The Prospect of Defined Benefit Schemes in the Pension World

Abstract

This thesis will investigate the prospects of the defined benefit pension scheme. When pension funds offer a defined benefit pension scheme, they promise a guaranteed rate of return while holding all the risk. The current investment environment has changed to an unknown territory for investors, which challenges the rationale behind such a product. This can be seen in how the quantity of defined benefit pension schemes is in decline. Some rates have been negotiated at times where the market was able to generate a certain return. Now that the market has changed to the unpredictable, pension funds still stands with the same obligations.
With an extended mean variance analysis which takes the promised return on the technical provisions and the solvency capital requirement of VaR (99.5%) into account, optimal asset allocations are found. The methodology is built on data from the Danish Council for Pension Forecast, where the data reflects the assumptions of average annually expected returns and standard deviations for ten asset classes and the correlations between them. We find that low yielding bonds under the set model requirements still have an important place in an optimal portfolio. Where the high allocation in bonds is derived from the VaR constraint and the wish to minimize variance but also their strong diversification effects. But more importantly, the strict VaR constraint is creating an investment environment where the defined pension funds have to be overfunded to a high degree, in order to deliver returns that matches the guaranteed products with the highest promised returns. Furthermore, we find that alternative assets risk/return profile is the most desirable risky asset to combine with bonds to increase the expected return when minimizing the risk.
Under the set scenarios, the optimal allocations are then simulated with a Monte Carlo approach to calculate the probabilities of whether a defined benefit will be underfunded or not. We find that defined benefit pension schemes have a high probability of default. Too high guaranteed rates for a pension holder is a difficult task to complete in the current investment environment. We can conclude that, for the defined benefit pension schemes to survive, something needs to be done.