Pension Liability Valuation And Asset Allocation In The Presence Of Funding Risk

The current practice of valuing pension liabilities using discount rates that do not reflect the risk inherent in the pension promise has no foundation in financial economics. The authors propose a new valuation approach that utilizes the term structure of funding-risk-adjusted discount rates. When a pension plan maximizes the expected utility of the terminal risk-adjusted funding ratio, discount rates and portfolio weights become interdependent and can be determined in a single optimization step. The resulting asset allocation varies with the initial funding ratio of the pension plan.