Unhedgeable Inflation Risk within Pension Schemes

Roel Beetsma, Damiaan Chen and Sweder van Wijnbergen

No 13742, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Pension schemes generally aim to protect the purchasing power of their participants, but cannot completely do this when due to market incompleteness inflation risk cannot be fully hedged. Without a market price for inflation risk the value of a pension contract depends on the investor's risk appetite and inflation risk exposure. We develop a valuation framework to deal with two sources of unhedgeable inflation risk: the absence of instruments to hedge general consumer price inflation risk and differences in group-specific consumption bundles from the economy-wide bundle. We find that the absence of financial instruments to hedge inflation risks may reduce lifetime welfare by up to 6% of certainty-equivalent consumption for commonly assumed degrees of risk aversion. Regulators face a dilemma as young (workers) and old participants (retirees) have different capacities to absorb losses from unhedgeable inflation risks and as a consequence have a different risk appetite.

Keywords: Unhedgeable inflation risk; Welfare loss; Incomplete markets; Pension contract; Valuation (search for similar items in EconPapers)
JEL-codes: C61 E21 G11 G23 (search for similar items in EconPapers)
Date: 2019-05
New Economics Papers: this item is included in nep-age, nep-mac, nep-rmg and nep-upt
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Journal Article: Unhedgeable inflation risk within pension schemes (2020)
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