Valuation and Hedging of Variable Annuities in Pension Schemes

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Abstract

This paper explores defined ambition pension schemes that provide (deferred) variable annuities. These pension schemes allocate various risks (i.e., real interest rate, expected inflation and stock market risk) to the policyholders on the basis of complete contracts. We show how these variable annuities can be valued in a market-consistent fashion and how the insurer can adopt the principle of liability-driven investment. Market-consistent valuation is important for ensuring generational fairness and avoiding conflicts between the policyholders of the insurer. We show that the costs of variable real annuities may be less sensitive to the nominal interest rate than the costs of fixed nominal annuities, thereby reducing the nominal interest rate duration of the intertemporal hedging portfolio. This is especially so if stochastic variations in
risk aversion impact equity risk premia and a lack of financial assets results in an incomplete financial market.
Original languageEnglish
Place of PublicationTilburg
PublisherTilburg University
Number of pages55
Publication statusIn preparation - 2018

Keywords

  • variable annuities
  • conversion factor
  • market-consistent valuation
  • liability-driven investment
  • asset-driven liabilities

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