DP13742 Unhedgeable Inflation Risk within Pension Schemes

Author(s): Roel Beetsma, Damiaan Chen, Sweder van Wijnbergen
Publication Date: May 2019
Keyword(s): incomplete markets, pension contract, Unhedgeable inflation risk, Valuation, welfare loss
JEL(s): C61, E21, G11, G23
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13742

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.