Valuing and Hedging Defined Benefit Pension Obligations

This study revisits two related questions that are fundamental for evaluating proposals for DB pension policy reform -- what is the value of DB pension liabilities, and what investment strategy provides the best hedge of pension obligations? The model takes an options pricing approach, and recognizes that earnings growth and stock returns are positively correlated over long horizons. It provides testable predictions about how pension plan portfolios would vary with differences in firm and worker characteristics if the investment goal of management is to hedge pension liabilities. The model predicts that a large share of a hedge portfolio for active workers would be invested in stocks, with the share in stocks declining as employees age. For companies with relatively few retirees and separated workers, the observed investment practice appears roughly consistent with a hedging strategy. For the many firms with a high proportion of retirees and separated workers, however, a hedge portfolio would be invested almost entirely in bonds, a prediction sharply at odds with observed behavior. Empirical evidence on how pension investment policy varies with the share of active relative to total participants supports the prediction that firms with a greater percentage of active workers invest more heavily in stocks, although the overall allocation to stocks is much higher than predicted by a hedging demand. Stock holdings also appear to increase with the firm