How Derivatives Can Help Solve the Pension Fund Crisis

Abstract

Properly constructed option strategies can add substantial value to pension fund management, according to a scenario-based asset-liability model that analyzes their effects on the risk-return profile of defined-benefit pension funds. The results are robust with respect to variations in horizon, equity risk premium, and volatility assumptions. The optimal strategy should be determined in an asset-liability context and not ad hoc, as the intuitively most appealing strategies are not necessarily the most effective. Different types of funds may require significantly different option strategies. What works well for one fund may be less effective or even counter-productive for another. Overall, incorporating options appears an efficient way to improve long-term pension fund health and thus the sustainability of defined-benefit pension plans.