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How Derivatives Can Help Solve the Pension Fund Crisis

Huub F. van Capelleveen, Harry M. Kat and Theo P. Kochen


In this paper we use a scenario-based ALM model to study the effects
on the risk-return profile of defined benefit pension funds from including
options in the pension fund portfolio. Our results show that properly
constructed option strategies can add substantial value to pension fund
management. The results are robust with respect to variations in horizon,
equity risk premium and volatility assumptions. The optimal strategy, however,
should be determined in an asset- liability context and not ad hoc, as the
intuitively most appealing strategies are not necessarily the most effective.
In addition, we find that 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 of improving long-term pension fund health and therefore the
sustainability of defined benefit pension schemes.