Market Valuation, Pension Fund Policy and Contribution Volatility

Abstract

Market valuation is becoming more and more popular, both in accounting and regulation, as well as in academic circles. For pension funds and their participants, the knowledge that market-valued pension liabilities can indeed be transferred to a third party, if necessary, is a great virtue. Using a simulation model, this paper demonstrates the implicit costs and benefits of using market valuation for a typical Dutch pension fund, which offers a guaranteed average pay nominal pension with conditional indexation. The impact turns out to be fairly small, if fixed discount rates are still used for conditional rights. However, if market valuation is used for both unconditional and conditional rights, contribution volatility increases significantly. A remedy is to increase the duration of assets considerably. It is not clear, though, whether this option is available for large pension funds given the limited supply of long-term bonds.

Keywords: asset and liability management, fair value versus actuarial discounting, defined benefit pension funds, Monte Carlo simulation, pension liabilities, conidtional indexation

JEL Classification: G23, C15, C59, J18