Working Paper: CEPR ID: DP13742
Authors: Damiaan Chen; Roel Beetsma; Sweder van Wijnbergen
Abstract: Pension schemes generally aim to protect the purchasing power of their participants, but cannot completely do this when due to market incompleteness inflation risk cannot be fully hedged. Without a market price for inflation risk the value of a pension contract depends on the investor's risk appetite and inflation risk exposure. We develop a valuation framework to deal with two sources of unhedgeable inflation risk: the absence of instruments to hedge general consumer price inflation risk and differences in group-specific consumption bundles from the economy-wide bundle. We find that the absence of financial instruments to hedge inflation risks may reduce lifetime welfare by up to 6% of certainty-equivalent consumption for commonly assumed degrees of risk aversion. Regulators face a dilemma as young (workers) and old participants (retirees) have different capacities to absorb losses from unhedgeable inflation risks and as a consequence have a different risk appetite.
Keywords: unhedgeable inflation risk; welfare loss; incomplete markets; pension contract valuation
JEL Codes: C61; E21; G11; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of financial instruments to hedge general consumer price inflation risk (G19) | significant reduction in lifetime welfare (D69) |
| differences in consumption bundles between young workers and retirees (J26) | exacerbation of welfare loss associated with unhedgeable inflation risk (D69) |
| inability to hedge inflation risk (G19) | significant disparities in welfare outcomes across age groups (I39) |