than $100bn (€76.8bn).

Proper valuation and sensitivity analysis of the above three options provides a number of insights. It shows for example that the relative risks, which employers and beneficiaries take in a pension fund depend heavily on the employer’s credit rating, the pension fund’s volatility and the funding ratio of the fund. In case of an AAA-rated sponsor with a highly volatile fund and low funding ratio, the employer is the risk taker. In a pension fund with a high funding ratio and a low rated mother company on the other hand, the beneficiaries absorb most of the risks.

All around the western world, the combination of an ageing population, new accounting rules, new regulation and adverse market conditions has changed employers’ attitude from risk takers to risk avoiders. This has led to a system in which employers will only provide a stable contribution rate.

The retreat of the employer as a risk taker has led to a completely new distribution of risks in pension funds. Using his embedded options approach, Kocken makes it painfully clear that the redistribution of wealth between active participants and retirees will eventually derail. In the long run, a shift to individual DC will, in the current collective pension fund design, make the active participants better off. This is true irrespective of the lack of solidarity and inflation indexation, which this implies.

Kocken shows that in a system without employers both risk and return are negatively skewed towards active participants. His thesis arrives at a solution, which unifies the best features of two competing systems: DB pension plans and Life Cycle DC plans. In Kocken’s ideal system, collective risk sharing is still possible, but only by transferring options at fair market prices. This means that people closer to retirement take less risk. Younger people take most of the risks, but with higher upside potential than they have today; a fair risk-return trade-off therefore.

Kocken’s collective risk sharing system between active participants and retirees does not require any additional solvency on top of the collective pensions sum. This stems from the fact that in his new pension system, active participants provide a kind of guarantee to the retirees.

In fact, active participants’ wealth accumulation serves as the equity (read: solvency) for the retirees, who implicitly own the senior debt of the pension fund. This implies that pension fund capital requirements, which in The Netherlands for example amount to 20%-30% of total pension liability value, can be abandoned.

In summary, Kocken’s approach provides an interesting solution to many current problems in the pensions industry. As such, this thesis is highly recommended reading for everyone interested in the future of our pensions system.

Harry M Kat is professor of risk management and director of the Alternative Investment Research Centre Cass Business School in London