The Discount Rate Debate and Its Implications for Defined Benefit Pensions

Woon Wong ()

No E2018/22, Cardiff Economics Working Papers from Cardiff University, Cardiff Business School, Economics Section

Abstract: Since defined benefit (DB) pensions are guaranteed, they are often priced using risk-free interest rates. This paper shows how time diversification limits the cost of guarantying DB pensions to no more than the required cash contributions to pay for outgo, which can be significantly cheaper than the risk-free interest rate approach. The discrepancy can be explained by the incompleteness of financial markets for pensions and hence the breach of Ross s (1976) arbitrage-free conditions to price DB benefits using interest rates. Given the current negative interest rates, it is optimal to hold more equity so that the increased risk can be mitigated by cash contributions, a higher funding ratio and long investment horizon. The above findings are applied to the Universities Superannuation Scheme, the largest privately funded DB scheme in the UK. Overlooking the role of cash contributions in mitigating risks is identified as the main reason for the scheme s deficits.

Keywords: pension; defined benefit; time diversification; de-risking; USS (search for similar items in EconPapers)
Pages: 29 pages
Date: 2018-11
New Economics Papers: this item is included in nep-age and nep-rmg
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Citations: View citations in EconPapers (3)

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Working Paper: TThe Discount Rate Debate and Its Implications for Defined Benefit Pensions (2018)
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